CHARACTER MATTERS!

 

Let’s start at the beginning. An early consideration of ethics and integrity, our character:

 ·         Definitions from Webster’s American Dictionary of the English Language, 1828 Edition:

Ø  Ethics:  1. The doctrines of morality or social manners; the science of moral philosophy, which teaches men their duty and reasons for it.  2.  A system of moral principles; a system of rules for regulating the actions and manners of men in society.

Ø  Integrity:  The entire unimpaired state of anything, particularly of the mind; moral soundness or purity; incorruptness; uprightness; honesty.  Integrity comprehends the whole moral character but has a special reference to uprightness in mutual dealings, transfers of property, and agencies for others.

High integrity and good ethics can be a foundation that enables us to achieve harmony among all the areas of life.   A character of high integrity and good ethics just simply makes life easier and a lot more fun!  A person’s character becomes his/her reputation.  Character matters in both one’s personal and professional life. 

Character vs. Compliance

Corporations registered with the SEC are required by the Sarbanes-Oxley Act to develop and publish a Code of Conduct for their employees. A Code of Conduct will not automatically cause all employees to perform their jobs with integrity, but the Code does communicate basic standards of behavior expected of them. Here is some illustrative content of a basic Code of Conduct for nonprofit and for-profit organizations:

·         Use of organization assets and resources for business and not personal use.

·         Using telephones, emailing, texting and the internet.

·         Avoiding actual and potential conflicts of interest.

·         Protecting the organization’s confidential information.

·         Maintaining complete and accurate accounting records.

·         Investigating and reporting any accounting, auditing and disclosure concerns.

·         Retaining and disposing of records and documents.

·         Prohibiting discrimination and harassment.

·         Prohibiting use of alcohol and illegal drugs.

·         Complying with laws, rules and regulations.

·         Protecting intellectual property and using copyrighted materials.

·         Giving and receiving gifts, meals, services and entertainment.

·         Understanding disciplinary actions for code violations.

·         Reporting concerns and code violations.

These issues underpin all job responsibilities and are intended to influence the behaviors of employees of an entity.  They are requirements for acceptable behavior seeking the compliance of employees. Most individuals, however, have behaviors formed through personal experience and life paradigms.  A person born and raised in a religious family will usually follow the norms in his/her family DNA. A crime family, on the other hand, may raise their children with different norms. While such individuals may endeavor to adhere to professional requirements as listed above, their behavior will always be influenced by their upbringing. Changing that behavior, therefore, must begin with adherence to all professional ethics requirements.

 What about one’s personal life?

 Ethical behavior is, however, not just based on compliance with standards or rules. It is also based on our perception of right and wrong. I once served five years in a southern Colorado penitentiary…AS A VOLUNTEER. In those years, I witnessed many different perspectives of right and wrong! Ethical behavior begins with standards and rules, but our individual life perspective determines our behavior. Our behavior produces our character. Our character is, in fact, the result of our thoughts and actions, particularly when no one is watching!

 So, then, how can an individual facilitate change to improve one’s character and not be trapped by preset behavior paradigms? Oswald Chambers offer this: “Drudgery is the cornerstone of character.” Here is some food for thought.

Practicing new habits may seem like drudgery but the new habits can become instinctive and part of our character. A decade or so ago, several large corporations were experiencing high employee turnover rates, mainly due to their autocratic style of management that had evolved over the years. They began to train management personnel in servant leadership principles, i.e., focusing on serving employees by helping them meet their needs and career objectives.  Not long after, these new habits of serving others became instinctive and employees were motivated to better job performance and practicing servant leadership as they advanced in their positions.

Becoming more others-centered, rather than self-centered, motivates rather than manipulates. It also helps develop mutually-satisfying relationships. Making change, however, is not for the weak. It requires deep introspection, accountability for our misbehavior, drudgery and actually making behavior changes while seeking accountability from others.

