Misstatements sometimes left uncorrected, particularly when the
financial statements preparer detects them after the statements have been
produced and distributed. Using an auditor perspective, how do you treat
uncorrected misstatements?
Before discussing type of misstatements, how to evaluate and treat uncorrected misstatements, let us have a look at why uncorrected misstatements occur.
A common reason for leaving a misstatement uncorrected is that the preparer judges the figure as “immaterial”. Consider this:
A Financial statement preparer, by the accounting standard, is expected to exercise professional judgment in determining the level of materiality to apply, while on other side she is also expected to be able to cost-effectively prepare full and complete financial statements without delay. With high degree of pressure, during the year end, the financial statements are finally completed and distributed. Back to her desk, she finds some misstatements on the statement and consider, “no time to make correction, they are not material anyway”.
The preparer catches up timeliness at the cost of financial statement users—having inaccurate statements.
In worst cases, which are truly happened, the materiality concept has been used to rationalize the non-correction of errors that should have been dealt with, indeed, even to excuse errors known when first committed. The fact that the concept of materiality has sometimes been abused led to the promulgation of further guidance relative to error corrections.
Materiality, defined by the FASB, as:
Despite many efforts to develop a firm definition of materiality that have been made by academicians and the profession over the decades, a universally agreed-upon definition of materiality remains elusive, and thus a matter for professional judgment.
Although materiality judgments have traditionally been primarily based on quantitative assessments, the nature of a transaction or event can affect a determination of whether that transaction or event is material.
Example: Transaction that, if recorded, changes a profit to a loss or changes compliance with ratios in a debt covenant to noncompliance would be material even if it involved an otherwise immaterial amount.
Also, a transaction that might be judged immaterial if it occurred as part of routine operations may be material if its occurrence helps meet certain objectives.
Example: Transaction that allows management to achieve a target or obtain a bonus that otherwise would not become due would be considered material, regardless of the actual amount involved.
The individual accountant, therefore, must exercise professional judgment in evaluating information and concluding on its materiality.
Materiality—as a criterion—has both quantitative and qualitative aspects, and items should not be deemed immaterial unless all potentially applicable quantitative and qualitative aspects are given full consideration and found not relevant.
Preparers of financial statements obviously will need to have control procedures to reduce the risk of accounting errors being committed and not detected. From the auditors’ perspective, it is required that the examination be conducted in a manner that will provide reasonable assurance of detecting material misstatements, including those resulting from errors.
In evaluating misstatements, an auditor would classify them into two categories: (a) known misstatements; and (b) likely misstatements.
The “known misstatements” could arise from:
The “likely misstatements” could arise from:
An auditor, following on the SAS 107, would evaluate both known and likely misstatements. Under the auditing standards, auditors are responsible for accumulating all known and likely misstatements except those that, in the auditors’ judgment, are trivial or inconsequential.
Auditors are expected to communicate known and likely misstatements to management in a timely manner, distinguishing between these categories. Timely communication is important in order to provide management the opportunity to evaluate whether they concur that the items are misstatements and to determine whether to adjust the financial statements or request that the auditor obtain additional evidence.
Auditors are obligated by professional standards to request that management record adjustments to correct all known misstatements, other than those deemed to be trivial. Because some of these may be based on audit sampling results, some management may either resist because there is inherent distrust of projections, or because it will not be clear how corrections can be recorded when the error items cannot be specifically identified.
Likely misstatements are treated as follows:
1. If the likely misstatement results from a projection to the population from examination of a sample, auditors will request management to examine the relevant population from which the sample was drawn. This might be a class of transactions, an account balance, or the information required to be presented in a disclosure. The purpose of the requested examination is for management to identify and correct misstatements in the remaining population.
Example: The auditor may identify a misstatement caused by an error in inventory pricing relative to raw materials. Management would be requested, in this case, to reexamine the entire raw materials inventory to determine whether it includes other misstatements and to correct any other misstatements found as a result of the reexamination.
2. If the likely misstatement results from differences in estimates (e.g. the amount needed for the allowance for uncollectible accounts receivable), the auditors should request that management review the methods and assumptions used to develop their estimate.
