9015 Evaluating the effect of uncorrected misstatements

Sep-2020

OAG Guidance

For guidance on the materiality level determination and reassessment, see OAG Audit 2100.

OAG Guidance

When determining the population of misstatements, it is important to understand the different types of misstatements and what is considered to be a misstatement.

Misstatement overview

The impact of the misstatement on the prior period and/or current period financial statements includes all of the following, if applicable, individually and in the aggregate for the purpose of accumulating and evaluating misstatements:

• Newly identified uncorrected misstatements (SUM items);

• Previously identified uncorrected misstatements which originated in a prior period but were not corrected (prior year SUM items);

• Misstatements that were corrected in the wrong period (misstatements related to prior periods, corrected in the current period).

As a general principle, we always strongly encourage entities to adjust all but clearly trivial uncorrected misstatements.

Whichever method of assessing uncorrected misstatements (Iron curtain or Rollover) is used, use it consistently, from period to period and in all components of a group audit. If engagement teams are considering changing from the Rollover method to the Iron curtain method or vice versa, they must consult with Audit Services.

It is important to note that these assessment methods (Iron curtain and Rollover) are used to evaluate if uncorrected misstatements of the current and/or prior years are material.

When correcting misstatements, correcting entries need to be consistent with the applicable financial reporting framework.

Use the SUM to assist in determining if the financial statements are free of material misstatement by:

• Evaluating each misstatement separately against the FSLI to which they relate;

• Evaluating the combined effect of all the factual, judgmental and projected misstatements for all FSLIs in the context of our judgment of what is material to the financial statements as a whole

• Evaluating the impact of prior period uncorrected misstatements (i.e., prior year SUM items and misstatements corrected in the wrong period), including a consideration of which ones from the prior year could impact the current year and which ones do not.

Engagement teams are required to evaluate and document whether uncorrected misstatements, individually or in aggregate, cause the financial statements as a whole to be materially misstated. They need to document the basis for that conclusion including both quantitative and qualitative factors.

Impact of Aggregated Uncorrected Misstatements

Inherent in the evaluation process is the possibility of netting certain items against others that are dissimilar in nature. When evaluating the impact of uncorrected misstatements on a set of financial statements, consider the manner in which the misstatements have been aggregated to avoid the netting of items that are dissimilar. Potential areas of focus include the following:

• Financial statement components: Netting of assets against liabilities, revenues against expenses or netting within respective asset, liability, revenue or expense categories on the basis that there is no “bottom line” impact generally is inappropriate. To verify that there is not a material misstatement of the respective financial statement component or an inadvertent oversight of disclosure requirements relating to separate FSLIs, the impact of netting uncorrected misstatements is considered at the individual FSLI level.

• Financial statement classifications: Use of overly broad financial statement classifications (e.g., assets, liabilities, equity, net income) for evaluating uncorrected misstatements may be insufficient. Many users evaluate financial statements using comparisons and ratios that are dependent upon the integrity of financial statement classifications, whereas others may determine certain information to be less relevant based on its classification. Accordingly, where appropriate, evaluate the impact of uncorrected misstatements in the context of the financial statement classifications of classes of transactions, account balances and disclosures (e.g., current vs. non-current, operating vs. non-operating, continuing vs. discontinued) to which they pertain.

• Cumulative effect of misstatements: Even if a misstatement of one FSLI is not material on its own, the cumulative effect of misstatements may be material and is considered carefully. In particular the trend and aggregate effect of immaterial misstatements in various components of a group is considered from a group perspective when assessing materiality in respect of the group financial statements. Furthermore, consider the effect of uncorrected misstatements from prior years on the current financial statements. Alert the entity to the possibility of immaterial misstatements in the current (and previous) year(s) becoming material in the future, especially where the misstatement is system generated.

• Omitted, incomplete or inaccurate disclosures: Omitted, incomplete or inaccurate disclosures may be identified during the completion of the disclosure checklist or the tie out of the financial statements. Discuss these with the client. If the client does not amend the financial statements, apply professional judgment to conclude on whether the item will be included on the SUM. Disclosure exceptions that are not summarized on the SUM need to be summarized in an alternative document for those matters warranting reporting to those charged with governance. Incomplete, omitted or inaccurate financial statement disclosures, whether recorded or not by the entity, could either individually or when aggregated with other misstatements have a material effect on the entity’s financial statements. Consider documenting the assessment in a significant matter and discussing with the engagement leader.

Group Audit Considerations

For guidance on evaluating uncorrected misstatements in group audits see OAG Audit 2362.

OAG Guidance

Determine Probable Overall Misstatement (POMs)

The SUM procedure determines automatically two probable overall misstatement (POMs). The first one is based on the total of uncorrected misstatements impacting the net income. The second POM is based on the total of uncorrected misstatements impacting equity and other comprehensive income.

