AC414 CLASS NOTES
MISSTATEMENTS (ISA 450)
MARCH 2023
Outline
• Defining misstatements
• Types of misstatements
• Causes of misstatements
• Identified misstatements
• Evaluation of accumulated misstatements
• Communicating misstatements
• Uncorrected misstatements
• Effect of uncorrected misstatements on AFS
• Documentation
LH, F&A
2
Introduction
- ISA 450 – Evaluation of misstatements identified during the audit,
provides guidance on how the auditor should proceed with regard to
misstatements identified on the audit.
- The statement says that the auditor must
• evaluate the effect of identified misstatements on the audit, and
• evaluate the effect of uncorrected misstatements if any, on the financial
statements.
LH, F&A
3
Defining misstatements
• ISA 450 defines a misstatement as
• “a difference between the reported amount, classification, presentation or
disclosure of a financial statement item and the amount, classification,
presentation or disclosure that is required for the item to be in accordance
with the applicable accounting framework”
• If the auditor does not agree with what is reported in the client’s
financial statements, based on what is required by IFRS (In this case),
a possible misstatement arises
LH, F&A
4
IFRS Requirements
Items in the entity’s financial
statements
- Amounts
Amounts -
- Classifications
Classifications -
- Presentations
Presentations -
- Disclosure
Disclosure -
LH, F&A
5
Causes of misstatements
Inacuracy in
gathering and
processing
data
Incorrect
accounting
estimates
“unreasonable
judgements of
management
Omission of an
amount or
disclosure
LH, F&A
6
Steps to be followed when evaluating
misstatements
LH, F&A
7
1.Identify
possible
misstateme
nts during
the
performanc
e of audit
procedures
2.Accumula
te these
identified
misstateme
nts
3.Determine
an amount
below which
misstateme
nts would be
clearly trivial
and remove
these
misstateme
nts from the
accumulated
misstateme
nts
4.Evaluate
the effect of
these
accumulated
misstateme
nts on the
audit
5.Commu
nicate
misstatem
ents to
managem
ent
LH, F&A
6.Evaluate
the effect of
uncorrected
misstateme
nts on the
AFS
7.Communic
ate
individual
and total of
uncorrected
misstateme
nts to those
charged
with
governance
8.Document
the findings
8
Step 1:
Identify possible misstatements during the performance
of audit procedures
- ISA 450 requires that the auditor record all misstatements identified
on the audit unless they are clearly trivial.
- Examples
- purchase invoices not accounted for at year end.
- Reclassification of receivables with credit balances.
LH, F&A
9
Step 2:
Accumulate these identified misstatements
An e.g. of a schedule of accumulated misstatements
Item
# (see
next
slide)
Type of
misstatement
Description
1
Factual
VAT input (SFP)
1,570
Inventory (SFP)
(1,570)
2
Judgmental
Assets
Dr/(Cr)
$’000
Liabilities
Dr/(Cr)
$’000
Projected
Retained
Earnings
Dr/(Cr)
$’000
(1,720)
Provision for bonuses (SCI)
1,720
Provision for bonuses (SFP)
3
Equity
Dr/(Cr)
$’000
Allowance for obsolete inventory (SCI)
Allowance for obsolete inventory (SFP)
(1,500)
TOTAL
(1,500)
LH, F&A
1,500
(1,720)
3,220
10
• Item 1: ABC Ltd’s inventory is purchased for cash and recorded inclusive of VAT,
totaling $1,570,000, in the inventory account in the general ledger.
• Item 2: There is a difference of opinion of $1,720,000 between the auditor and
management of ABC Ltd regarding the provision for performance bonuses payable to
staff (the auditor believes that the provision is understated by this amount).
• Item 3:
- The inventory balance of ABC Ltd is $9,326,597 at 31 December 2022.
- The audit team conducted an inventory count at only one of the warehouses where the inventory is
stored.
- The carrying amount of inventory at this warehouse was $7,461,277 according to ABC Ltd’s records.
- The inventory count at this warehouse revealed that inventory to the value of $1,200,000 should be
recorded as obsolete.
- Based on a rough estimate, the projected misstatement is therefore in the region of $1,500,000 i.e.
{
$1,200,000
$7,461,277
}
x $9,326,597
LH, F&A
11
Step 3:
Determine an amount below which misstatements would be clearly trivial and
remove these misstatements from the accumulated misstatements
• “Clearly trivial” should be taken to mean that the misstatement is very small,
insignificant and inconsequential.
