One of the most important engagement completion procedures to be performed by an in-charge accountant and/or an engagement leader is the final determination that there is an acceptable level of error, both known and unknown, remaining in the financial statements after all auditing procedures have been completed. This is the culmination of the risk assessment process and the final determination that detection risk has been reduced to an acceptable low level, thereby permitting an unqualified audit opinion on the financial statements. This Part will discuss this process.
AU-C 450 Requirements
AU-C 450 requires the auditor to accumulate misstatements discovered during the audit. If aggregated misstatements approach performance materiality for the financial statements as a whole or the individual account classifications, additional substantive procedures may be necessary. The size and nature of uncorrected misstatements should be considered individually and in the aggregate when performing error analysis.
Good error analysis should ordinarily be performed, of course, when an auditor evaluates the results of specific auditing procedures. It should contain both quantitative and qualitative analysis by the person performing the procedures. The comparison of aggregated known and likely error and performance materiality by financial statement classification (normally performed by the engagement leader during engagement completion) may indicate, however, the need for additional analysis when aggregated error approaches or exceeds performance materiality. It is possible that additional substantive procedures may still be necessary to reduce detection risk to an acceptable low level.
Aggregated known and likely error (uncorrected misstatements) should also be compared with the totals of material financial statement classifications (such as various current and long-term assets and liabilities, equity, revenues, expenses, net income, etc.) to determine if the level of known and likely error is acceptable. This could be called accounting materiality, i.e., evaluating aggregated uncorrected audit differences and likely error as a percentage of the financial statement classifications balances. Acceptable percentages of known and likely error will vary according to risk at the financial statement and assertion levels. Ultimately, the auditor will make these final materiality decisions based on how the user of the financial statements would evaluate the level of error. After appropriate qualitative error analysis and any necessary additional procedures have been performed, the auditor may propose general journal entries to correct certain known errors that have a material effect, individually or in the aggregate, on financial statement classifications.
Common acceptable percentages of error may be 1-2% of assets, liabilities, revenues and expenses and 5% for equity and net income; however, these percentages may vary depending on the planned use of the financial statements. The higher the risk associated with the use of statements, the lower are the acceptable percentages.
Performing Error Analysis
Contrary to the practices of some auditors, the use of a practice aid aggregating uncorrected misstatements is not to make the numbers come out right! The purpose is to make sure effective error analysis has been done. As mentioned above, error analysis should be both quantitative and qualitative. It may include:
a. Proposing adjustments for some or all of the actual errors.
b. Considering the nature of the projected or estimated errors to isolate causes for further investigation and corrective action.
c. Expanding auditing procedures in the areas that resulted in large amounts of projected or estimated errors.
Most commonly, an auditor’s error evaluation process will result in some combination of making adjustments for actual errors and “carving out” the causes of projected or estimated errors. From an efficiency standpoint, the last thing an auditor wants is to increase sample sizes and perform more sampling procedures!
Good error analysis includes consideration of both the error itself and the condition it may represent. Qualitative factors may cause small, seemingly isolated errors to have a material effect on the financial statements as a whole. Here are some qualitative factors that should be considered when evaluating error conditions:
a. Related-party transactions.
b. Errors resulting from conflicts of interest.
c. Errors arising from fraud or illegal acts.
d. Error effects that could be material in some future period.
e. Errors with psychological impacts, e.g., changing earnings from a small profit to a loss or changing cash in bank to an overdraft.
f. Errors symptomatic of larger problems, e.g., numerous sales returns, extensive product warranty claims.
g. Errors affecting contractual obligations such as covenants in debt agreements.
Qualitative error analysis is always necessary to determine that potential known and unknown error has been considered and, when necessary, that additional substantive procedures have been performed. Performing good error analysis is the key to reducing detection risk to an acceptably low level, which is required for issuing an unqualified audit opinion.
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- Staff Training Series for Entry-Level Accountants, New In-Charge Accountants and Engagement Leaders
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- The Financial Reporting Framework for Small- and Medium-Sized Entities