Ultimately, management is responsible for deciding how to respond to auditors’ requests and whether it wishes to correct some or all of the misstatements brought to its attention by the auditors.
Both the auditors and management, in assessing the impact of uncorrected misstatements, are required to assess materiality both quantitatively and qualitatively, from the standpoint of whether a financial statement user would be misled if a misstatement were not corrected or if, in the case of informative disclosure errors, full disclosure was not made.
Qualitative considerations include (but are not limited to) whether the misstatement:
Management, with the concurrence of the reporting entity’s auditors, may have decided to not correct misstatements that occurred in one or more prior years because, in their judgment at the time, the financial statements were not materially misstated.
Two methods of making that materiality assessment have been widely used in practice:
1. Rollover Method – This method quantifies a misstatement as its originating or reversing effect on the current period’s statement of income, irrespective of the potential effect on the balance sheet of one or more prior periods’ accumulated uncorrected misstatements.
2. Iron Curtain Method – This method quantifies a misstatement based on the accumulated uncorrected amount included in the current, end-of-period balance sheet, irrespective of the year (or years) in which the misstatement originated.
For a publicly held corporation, the SEC staff issued SAB 108, in order to address how publicly held corporations are to evaluate misstatements. SAB 108 prescribes that if a misstatement is material to either the income statement or balance sheet, it is to be corrected in a manner set forth in the bulletin.
In addition, the SEC provided transition relief for certain reporting entities initially adopting SAB 108. The SEC staff indicated in SAB 108 that in the following circumstances the ASC 250 requirement for prior period restatement would be waived:
1. The reporting entity’s initial registration statement was effective on or before November 15, 2006, and
2. Management had, in the past, properly applied its pervious method of evaluating misstatements (either iron curtain or rollover), including consideration of all relevant qualitative factors (set forth in SAB 99, “Materiality”). Registrants that meet these criteria are permitted to reflect the results of initial application of SAB 108 as a cumulative effect adjustment to retained earnings as of the beginning of the fiscal year. Disclosures are required of:
The SEC encouraged early adoption of this guidance in any report for an interim period ending in the first fiscal year ending after November 15, 2006, that is filed after September 13, 2006, the publication date of SAB 108.
If the cumulative effect adjustment occurs in an interim period other than the first interim period, the SEC waived the requirement that previously filed interim reports for that fiscal year be amended. Instead, comparative information presented for interim periods of the first year subsequent to initial application are to be adjusted to reflect the cumulative effect adjustment as of the beginning of the fiscal year of initial application. The adjusted results are also required to be included in the disclosures of selected quarterly information that are required by Regulation S-K, Item 302. Entities that do not meet the criteria to use the cumulative effect adjustment are required to follow the provisions of ASC 250 that require restatement of all prior periods presented in the filing.
Before discussing type of misstatements, how to evaluate and treat uncorrected misstatements, let us have a look at why uncorrected misstatements occur.
Why Do Uncorrected Misstatements Occur?
A common reason for leaving a misstatement uncorrected is that the preparer judges the figure as “immaterial”. Consider this:
A Financial statement preparer, by the accounting standard, is expected to exercise professional judgment in determining the level of materiality to apply, while on other side she is also expected to be able to cost-effectively prepare full and complete financial statements without delay. With high degree of pressure, during the year end, the financial statements are finally completed and distributed. Back to her desk, she finds some misstatements on the statement and consider, “no time to make correction, they are not material anyway”.
The preparer catches up timeliness at the cost of financial statement users—having inaccurate statements.
In worst cases, which are truly happened, the materiality concept has been used to rationalize the non-correction of errors that should have been dealt with, indeed, even to excuse errors known when first committed. The fact that the concept of materiality has sometimes been abused led to the promulgation of further guidance relative to error corrections.
What is Materiality?
Materiality, defined by the FASB, as:
“the magnitude of an omission or misstatement in the financial statements that makes it probable that a reasonable person relying on those financial statements would have been influenced by the omitted information or made a different judgment if the correct information had been known.”