Clarified Auditing Standard, Audit Evidence (AU-C 500)—Part 2: More Types of Tests

Analytical Procedures (AU-C 520)

Analytical procedures consist of absolute comparisons of dollar balances with prior years’ account balances, or with budgets, ratio comparisons and trend analysis, and computations based on financial or operational data designed to predict the balance in a general ledger account. Analytical procedures also extend beyond numerically-based procedures to become a part of an auditor’s thought process. Challenging financial information or the lack of such information that appears unusual, maintaining a positive, healthy skepticism when considering client responses to inquiries, and searching for the cause of a problem beyond its symptoms are examples of analytical thinking. The term “professional skepticism” is used in the literature to describe this kind of thinking. It is loosely defined as neither blindly trusting every client or, on the other hand, considering each client dishonest as information is gathered.

The most common analytical procedures are corroborative in their nature. Their primary purpose is to corroborate evidence gathered from other tests designed to enable an auditor to evaluate financial statement assertions.

When the results of analytical procedures contribute evidence to evaluate financial statement assertions, related tests of balances can be reduced at least to a limited extent. The extent of the reductions of tests of balances depends on the effectiveness of the analytical procedures. Determination of the effectiveness of a procedure must be based on the procedure’s contribution of evidence for evaluating the financial statement assertions. Computations designed to predict the balance in a general ledger account based on audited financial or operational data, e.g. quantity reconciliations and reasonableness tests, are the most effective analytical procedures. Corroborating procedures performed at lower levels of detail are more effective than corroborating procedures based on balances of financial statement classifications.

Examples of analytical procedures, in the order of their effectiveness, are:

1.      Quantity reconciliations:

Multiplying the number of units sold times sales price or the number of employees times weekly or monthly salaries, for example, can contribute evidence that will enable an auditor to evaluate substantially all the financial statement assertions for the applicable general ledger account. Only a few other tests of balances would ordinarily be necessary for the affected accounts if the data used in the computations has been audited.

To achieve maximum effectiveness, the reliability of the underlying data for these procedures must be established by other tests. For example, performing a quantity reconciliation for copy sales by a quick-copy business would simply require multiplying the number of copies sold times sales price. The number of copies could be obtained from the client’s copy log; however, beginning and ending numbers from the meter would need to be physically obtained to establish the reliability of the log. To determine the meter had not been altered, it may also be necessary to trace the number of copies to billings for copy machine rentals from the supplier. Copy prices would have to be determined by references to sales tickets or price lists.

2.       Reasonableness tests:

Depreciation computations performed by computing depreciation by financial statement classification and method, based on average lives and one-half year for additions and disposals, is an example of a reasonableness test. Computing interest expense based on average note balances and interest rates is another example.

Different from quantity reconciliations, reasonableness tests are based on averages and estimates. Reasonableness tests are not as effective as quantity reconciliations in providing evidence to evaluate financial statement assertions. Since they are usually applied to smaller account balances, however, other tests of balances may not be necessary. Other limited tests of controls or balances may be necessary to complete the evaluation of the relevant assertions for material balances.

3.      Corroborating procedures:

The most common analytical procedures, such as absolute dollar comparisons of account balances and ratio analysis, provide evidence that corroborates other tests of controls and balances. While using corroborating analytical procedures may enable some modification of the nature, extent and timing of tests of balances procedures, more tests of balances procedures will ordinarily be necessary for satisfactory evaluation of the financial statement assertions.

The lower the level of detail of the corroborating procedures, the more effective they are. Gross profit margin computed by product line, for example, is more effective than when computed using amounts in financial statement classifications. Risks of material misstatements, in other words, are more easily identified using corroborating procedures at lower levels of detail.

SAS No. 56, redrafted in AU-C 520, Analytical Procedures, instructs auditors to perform analytical procedures during the planning phase of an engagement to help identify potential risks of misstatements. SAS No. 109, redrafted in AU-C 315, re-emphasizes the use of analytical procedures as risk assessment procedures. Analytical procedures should also be used during the review phase of an engagement to evaluate the results of an auditor’s completed work.

Minimum analytical procedures performed during planning may consist of comparing material unadjusted, current year account balances with prior year final balances. Significant variances usually indicate the need for adjusting journal entries. These differences should be investigated, documented in the working papers and, if necessary, adjustments proposed to correct errors or post year-end adjustments.