• “Clearly trivial” is not another phrase for not material; because a
misstatement falls below the materiality level it does not mean it is
automatically regarded as trivial and therefore not part of the accumulation
of misstatement.
LH, F&A
12
Step 4:
Evaluate the effect of these accumulated misstatements on the audit
This is done by:
a) Distinguishing between
i. Factual misstatements
ii. Judgemental misstatements
iii. Projected misstatements
b) Determining whether overall audit strategy and audit plan should
be revised by taking into account the NATURE and AMOUNT of
identified misstatements that have been accumulated.
c) Request management to examine causes of misstatements, record
the amount of actual misstatements and make adjustments to the
AFS where deemed appropriate. Perform additional audit
procedures to see if misstatements
remain.
LH, F&A
13
Step 5:
Communicate misstatements to management
Consider reasons for and the effects on the AFS if management
refuse to correct all or some of these.
In communication, distinguish between factual, judgemental and
projected misstatements.
Consider the effect on the fair presentation of AFS
LH, F&A
14
Step 6:
Evaluate the effect of uncorrected misstatements on the AFS
• This is done by
a) Re-assessing materiality
b) Considering the:
 size (quantitative aspects) and
 Nature (qualitative aspects)
of uncorrected misstatements
c) Do this for individual misstatements and for the aggregate
LH, F&A
15
Step 7:
Communicate individual and total of uncorrected
misstatements to those charged with governance
• Consider the effect on the audit report.
• Request the relevant people to correct the misstatements.
• Consider the possible effect of not correcting the misstatements on
future audit involvement.
• Communicate the possible effect of prior period uncorrected
misstatements.
• Request a management representation letter (that uncorrected
misstatements are immaterial).
LH, F&A
16
Step 8:
Document the findings
• Document
Clearly trivial amounts.
Accumulated misstatements and whether they are corrected.
Conclusion on uncorrected misstatements.
LH, F&A
17
Conclusion
- This section dealt with misstatements that the auditor identifies
during the audit and how they should be evaluated.
- The auditor should consider the sufficiency of the evidence gathered
in support of management’s assertions underlying financial
statements.
- He/she must also evaluate the differences between the amounts
included in the financial statements and amounts supported by audit
evidence gathered by the application of substantive procedures.
- These differences are referred to as misstatements and arise from:
• Misstatement of fact,
• The misapplication of accounting practices or
• Unreasonable accounting estimates.
LH, F&A
18
Practice question (10 marks)
You completed the detailed fieldwork for the audit of Afric Art Pvt Ltd on 19 September
2022 and the only work remaining is the resolution of certain outstanding audit issues as
well as the final review of the annual financial statements. You have settled on $25000 to
be used as performance materiality.
Afric Art Pvt Ltd calculated the allowance for obsolete inventory in the 2022 financial year
on a different basis, which is not in accordance with IFRS, in an attempt to overstate
inventory and profit before tax.
The allowance for obsolete inventory on 30 June 2022 calculated in terms of the new
approach, amounted to $5806. The allowance would have been $53,675 had the company
applied its previous policy which was in accordance with IFRS.
Required
Discuss, giving reasons, what actions you would take should the directors of Afric Art Pvt
Ltd be prepared to make all adjustments requested by you, except for an adjustment to the
allowance for obsolete inventory which, based on the audit evidence you have gathered,
should be $53, 675
(Graded Questions on Auditing)
LH, F&A
19
Solution
1. The difference between management’s estimate and the amount best
supported by the available evidence is a misstatement, and its effect on
the financial statements should be considered to evaluate if it has a
material effect on fair presentation.
2. Is the misstatement material
Difference $53675 - $5806
Performance materiality
Profit before tax
$47869
$25000
As the effect of the misstatement exceeds performance materiality, it is quantitatively
material.
3. The matter should be communicated on the audit report as a key audit
matter under “key audit matters” section per the requirements of ISA
701.
cont…
LH, F&A
20
4. Management should be informed that you would have to qualify your
audit opinion should they fail to make the adjustment required to the
allowance for obsolete inventory and that you would have to
communicate the matter as a key audit matter on the audit report.
5. Should management continue to refuse to make the adjustment, you
must then consider whether the material misstatement has a pervasive
effect on the financial statements (affecting the fair presentation of the
financial statements)
a. If the misstatement is material and pervasive, an adverse audit
opinion should be reported.
b. If the misstatement is material but not pervasive (more likely in this
instance), a qualified “except for” audit opinion should be expressed.
6. The auditor must consider whether he can rely on any other information
obtained from management.
