7033.4 Investigate and corroborate significant differences

Jul-2017

OAG Guidance

Step 4: Investigate significant differences and draw conclusions

The fourth step is the investigation of significant differences and formation of conclusions. Differences indicate an increased likelihood of misstatements. The greater the degree of precision, the greater the likelihood that the difference is a misstatement.

Seek explanations for the full amount of the difference, not just the part that exceeds the threshold. In other words, if a difference of $5 million is identified and the threshold is $3 million, we would seek an explanation for the full difference and not just the $2 million above the threshold. There is a chance that the unexplained difference may indicate an increased risk of material misstatement. In addition, while in this instance the potential misstatement would be less than performance materiality, there is a possibility that a combination of misstatements in the specific account balances, or classes of transactions, or other balances or classes could aggregate to an unacceptable amount. Consider whether the differences were caused by factors previously overlooked when developing the expectation in Step 1; e.g., unexpected changes in the business or changes in accounting treatments. If the difference is caused by factors previously overlooked, it is important to verify the new data, to show what impact this would have on our original expectations as if this data had been considered in the first place, and to understand any accounting or auditing ramifications of the new data.

It is important to show a clear audit path between our original estimate and the actual figures, including the impact of additional factors not included in our original expectation. This can be done by documenting the impact of the new data when explaining the difference and producing a revised expectation. The impact of the new data on other expectations also needs to be considered and where necessary those expectations revised.

Inquiry is frequently an important aspect of the investigation of differences and is ordinarily the beginning of the investigation. Nevertheless, management inquiry is not the sole support for an explanation.

Corroboration of explanations may include one or more of the following:

• Comparison to third party data or other corroborating data.
• Examination of other client information prepared or available (e.g., non-financial data such as marketing or production data, contracts, etc.).
• Comparison to the results of other audit procedures performed.

The following are the common possible causes of significant differences:

• Economic and/or operating conditions or events
• Error
• Fraud

In most instances, the cause of an identified difference involves an economic condition/event. However, even when a significant difference is due to error or fraud, the entity may provide a plausible, yet ultimately inadequate, business explanation. Thus, the effectiveness of analytical procedures in identifying material misstatements is enhanced when we develop potential explanations before obtaining the entity’s explanation. By doing this, we are better able to exercise appropriate professional skepticism and challenge the entity’s explanation, where necessary. Once the entity’s explanation has been received, we may have difficulty identifying alternative explanations. In addition to improving our ability to detect material misstatements, the consideration of potential causes of a difference may assist us in improving our expectations.

Reexamine and understand the various relationships in the financial and non-financial data, and maintain an open mind and skeptical attitude regarding possible explanations, so as to avoid focusing on only one possible explanation. Develop potential explanations based on prior audit experience, other work performed, industry knowledge, and discussions with other members of our team. The independent consideration of alternative explanations for differences is more important for more significant accounts and when a higher degree of assurance is desired from substantive analytical procedures.

OAG Guidance

Resolve explanations for significant differences

Explanations for significant differences are followed up and resolved through inquiry, quantification, corroboration and evaluation of the entity’s oral explanations, and then drawing a conclusion regarding the explanation.

Inquiry: Investigating unusual fluctuations and relationships ordinarily begins with inquires of management.

Quantification: It is usually not practicable to identify explanations for the exact amount of a difference. However, quantify the portion of the difference that can be explained. Quantification involves determining whether the explanation or error can explain the observed difference. While our goal is to obtain an explanation for the entire significant difference, as a practical matter, we may only be able to explain a portion of the difference. If the remaining unexplained difference is sufficiently small to enable us to conclude that there is no material error, no further explanation is required. If the remaining unexplained difference is still greater than the threshold, we either obtain assurance that the account balance is fairly stated through other auditing procedures or conclude that the difference is a misstatement.

Corroboration: Corroborate explanations for significant differences by obtaining sufficient appropriate audit evidence that the explanation is an accurate representation of the contributing factors to the difference and, that the information supporting the explanation is reliable. If intending the analytical procedure to provide substantive evidence, this corroborative evidence needs to be of the same quality as the evidence we obtain to support tests of details. The evidence could vary from simply comparing the explanation to prior audit experience, to employing other detailed tests to confirm or refute the explanation including inspection of third-party evidence such as contracts and the like. The procedures necessary to corroborate the explanation will depend on the nature of the explanation, the nature of the account balance, and the results of other substantive procedures.

Common corroborating procedures include examination of supporting evidence, inquiries of independent persons, and obtaining evidence from other auditing procedures. It is not sufficient to accept the entity’s explanation without corroborating the explanation. Also consider the impact on other account balances as well as the likelihood of similar misstatements in other FSLIs. Each time we receive additional explanations, consider the impact on all other balances and where necessary revise our expectations.

Evaluation: The key mindset behind effective substantive analytical procedures is one of appropriate professional skepticism combined with the desire to obtain sufficient appropriate audit evidence, the same as with other auditing procedures. Evaluate the results of the substantive analytical procedures to conclude whether the desired level of assurance has been achieved. Identify known and likely misstatements arising from error and fraud and consider the potential effects on the financial statements. If we obtain evidence that a misstatement exists and can be sufficiently quantified, the misstatement is posted to the summary of uncorrected misstatements (SUM) as a known difference. If an unexplained portion above the threshold cannot be explained or corroborated, and if we are confident that we have considered the relevant data, the unexplained difference is considered a misstatement. When the amount of the misstatement cannot be sufficiently quantified, conduct additional testing, request the entity to conduct a detailed analysis to quantify the misstatement, or record the unexplained difference as an estimated difference on the summary of uncorrected misstatements.

Even if the difference between our expectation and the entity’s recorded amount is less than the threshold, we may consider investigating the difference if it is unusual. For example, we may find a change from a credit to a debit balance in an accrued liability account to be unusual and may choose to investigate to determine whether our understanding is incomplete, controls are inadequate, or misstatements exist even if the difference does not exceed the threshold.

The manner of investigation and the form of conclusion differ greatly for the different purposes of analytical procedures. A key aspect of our investigation of significant differences and of the ultimate conclusion regarding the findings, particularly with regard to substantive and overall conclusion analytical procedures, is to consider not only the plausibility of the explanation (i.e., does it make sense?), but also its sufficiency (i.e., by the use of quantification and corroboration).

Finalize the investigation of significant differences and concluding

An assessment of the plausibility and sufficiency of the explanations is made in light of the objectives set for the analytical procedure and whether we have received explanations consistent with those objectives.

If concluding that the substantive analytical procedure performed did not provide the desired level of assurance, perform additional substantive analytical procedures and/or tests of details. Bring specific matters requiring further consideration to the team manager’s attention and, if necessary, to the appropriate level of the entity’s management.

Document if the procedure met the desired objective, and if additional work is needed based on the results of the analytical procedure.

OAG Guidance

Document adequately the investigation of significant differences and the conclusions, including:

• the explanation of any difference greater than the threshold;
• the explanation of any difference less than the threshold, but which we decided to investigate because it was unusual or unexpected;
• the corroborative evidence obtained, if applicable, of the significant difference from our expectation (not just the difference above the threshold); and
• the conclusion, including any further audit procedures considered necessary and the results of such additional procedures.

For documenting this step of the four-step process, use the substantive analytics procedures for the specific financial statement line item (FSLI) from the relevant cabinet: IFRS, or PSAS—Substantive Tests.