Placing high reliance on corroborating or predictive procedures requires, simply, that all variances are investigated and appropriate corrective action is taken by an auditor. From the investigation, the auditor may determine that the variance is not indicative of a problem or, on the other hand, that it is caused by an error or conditions that could cause errors in financial information. The auditor may, or may not, determine adjustments are necessary.

If analytical procedures can be performed extensively for high reliance during planning, related tests of balances procedures should be reduced. If extensive analytical procedures cannot be performed until engagement completion, as in the case of small clients with weak accounting systems, past experience can be relied upon to anticipate favorable results and plan for reductions in tests of balances. To repeat this significant time-savings opportunity, reductions in tests of balances evidence may be achieved by placing high reliance on analytical procedures performed during the risk assessment process.

Tests of Balances

Substantive tests of the details of general ledger account balances include the following:

·        Physical examination of assets.

·        Confirmation of account balances.

·        Inspection of support for transactions and balances.

·        Observation of the work of client personnel.

·        Inquiries of client personnel.

·        Tests of the mechanical accuracy of balances.

The substantive tests of balances make the most substantial contributions of evidence for evaluating the financial statement assertions. The larger the engagement, the higher the costs of obtaining most evidence from the tests of balances will likely be. When the client has good internal control procedures or a good accounting system, high reliance on tests of balances may not be the most efficient audit strategy. On some engagements, auditing in the least amount of time may best be accomplished by a combination of evidence from risk assessment procedures including tests of controls and/or systems walk-through procedures, analytical procedures and tests of balances. The auditor should always endeavor to design an audit strategy that produces necessary evidence in the least amount of time.

More Information

These eBook resources, without CPE credit, can be obtained from my website, www.cpafirmsupport.com :

• Small Audits Made Easy and Profitable
• Performing Auditing Tests of Balances Procedures
• Staff Training Series for Entry-Level Accountants, New In-Charge Accountants and Engagement Leaders
• Key Accounting Issues for Non-Profit Organizations
• A Practical Potpourri of Time Savings on Audits
• The Financial Reporting Framework for Small- and Medium-Sized Entities

My exclusive presentation of webcasts on CPE Credit.com and self-study courses covering various applications of auditing standards can be accessed by clicking the appropriate box on the left side of my home page, www.cpafirmsupport.com. Registered users accessing webcasts or self-study courses on my website receive a 20% discount on CPE materials presented by myself and numerous other authors on a variety of professional topics.

My assistance in CPA firm quality control consulting, audit planning and peer review preparation can be obtained by sending an email using the “Contact Us” tab on my home page.

Clarified Auditing Standard, Audit Evidence—Part 1 (AU-C 500)

AU-C Section 500 describes the sufficiency and appropriateness of audit evidence in the following paragraphs

.A4 Sufficiency is the measure of the quantity of audit evidence. The quantity of audit evidence needed is affected by the auditor's assessment of the risks of misstatement (the higher the assessed risks, the more audit evidence is likely to be required) and also by the quality of such audit evidence (the higher the quality, the less may be required). However, obtaining more audit evidence may not compensate for its poor quality.

.A5 Appropriateness is the measure of the quality of audit evidence (that is, its relevance and reliability in providing support for the conclusions on which the auditor's opinion is based). The reliability of evidence is influenced by its source and nature and is dependent on the individual circumstances under which it is obtained.

General types of audit procedures are also discussed in this statement:

.A10 As required by and explained further in section 315 and section 330, audit evidence to draw reasonable conclusions on which to base the auditor's opinion is obtained by performing the following:

a. Risk assessment procedures

b. Further audit procedures, which comprise

i. tests of controls, when required by the AU-C sections or when the auditor has chosen to do so, and

ii. substantive procedures, which include tests of details and substantive analytical procedures.

A Brief Discussion of Basic Types of Tests

To build the foundation for designing the most cost-beneficial audit strategies, a thorough knowledge of the basic types of tests recognized in AU-C 500 is necessary.