Probable Overall Misstatement Thresholds

If either of the POMs is greater than 50% of overall materiality, the engagement leader will consider the impact of undetected misstatements, which while not probable, are still possible. In addition, the qualitative factors described in the following sections must be considered in concluding whether the financial statements are at risk of being materially misstated.

The thresholds POMs are intended only to trigger consultation requirements. They do not represent safe harbors. There may be situations in which larger uncorrected misstatements may be deemed to be acceptable. Conversely, there may be situations in which smaller aggregate amounts may be deemed to be material e.g., when they have the effect of changing a loss into a profit or of bringing the entity’s financial statements into compliance with a covenant in a loan agreement that would otherwise be violated.

Consultations

The engagement leader should consult in accordance with OAG Audit 3081 if he or she encounters any of the following circumstances:

• An entity insists on us allowing Cumulative Uncorrected Audit Misstatements (CUAM) assessed under the rollover method to increase relative to the CUAM at the end of the preceding year.

• An entity has decided to reduce or eliminate the CUAM over a period of time, with a resultant material impact on the financial statements.

• For a commercial entity, the CUAM is greater than 5% of equity, or the net uncorrected misstatements for the period are greater than 5% of income.

• For a not-for-profit entity organization, the CUAM is greater than 5% of net assets, or the net uncorrected misstatements for the period are greater than 5% of total revenue or total expenses.

For further guidance on performing and documenting consultations, refer to OAG Audit 3081.

OAG Guidance

The relative materiality of uncorrected misstatements is ordinarily assessed by either of two different but generally accepted methods, generally referred to as the Iron curtain method and the Rollover method.

Engagement teams will normally use the Rollover method to deal with the impact of the reversal of prior year errors. It may be appropriate in certain circumstances, such as where the financial statements are prepared in accordance with the Public Sector Accounting Handbook, to use the Iron curtain method. If engagement teams are considering changing from the Rollover method to the Iron curtain method or vice versa, they must consult with Audit Services.

Note that although the correcting entries in the examples below are consistent with the respective assessment method, we need to consider if the entries are consistent with the applicable financial reporting framework.

Iron Curtain Method

The Iron curtain method considers it inappropriate to offset any amounts from the prior period’s Cumulative Uncorrected Audit Misstatements (CUAM) against the CUAM at the end of the current year. Therefore, all uncorrected misstatements noted in the current year would be accumulated, including amounts arising in prior years that were not recorded by the entity and are still applicable. Once a decision is reached not to record corrections in a given period, an “iron curtain” falls over that period and any eventual recording of the prior uncorrected amounts will be made in a future period. However, when such an entry is made in the later period, there can be an issue relating to the quality of earnings in that period. Under the Iron curtain method, an adjustment needs to be made sufficient in amount so that the remaining CUAM at the end of the period is reduced to an amount deemed not material to the current year’s financial statements.

Rollover Method

The Rollover method considers that misstatements not corrected in the period in which they arise may be an offset to uncorrected misstatements of a subsequent period.

Each uncorrected item on the prior year's SUM is separately evaluated to determine if it is appropriate to roll over its effect to the current year's SUM.

While the rollover method is acceptable and commonly used, monitor it carefully since it may allow a “build up” of a CUAM that may cause problems for the entity and be troublesome for the audit team if subsequently it is concluded that adjustment needs to be made for the whole amount and it becomes known that the full amount includes parts that could have been adjusted in prior periods, but were not. For example:

• The CUAM may ultimately become material to equity.

• The entity may enter into a sale agreement based on book value or multiple of earnings.

• The significance of the CUAM may increase dramatically in the event of a sale of the entity or of a segment or subsidiary to which the CUAM relates in whole or in part.

• New management or audit committee members may want to “clean house” and book the entire CUAM.

• The CUAM may come under the scrutiny of regulators or other third parties.

In any of the above situations, an adjustment material to income may have to be made with a full explanation by way of note disclosure. If the entity’s shares are listed, there could be adverse ramifications for the share price and possible regulatory enquiries. For these reasons, any increase in the CUAM is discouraged. If there is any increase in the CUAM (either in absolute numbers or as a percentage to equity), evaluate the potential impact on the engagement, and consider the consultation requirements. We may consider consulting Audit Services if we determine that there is a risk that the CUAM may become material to equity in subsequent years.

Thus, in circumstances where the Rollover method is used, be satisfied that the effect of uncorrected misstatements in the current period is clearly immaterial. Also consider the impact of uncorrected misstatements in the current period on the results of future periods, because differences that are initially insignificant may become material in subsequent years.

Where the Rollover method is used, be satisfied that management and those charged with governance properly understand the implications of the treatment proposed, including discussing the potential impact of currently immaterial misstatements that may have a material effect in future periods, including those that are less than a full year.