Despite many efforts to develop a firm definition of materiality that have been made by academicians and the profession over the decades, a universally agreed-upon definition of materiality remains elusive, and thus a matter for professional judgment.
Materiality According to SEC
The Securities and Exchange Commission has, in various of its pronouncements, defined materiality as:- 1% of total assets for receivables from officers and stockholders;
- 5% of total assets for separate balance sheet disclosure of items; and
- 10% of total revenue for disclosure of oil and gas producing activities
Although materiality judgments have traditionally been primarily based on quantitative assessments, the nature of a transaction or event can affect a determination of whether that transaction or event is material.
Example: Transaction that, if recorded, changes a profit to a loss or changes compliance with ratios in a debt covenant to noncompliance would be material even if it involved an otherwise immaterial amount.
Also, a transaction that might be judged immaterial if it occurred as part of routine operations may be material if its occurrence helps meet certain objectives.
Example: Transaction that allows management to achieve a target or obtain a bonus that otherwise would not become due would be considered material, regardless of the actual amount involved.
The individual accountant, therefore, must exercise professional judgment in evaluating information and concluding on its materiality.
Materiality—as a criterion—has both quantitative and qualitative aspects, and items should not be deemed immaterial unless all potentially applicable quantitative and qualitative aspects are given full consideration and found not relevant.
Although independent auditors are charged with
obtaining sufficient evidence to enable them to provide the financial statement
user with reasonable assurance that management’s financial statements are free
of material misstatement, the financial statements are primarily the
responsibility of the preparers.
Types of Misstatements
Preparers of financial statements obviously will need to have control procedures to reduce the risk of accounting errors being committed and not detected. From the auditors’ perspective, it is required that the examination be conducted in a manner that will provide reasonable assurance of detecting material misstatements, including those resulting from errors.
In evaluating misstatements, an auditor would classify them into two categories: (a) known misstatements; and (b) likely misstatements.
The “known misstatements” could arise from:
- Incorrect selection or application of accounting principles
- Errors in gathering, processing, summarizing, interpreting, or overlooking relevant data
- An intent to mislead the financial statement user to influence their decisions
- To conceal theft
The “likely misstatements” could arise from:
- Differences in judgment between management and the auditor regarding accounting estimates where the amount presented in the financial statements is outside the range of what the auditor believes is reasonable
- Amounts that the auditor has projected (the statistical term “extrapolated” is also used in this context) based on the results of performing statistical or nonstatistical sampling procedures on a population.
An auditor, following on the SAS 107, would evaluate both known and likely misstatements. Under the auditing standards, auditors are responsible for accumulating all known and likely misstatements except those that, in the auditors’ judgment, are trivial or inconsequential.
In forming judgments regarding the
triviality of misstatements, auditors consider whether the
misstatement individually or when aggregated with other similar amounts would be
considered immaterial to the financial statements.
How Should Auditors Treat Misstatements?
Auditors are expected to communicate known and likely misstatements to management in a timely manner, distinguishing between these categories. Timely communication is important in order to provide management the opportunity to evaluate whether they concur that the items are misstatements and to determine whether to adjust the financial statements or request that the auditor obtain additional evidence.
Auditors are obligated by professional standards to request that management record adjustments to correct all known misstatements, other than those deemed to be trivial. Because some of these may be based on audit sampling results, some management may either resist because there is inherent distrust of projections, or because it will not be clear how corrections can be recorded when the error items cannot be specifically identified.
Likely misstatements are treated as follows:
1. If the likely misstatement results from a projection to the population from examination of a sample, auditors will request management to examine the relevant population from which the sample was drawn. This might be a class of transactions, an account balance, or the information required to be presented in a disclosure. The purpose of the requested examination is for management to identify and correct misstatements in the remaining population.
Example: The auditor may identify a misstatement caused by an error in inventory pricing relative to raw materials. Management would be requested, in this case, to reexamine the entire raw materials inventory to determine whether it includes other misstatements and to correct any other misstatements found as a result of the reexamination.
2. If the likely misstatement results from differences in estimates (e.g. the amount needed for the allowance for uncollectible accounts receivable), the auditors should request that management review the methods and assumptions used to develop their estimate.