Tests of Controls—Compliance Transactions Tests (author’s words)

Compliance tests are designed as tests of internal control procedures or activities to determine:

1.      The frequency with which the control procedures are performed.

2.      The quality of the performance of the control procedures.

3.      The person performing the procedures.

4.      The design effectiveness of the procedures.

Compliance tests of controls are performed to measure the likelihood of errors occurring and going undetected and to reduce the amount of substantive testing. Compliance procedures consist mainly of observations, inspections and inquiries. Documented evidence of the internal control procedures performed by a client personnel is necessary to evaluate compliance for larger entities with effectively designed internal controls. Examining a foreperson’s approval of hours worked on employees’ time cards, for example, is a compliance test of control. Materiality is measured by the frequency of errors.

Owners or managers for small entities may perform key controls that are not documented. In these circumstances, the auditor can assess compliance by making inquiries of an owner or manager, evaluating their responses, and documenting their compliance in a memo or on a working paper.

Tests of Controls—Substantive Transactions Tests (author’s words)

A substantive transactions test is a test of the accounting system and is normally designed to test for monetary errors. Determining that all entries recorded in the cash disbursements journal are valid by examining supporting documents, or that the extension of sales prices and units on sales invoices are correct, are examples of substantive transactions testing procedures. Tests of controls are often used as “dual-purpose” tests, i.e., both compliance and substantive tests of transactions are performed. While both may supply sufficient evidence for evaluation of applicable financial statement assertions, auditors can be more efficient by performing one or the other. Only a “handful” (10%-20%) of the transactions need be tested substantively if compliance tests are chosen.

If a client has limited internal controls, but has a solid accounting system, an auditor may perform only substantive transactions tests or make an assessment of control risk using other procedures such as a systems walk-through procedure, or tests of an owner/manager’s key controls by making inquiries and/or observations of procedures and inspection of documents.

System’s Walk-Through Procedure

The system’s walk-through procedure is often the most cost-efficient, annual risk assessment procedure auditors can use, and is discussed in the auditing standards. It is performed by tracing documents and data through the accounting system from the inception of transaction cycles to their termination. Its primary purpose is to provide a good understanding of the accounting system and any control procedures or activities for risk assessment purposes. Ordinarily 5-10 transactions will be selected for this purpose; selecting more transactions will increase the substantive evidence from this procedure.

The walk-through procedure, coupled with good prior year experience with a client and evidence from reading general ledger account activity, may permit an assessment of control risk at slightly less than high to moderate. An auditor may be able to use lesser reliable procedures (nature) for small details of an account balance, lesser audit coverage of an account balance (extent), and/or perform some procedures before year-end (timing) at these lower risk levels. This procedure, considered along with other risk assessment procedures, can provide substantive evidence that enables the auditor to plan an audit strategy that reduces tests of balances procedures.

Reading (Scanning) the General Ledger 

One of the most pervasive analytical procedures is reading, or scanning, the general ledger account activity. Whether done manually, or with the assistance of data extraction software, this analytical procedure is discussed for the auditing standards.

Many auditors perform this procedure but fail to consider its affect on their audit strategy. After any errors are corrected by proposed journal entries, the auditor has obtained significant, substantive evidence that relevant assertions for many account balances are reasonable. The evidence obtained from this risk assessment procedure should enable the auditor to reduce the assessed level of risk of material misstatement and, therefore, the extent of evidence desired from detailed tests of balances.

This procedure is usually performed by looking for unusual amounts or postings, transactions or general journal entries greater than the lower limit for individually significant items, checks or disbursements to be used in support tests, and other unusual matters. Documentation of the procedure should include the parameters of the test, the exceptions the test revealed and the resolution of the exceptions in a spreadsheet, memo or other working paper. Other modules of this small audit series discuss a General Ledger Analysis Worksheet (an Excel spreadsheet) as the most efficient documentation for listing and following up on unusual matters.

AU-C 620, Using the Work of an Auditor’s Specialist, differs from the previous AU section only in that management’s specialists’ issues are discussed in the Clarified Auditing Standard on quality control.  The auditor has responsibility to evaluate the reputation of any specialist used in and audit and the auditor must have at least a general knowledge of the processes used by the specialist.

Analytical procedures and tests of balances will be discussed in Part 2 of this article.

