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.
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