Ultimately, management is responsible for deciding how to respond to auditors’ requests and whether it wishes to correct some or all of the misstatements brought to its attention by the auditors.
Both the auditors and management, in assessing the impact of uncorrected misstatements, are required to assess materiality both quantitatively and qualitatively, from the standpoint of whether a financial statement user would be misled if a misstatement were not corrected or if, in the case of informative disclosure errors, full disclosure was not made.
Qualitative considerations include (but are not limited to) whether the misstatement:
- Arose from estimates or from items capable of precise measurement and, if the misstatement arose from an estimate, the degree of precision inherent in the estimation process
- Masks a change in earnings or other trends
- Hides a failure to meet analysts’ consensus expectations for the reporting entity
- Changes a loss to income or vice versa
- Concerns a segment or other portion of the reporting entity’s business that has been identified as playing a significant role in operations or profitability
- Affects compliance with loan covenants or other contractual commitments
- Increases management’s compensation by affecting a performance measure used as a basis for computing it
- Involves concealment of an unlawful transaction
Misstatements from Prior Years
Management, with the concurrence of the reporting entity’s auditors, may have decided to not correct misstatements that occurred in one or more prior years because, in their judgment at the time, the financial statements were not materially misstated.
Two methods of making that materiality assessment have been widely used in practice:
1. Rollover Method – This method quantifies a misstatement as its originating or reversing effect on the current period’s statement of income, irrespective of the potential effect on the balance sheet of one or more prior periods’ accumulated uncorrected misstatements.
- Focus on: Current period income statement.
- Strength: Focuses on whether the income statement of the current period is materially misstated assuming that the balance sheet is not materially misstated.
- Weakness: Material misstatement of the balance sheet can accumulate over multiple periods.
2. Iron Curtain Method – This method quantifies a misstatement based on the accumulated uncorrected amount included in the current, end-of-period balance sheet, irrespective of the year (or years) in which the misstatement originated.
- Focus on: End of period balance sheet
- Strength: Focuses on ensuring that the balance sheet is not materially misstated irrespective of the year or years in which a misstatement originated
- Weakness: Does not consider whether the effect of correcting a balance sheet misstatement that arose in one or more periods is material to the current period income statement
For a publicly held corporation, the SEC staff issued SAB 108, in order to address how publicly held corporations are to evaluate misstatements. SAB 108 prescribes that if a misstatement is material to either the income statement or balance sheet, it is to be corrected in a manner set forth in the bulletin.
In addition, the SEC provided transition relief for certain reporting entities initially adopting SAB 108. The SEC staff indicated in SAB 108 that in the following circumstances the ASC 250 requirement for prior period restatement would be waived:
1. The reporting entity’s initial registration statement was effective on or before November 15, 2006, and
2. Management had, in the past, properly applied its pervious method of evaluating misstatements (either iron curtain or rollover), including consideration of all relevant qualitative factors (set forth in SAB 99, “Materiality”). Registrants that meet these criteria are permitted to reflect the results of initial application of SAB 108 as a cumulative effect adjustment to retained earnings as of the beginning of the fiscal year. Disclosures are required of:
- The nature and amount of each individual error correction included in the cumulative effect adjustment;
- When and how each error arose; and
- The fact that the errors had been previously considered to be immaterial.
The SEC encouraged early adoption of this guidance in any report for an interim period ending in the first fiscal year ending after November 15, 2006, that is filed after September 13, 2006, the publication date of SAB 108.
If the cumulative effect adjustment occurs in an interim period other than the first interim period, the SEC waived the requirement that previously filed interim reports for that fiscal year be amended. Instead, comparative information presented for interim periods of the first year subsequent to initial application are to be adjusted to reflect the cumulative effect adjustment as of the beginning of the fiscal year of initial application. The adjusted results are also required to be included in the disclosures of selected quarterly information that are required by Regulation S-K, Item 302. Entities that do not meet the criteria to use the cumulative effect adjustment are required to follow the provisions of ASC 250 that require restatement of all prior periods presented in the filing.
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