More Information

These eBook resources, without CPE credit, can be obtained from my website, www.cpafirmsupport.com :

• Small Audits Made Easy and Profitable
• Performing Auditing Tests of Balances Procedures
• Staff Training Series for Entry-Level Accountants, New In-Charge Accountants and Engagement Leaders
• Key Accounting Issues for Non-Profit Organizations
• A Practical Potpourri of Time Savings on Audits
• The Financial Reporting Framework for Small- and Medium-Sized Entities

My exclusive presentation of webcasts on CPE Credit.com and self-study courses covering various applications of auditing standards can be accessed by clicking the appropriate box on the left side of my home page, www.cpafirmsupport.com. Registered users accessing webcasts or self-study courses on my website receive a 20% discount on CPE materials presented by myself and numerous other authors on a variety of professional topics.

My assistance in CPA firm quality control consulting, audit planning and peer review preparation can be obtained by sending an email using the “Contact Us” tab on my home page.

Clarified Auditing Standard--Performing Audit Procedures in Response to Assessed Risks and Evaluating the Audit Evidence Obtained (AU-C 330)

Risk Assessment and Responses to Assessed Risks

This standard requires the auditor to design and implement overall responses for the assessed risks of material misstatement at the financial statement level. Overall responses at higher levels of risk may include assigning more experienced personnel to the engagement, providing increased supervision by the engagement leader and planning more reliable and more extensive detailed tests of balances procedures.

Audit Procedures Responsive to the Assessed Risks of Material

Misstatement at the Relevant Assertion Level

Following are essential requirements from AU-C 330 paragraphs:

.06 The auditor should design and perform further audit procedures whose nature, timing, and extent are based on, and are responsive to, the assessed risks of material misstatement at the relevant assertion level.

.07 In designing the further audit procedures to be performed, the auditor should

a. consider the reasons for the assessed risk of material misstatement at the relevant assertion level for each class of transactions, account balance, and disclosure, including

i. the likelihood of material misstatement due to the particular characteristics of the relevant class of transactions, account balance, or disclosure (the inherent risk) and

ii. whether the risk assessment takes account of relevant controls (the control risk), thereby requiring the auditor to obtain audit evidence to determine whether the controls are operating effectively (that is, the auditor intends to rely on the operating effectiveness of controls in determining the nature, timing, and extent of substantive procedures), and

b. obtain more persuasive audit evidence the higher the auditor's assessment of risk.

Practical Considerations for Audit Responses

Selecting the Audit Strategy:

To select the proper strategy and prevent over auditing, the auditor must consider (1) the opportunity to assess risk of material misstatement at less than high and (2) the relative efficiency with which substantive tests of balances procedures can be performed.  When a reporting entity has good internal controls and/or a good financial reporting system, using tests of controls may be the most cost-efficient strategy.  However, when an auditor can perform other risk assessment procedures on smaller audits, e.g., reading the general ledger and performing a systems walk-through procedure and then making at least slight reductions in substantive tests of balances to evaluate applicable financial statement assertions in minimum time, detailed tests of controls would not ordinarily be necessary.  

Since the evaluation of the risk of material misstatement is made at both the financial statement and the assertion levels, and because performance materiality (tolerable misstatement) must be determined for each material financial statement classification, the auditor may achieve efficiencies by planning unique audit strategies for each financial statement classification.

Effects of Inherent Risks:

As an auditor considers the design of an audit strategy, it is important to remember the higher the inherent risk in a transaction or balance, the higher the reliance normally required for tests of balances procedures. However, it is the combination of inherent risk and control risk that determines the assessed levels of RMM.  Tests of controls or systems walk-through procedures may provide evidence to mitigate higher inherent risks in account balances or classes of transactions.

Effects of Control Environment on Control Risk:

The more effective an entity’s control environment is, the lower the control risk.  The lower the control risk, the lower the necessary reliance on detailed tests of balances.  A more effective control environment normally results in a stronger financial reporting system and even effective owner or manager key controls, particularly on smaller audits.  A less effective control environment normally results in deficiencies in the design and operation of internal control activities.

Effects of Low-Reliance Tests of Controls or Systems Walk-Through Procedures:

Deciding to perform low-reliance tests of controls, other risk assessment procedures and/or system’s walk-through procedures when an entity has a good financial reporting system and control environment may permit an evaluation of risk of material misstatement at slightly less than high to moderate, even on smaller audits.  When risk of material misstatement is slightly less than high or moderate, the extent of some sampling and non-sampling procedures may be reduced.