Many of the more difficult and complex circumstances related to waived prior period adjustments can be avoided by exercising care in the period in which misstatements are first identified and discussed with the entity’s personnel. When discussing adjustments, consider the following:

• Materiality not only in terms of current period effects, but also in terms of expected and even possible effects in future reporting periods. This can be particularly important when a waived adjustment is expected to have a significant reversing effect in a single future period. For example, sales cut-off errors that will have a reversing effect in the subsequent period.

• The continuing nature and cumulative effect of proposed adjustments that will continue to increase in the ordinary course of business. In such cases, evaluate whether it is likely such items will increase to an amount that would be material if they were to be corrected in any single future period.

Determining which prior year uncorrected misstatements impact the current period financial statements require judgment. When considering which prior year misstatements have an impact on the current period financial statements, and therefore is “rolled over” to the current year’s SUM, consider:

• The recurring impact of prior year uncorrected misstatements. If an adjustment has a recurring impact each year (e.g., a sales cut-off adjustment is required every year due to an internal control deficiency), the prior year effect of the adjustment would be carried forward.

• The nature of the adjustment. If an adjustment is a “one-time adjustment” related to a non-recurring event (e.g., a legal accrual related to the settlement of an outstanding lawsuit that is paid in the following year), the effect of the adjustment is carried forward to the subsequent year’s SUM. However, in evaluating the materiality of all uncorrected misstatements, consider the one-time nature of this item. This is because even though the expense was recorded in the wrong period, rolling it over could permit a misstatement for a similar amount, although unrelated event, to remain uncorrected in the subsequent year.

• Differences in judgments about accounting estimates. If the entity’s estimate was considered reasonable at the time the prior period financial statements were issued, then any difference in judgment between us and the entity is not considered an error, and would not be rolled forward.

• The significance of the item. Items that are clearly insignificant, or items that are immaterial in the year they arise and reverse over a few subsequent years, are unlikely to be significant to the current year’s assessment. These items may be, but do not have to be, rolled over.

Therefore, under the rollover method, each item on the prior year’s SUM is separately evaluated to determine if it is appropriate to roll over its effect to the current year’s SUM.

In order to assess the impact of the CUAM on equity and other financial groupings that would not be evaluated using the rollover method, the SUM records adjustments on both a “gross” basis (the total effect of a recurring difference) and on a “net effect” basis (giving effect to the rollover amounts). This can be accomplished by segregating the rollover amounts in a separate section of the SUM.

Note that use of the rollover method may result in adjustments being required even when the CUAM is immaterial in relation to equity and would be considered immaterial to the income statement under the iron curtain method. For example, if, as the result of a recurring inventory adjustment, inventory is overstated at the end of Year 1 and understated at the end of Year 2, the effect of the “swing” could be material to the income statement under the rollover method.

OAG Guidance

Amounts Exceeding Overall Materiality Level

We may conclude that in certain situations amounts exceeding our quantitative materiality level are not material because of their qualitative nature. For example, we may conclude that users of financial statements have a higher tolerance to misstatements which only affect balance sheet classifications; however, consider all relevant factors such as the impact on key performance measures, ratios and indicators before reaching that conclusion.

Insignificant Balances

Under either the iron curtain or the rollover method, the denominator used in determining the relative quantitative materiality of uncorrected misstatements sometimes may be quite small. This may especially occur with respect to pretax or net income. In that case, a mathematical calculation of the effect of the uncorrected misstatements on the particular financial statement subtotal may not be meaningful. In such an instance, quantitative measures against other financial statement subtotals, trends of financial statement measures, and qualitative factors may be more relevant to the evaluation than one simple quantitative measure.

Amounts Below Overall or Performance Materiality Level

Further circumstances which may cause us to conclude that amounts below overall or performance materiality are material for particular classes of transactions, account balances or disclosures, include the extent to which the misstatement:

• Hides a failure to meet analysts’ consensus expectations for the entity (e.g., whether the misstatement changes a loss into profit, if profits were forecast).

• Relates to the primary financial statements, key financial indicators or some other aspect of the financial statements such as note disclosures.

• Is a misclassification between particular account balances (e.g., between operating or non-operating income or recurring and non- recurring income items).

• Involves concealment of an unlawful transaction, such as failure to disclose an illegal loan to management or a director, or conceals poor corporate governance.

• Conceals technical insolvency or going concern problems or could affect the entity distributable profits and hence the ability to pay dividends.

• Is one of a systematic trend of misstatements (either cumulatively over time or in the same accounting period) in the financial statements that together potentially gives rise to any of the above indicators.