7. The auditor would consider if he can still continue with the appointment.
8. The auditor should consider resigning after having complied with his
responsibility in terms of the PAA Act.
LH, F&A
21
Practice
Question
You are the senior in charge of the audit of Inside-Out (Pvt) Ltd, a company which sells an extensive range of home products,
e.g. furniture, appliances. You have commenced with the concluding stage of the audit and are currently evaluating the
uncorrected misstatements with a view to determining whether adjustments are required to the client’s draft annual
financial statements for the 2022 financial year. The final materiality figure for this audit has been set as $200000.
Uncorrected misstatement 1
• During the course of the 2022 financial year, three of the five directors of the company had taken loans in their personal
capacities from third party financiers in the amount of $200,000 each to enable them to participate in a private
investment venture. Having obtained the appropriate statutory authority in terms of section 208(2) of the Companies and
Other Business Entities Act, Inside Out (Pvt) Ltd provided security for these loans. The financial director has made no
disclosure of the security provided in the company’s 2022 annual financial statements – on the basis that this is not
relevant to shareholders.
Uncorrected misstatement 2
• A calculation error of $85,000 was detected on the costed inventory sheets resulting in an overstatement of the year-end
inventory balance. Management has acknowledged the error, and the following adjusting journal entry has been recorded
Dr
$85,000
Cr
Inventory
Cost of Sales
$85,000
To account for a misstatement detected by external auditors
• Uncorrected misstatement 3
• Based on the audit evidence gathered, the audit team concluded that there is an understatement of the allowance for
credit losses of between $100,000 and $150,000.
Required
• Evaluate the materiality of the uncorrected misstatements both individually and in aggregate (12 marks)
LH, F&A
22
Solution
Solution
• Uncorrected misstatement 1
1. As the directors are members of the key management personnel of the reporting
entity, the security provided will give rise to a related party transaction in terms
of IAS 24 – and as such disclosure of this is necessary. (1)
2. This factual uncorrected misstatement is quantitatively material as the amounts
involved are in excess of the final material figure. (1)
3. The failure to disclose the details of the security provided is also qualitatively
material as: (1)
a. Given the inherent conflict of interest in directors using company resources for their personal
benefit, the users of the company’s financial statements need to be made aware / reminded of
this when they evaluate the directors’ performance for the financial year. (1)
b. The third party financiers are also likely to check the notes to the company’s annual financial
statements for disclosure of this security. (1)
Cont…
LH, F&A
23
• Uncorrected misstatement 2
1. There is a factual uncorrected misstatement in the overstatement of
$170,000 ($85,000 x 2) in respect of inventory and gross profit /
profit for the year - due to the adjusting journal entry being recorded
incorrectly. (1½)
2. The uncorrected misstatement is not quantitatively material in
isolation due to it being below the final materiality limit. (1)
3. Neither is the uncorrected misstatement qualitatively material
individually as the mere knowledge of the misstatement is unlikely to
influence the economic decisions of users. (1)
cont,…
LH, F&A
24
Uncorrected misstatement 3
1. The auditor should determine whether the difference between the
client’s estimate and the estimate supported by the auditor’s evidence
requires adjustment or whether it can be accepted as reasonable. (1)
2. It would appear that the difference is unreasonable and management’s
failure to revise their estimate will result in the difference being a
judgmental uncorrected misstatement. (1)
3. This uncorrected misstatement in isolation is neither quantitatively
nor qualitatively material. (1)
Cont…
LH, F&A
25
Individually immaterial uncorrected misstatements considered in aggregate
Schedule of Uncorrected Misstatements
(after removing individually material matters & ignoring the tax effects)
Assets
$’000
Dr / (Cr)
Uncorrected misstatement #2
Uncorrected misstatement #3
Total unadjusted misstatements
FM (170)
JM (150)
(320)
LH, F&A
Liabilities Statement of
$’000
Profit or Loss
Dr / (Cr)
$’000
Dr / (Cr)
(170)
(150)
(320)
26
Cont…
1. When uncorrected misstatements 2 and 3 are aggregated, it is evident
that pre-tax profit for the year will be overstated by an amount which
is in excess of the final materiality figure, and these misstatements in
aggregate must be regarded as quantitatively material. (1)
2. Therefore, one of the uncorrected misstatements (probably
uncorrected misstatement #2) must be regarded as being material, and
will have to be corrected by the client’s directors, else a modification
of the auditor’s opinion will be necessary. (1)
LH, F&A
27
LH, F&A
28