These limited reductions of tests of balances will generally occur by:

• Raising the lower limit for individually significant items from approximately 10% of performance materiality (high risk) up to 50-60% for financial statement classifications or relevant assertions.
• Using less reliable procedures for the lower stratum in a sampling population, such as sending negative confirmations for small accounts receivable balances.
• Risk factors on a sampling planning and evaluation form can be reduced somewhat.  Without good prior experience with the client, and without significant substantive evidence from analytical procedures, the risk factor would be close to 3.0.  These factors remaining the same and control risk at slightly less than high or moderate may allow a risk factor of from 2.3 to 3.0.
• Certain detailed tests of balances procedures may be performed before the reporting date.  Accounts receivable, for example, may be confirmed up to 30 days before the engagement date, along with performance of appropriate roll-forward procedures.

Effects of Analytical Procedures:

The more effective the analytical procedures used, the lower the amount of evidence required from detailed tests of balances.  High reliance presumes using analytical procedures to the maximum extent practical to generate substantive evidence to evaluate financial statement assertions. Quantity reconciliations, such as the number of units sold times sales price, or reasonableness tests for such accounts as depreciation, interest or payroll taxes generally produce more substantive evidence than corroborative procedures like comparing account balances or ratios among years.

Evaluating the Completeness Assertion:

When detailed tests of balances or analytical procedures can be performed to efficiently evaluate the completeness assertion, tests of controls are not necessary for this purpose.  Evaluating the completeness of revenues through detailed tests of balances, however, is difficult at best.  Examples of tests of balances that can be used to produce substantive evidence to evaluate the completeness assertion for revenues include examining contracts to determine all revenues that should be recorded are recorded (for the construction industry) or using predictive analytical procedures to determine the accuracy of recorded revenues or expenses, e.g., using copy machine meter readings for a copying business to compute copying revenues and copy machine rental expense. 

In other instances, limited tests of controls may be necessary to evaluate the completeness of revenues.  Tracing, say, 15 documents originating sales transactions such as customer orders or shipping reports to the sales journal is an example of a limited test of control procedure for completeness.  In some moderate risk circumstances, tracing 10-15 transactions through the sales and collections transaction cycle during the systems walk-through procedure may produce sufficient evidence to evaluate the completeness assertion.  Higher risk may require more transactions.

Nature, Extent and Timing of Detailed Tests of Balances:

Reductions in detailed tests of balances will occur in the nature, extent and timing of the procedures.  Ultimately, the integration of the results of the risk assessment procedures, the results of the analytical procedures and the nature, extent and timing of tests of balances procedures will culminate in audit strategies for account classifications as an auditor designs and performs sampling and non-sampling procedures.  The Clarified Auditing Standard, Audit Sampling, will be discussed later in this series.

More Information

These eBook resources, without CPE credit, can be obtained from my website:

• Small Audits Made Easy and Profitable
• Performing Auditing Tests of Balances Procedures
• Staff Training Series for Entry-Level Accountants, New In-Charge Accountants and Engagement Leaders
• Key Accounting Issues for Non-Profit Organizations
• A Practical Potpourri of Time Savings on Audits
• The Financial Reporting Framework for Small- and Medium-Sized Entities

Clarified Auditing Standards—Evaluation of Misstatements Identified During the Audit (AU-C 450)

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

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.

More Information

These eBook resources, without CPE credit, can be obtained from my website, www.cpafirmsupport.com :

• Small Audits Made Easy and Profitable
• Performing Auditing Tests of Balances Procedures
• Staff Training Series for Entry-Level Accountants, New In-Charge Accountants and Engagement Leaders
• Key Accounting Issues for Non-Profit Organizations
• A Practical Potpourri of Time Savings on Audits
• The Financial Reporting Framework for Small- and Medium-Sized Entities

Clarified Auditing Standards—Materiality in Planning and Performing an Audit (AU-C 320)—Part 2

In Part 1 of the article on AU-C 320, requirements of the standard, definitions and types of error were discussed.  This Part will focus on the practical application of the standard.