• Indicates management’s motivation with respect to the misstatement, for example: (i) an intentional misstatement to “manage” earnings or “smooth” earnings trends; (ii) an indication of a possible pattern of bias by management when developing and accumulating accounting estimates; or (iii) a misstatement precipitated by management’s continued unwillingness to correct deficiencies in the financial reporting process.

• Affects the entity’s compliance with legal or regulatory requirements.

If any of the indicators in CAS 450.A21 or above arise, the risk that the misstatement is material increases, regardless of its quantitative amount. If the misstatement is material then request that the entity correct it in the financial statements, regardless of whether the amount of the misstatement is below a pre-determined materiality threshold.

These circumstances are only examples; not all are likely to be present in all audits nor is the list necessarily complete. The existence of any circumstances such as these does not necessarily lead to a conclusion that the misstatement is material.

Obtaining the views and expectations of the entity’s management and those charged with governance may be helpful in gaining or corroborating an understanding of user needs, such as those illustrated above.

• The definitive character of the misstatements, e.g., the precision of an error that is objectively determinable as contrasted with a misstatement that unavoidably involves a degree of subjectivity through estimation, allocation, or uncertainty.

• The existence of offsetting effects of individually significant but different misstatements.

• The likelihood that a misstatement that is currently immaterial may have a material effect in future periods because of a cumulative effect, for example, that builds over several periods.

• The cost of making the correction. It may not be cost-beneficial for the client to develop a system to calculate a basis to record the effect of an immaterial misstatement.

Misstatements Caused by Management

Misstatements caused by management are, by definition, almost always material (regardless of size) because of intent to influence some action or decision.

The key qualitative factors in CAS 450.A21 and above highlight the increasing impact of pressures on management from a variety of sources to report expected earnings and financial position. Therefore, take reasonable steps to understand the various pressures management face and hence key sensitivities. Carry this out as part of risk assessment audit procedures as facilitated by the Acceptance and Continuance process.

Such pressures on management increase the risk that management will use misstatements to help manage their reported figures. Be alert to such a risk, particularly if coupled with weak corporate governance. If evidence clearly indicates that this may be the case, then such misstatements are almost by definition material (regardless of size) because some action or decision is intended to be influenced by the misstatement. It therefore ordinarily requires adjustment. Furthermore, management’s integrity and the effectiveness of the entity’s internal control systems are brought into question.

International Financial Reporting Standards (IFRS) regard information in the financial statements as material if obscuring it could reasonably influence the decisions of the primary users of the financial statements. Also CAS 450.A22 states that misstatements in disclosures could arise from duplicative or uninformative disclosures that obscure a proper understanding of matters in the financial statements.

If we believe that the financial statements may be materially misstated because information is obscured and management does not correct the misstatement, consider whether this could be indicative of fraud.

For detailed guidance on considering fraud risk, see OAG Audit 5500.

OAG Guidance

If prior period errors meeting the criteria outlined in the policy above are identified directly by Audit Services, the matter will be discussed with the audit team and a consultation document requested as appropriate.

Where material misstatements are found relating to prior periods that were not identified at the time of the prior period audit, determine whether a restatement of the previous period financial statements is required.

When management corrects known prior year misstatements (referred to as uncorrected misstatements related to prior periods) in order to correct the balance sheet in the current year, the ending balance sheet does not require adjustment.

As explained above, we need to consider the effects of correcting misstatements related to prior periods when evaluating the impact of misstatements on the prior and/or current period financial statements

Note that uncorrected misstatements related to prior periods, if identified,  need to be evaluated using  both the iron curtain and rollover method of misstatements evaluation, i.e., even when we use iron curtain method, we still consider the effect of correcting misstatements related to prior periods.  Uncorrected misstatements related to prior periods are different from rollover adjustments, and we need to appropriately consider both when using the rollover method of misstatements evaluation.

Determine the materiality of the effect of correcting misstatements related to prior periods on relevant income statement measures, e.g., the current year amounts of pre-tax and net income and comprehensive income. There could be “quality of earnings” issues relating to the current year if the total of such misstatements is significant, and they would be considered together with other misstatements as part of current period SUM evaluation. In these circumstances, discuss such issues within the team and communicate them to management and those charged with governance as appropriate.

As management is responsible for the true and fair presentation of the financial statements, including consideration of uncorrected misstatements related to prior periods, a related representation on this matter will be included in the management representation letter.

OAG Guidance

Audit Services informs and seeks advice from the Annual Audit and Special Examination Oversight Committee (AASEOC) on the accounting treatment of prior period errors meeting any of the criteria listed in the policy above or any additional prior period errors at the discretion of Audit Services.

Following receipt of AASEOC advice, Audit Services informs the audit team of Audit Services’ conclusion. Audit Services tracks identified prior period errors for purposes of recommending root cause analyses, practice statistics and risk management.