Preliminary Estimate of Materiality for the Financial Statements as a Whole (Planning Materiality)

Simply put, the preliminary estimate of materiality at the financial statement level is the maximum amount by which the auditors believe the statements could be misstated, by known or unknown error or fraud, and still not affect the decisions of reasonable financial statement users.  Clarified Auditing Standards require quantification of materiality levels, which are estimates of the perceptions of likely users of financial statements. These estimates guide auditors’ decision-making and design of auditing procedures.  Again, these estimates are only guides and are not specific determinations of what is, and is not, material in an audit.  The nature of engagement risks, the needs of financial statement users, and audit objectives provide information for the ultimate determination of materiality.

Usually, a single base such as the higher of total revenues or total assets is selected for the financial statements taken as a whole.  Once the base is determined, the dollar amount of the base is normally multiplied by a percentage factor, sometimes determined by the volume of the base, to determine the allowance for known and unknown error and fraud in the financial statements taken as a whole. Next, a percentage factor based on risk at the financial statement level is multiplied times planning materiality to determine tolerable misstatement, or performance materiality, which is the maximum amount of known and likely error (uncorrected error) an auditor can accept in the financial statements without adjustment.

A Practical Framework for Materiality Calculations

A general range of 50% to 75 % of planning materiality, based on moderate risk at the financial statement level, is commonly used to calculate tolerable misstatement (performance materiality) at the financial statement level.  Extremely low risk could enable an auditor to calculate performance materiality at an even higher level, say 80% to 90%. Lower risk at the financial statement level will result in fewer individually significant items.

When risk is high at the financial statement level, a lower level of tolerable misstatement can result by using a factor of 10% to 30%. This will result in a lower, lower limit for individually significant items and gathering more evidence from auditing smaller account balances, general journal entries, unusual transactions, etc. 

All the percentage factors illustrative above are based on an auditors’ professional judgment resulting from the assessed level of risk at the financial statement level. None of the factors are specified in the auditing standards.

Calculating Individually Significant Items

Individually Significant Items for Financial Statements Taken as a Whole:

Performance materiality (tolerable misstatement) is the base for determining the lower limit for individually significant items in the financial statements taken as a whole, ranging from 10% to 100% of performance materiality, depending on high risk or low risk respectively.  For engagements with higher risk of material misstatement at the financial statement level, individually significant items will generally be those account balances, transactions or general journal entries in excess of 10% to 30% of performance materiality.  When risk of material misstatement at the financial statement level is lower, a percentage of up to 100% may be used for determining individually significant items.  When risk is low at the financial statement level, the lower limit may be commonly calculated at 80% to 90% of performance materiality; moderate risk calculations may be 50% to 60% of tolerable misstatement and high risk 20% to 30%.  The determinations of appropriate percentages are matters of professional judgment based on the facts and circumstances of each engagement.

Individually Significant Items for Financial Statement Classifications—Assertion Levels

Clarified Auditing Standards clearly indicate that performance materiality (tolerable misstatement) is affected by risk.  Risk of material misstatement is often different for each financial statement classification. Because the lower limit for individually significant items is calculated based on performance materiality, and because performance materiality must be determined separately for each material financial statement classification, the lower limit for individually significant items will also vary by financial statement classification.  Performance materiality at the assertion or account classification level can range from 10% to 100% of performance materiality at the financial statement level. The same general rule of 10% to 100%, based on high or low risk, may be followed for calculating individually significant items at the assertion or account classification levels.

Some auditors have used 100% of tolerable misstatement at the financial statement level to determine the lower limit for individually significant items and sample sizes at the assertion level.  To reach this level of tolerable misstatement at the assertion level for sampling or non-sampling purposes, the risk assessment procedures must provide sufficient evidence to reduce the assessed level of risk of material misstatement to a very low level. Risk of material misstatement at account classification (assertion) levels for smaller entities ordinarily will be slightly less than high to moderate resulting in tolerable misstatement calculated at 30% to 60% of financial statement tolerable misstatement.

Part 3 of this materiality article will contain a discussion of how to perform good error analysis, which is the end of the risk assessment process.  A later article will discuss the Clarified Auditing Standard, Audit Sampling.

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