Evaluating misstatements and the overall review (ISA 450)

During the audit, the senior has found a ₦8 million error in inventory, a ₦5 million overstatement of receivables and a ₦3 million expense in the wrong year. Management says each is too small to bother with. Materiality is ₦20 million. Are the errors acceptable? Added together, they are ₦16 million, close to materiality, and each has been left uncorrected.

The auditor must add them up, decide whether to revise the plan, press management to correct and judge the effect of what stays uncorrected. At the end, a senior reviews the whole set of statements to check that they make sense.

This topic covers the objective and requirements of ISA 450 on evaluating misstatements, the summary of unadjusted differences, and the overall review of the financial statements at the end of the audit, both general and specific. The previous topic covered written representations, and the next covers the purpose of the audit report and the expectation gap.

Key terms in plain English

Syllabus check

This topic is in syllabus area C, audit evidence, completion and reporting (25% of marks). It covers:

• evaluation of misstatements (ISA 450)
• the overall review of the financial statements
• materiality (ISA 320)

CAMA 2020 and misstatements

The Companies and Allied Matters Act 2020 (CAMA 2020) is the company law of Nigeria. The sections below apply to this topic.

The rules in more depth

Objective of ISA 450

ISA 450 Evaluation of Misstatements Identified during the Audit requires a list of uncorrected misstatements to be attached to the letter of representation. The list is often called a summary of unadjusted audit differences. The auditor's objective is to evaluate:

• the effect of identified misstatements on the audit; and
• the effect of any uncorrected misstatements on the financial statements.

A misstatement may relate to the amount, classification, presentation or disclosure of an item. Misstatements may be factual, where there is no doubt; judgemental, from management's estimates or choice of policies that the auditor considers unreasonable; or projected, the auditor's best estimate of misstatements in a population based on a sample.

Requirements of ISA 450

1. Accumulate all misstatements found during the audit, unless they are clearly trivial.
2. If the total of misstatements found approaches, or could approach, materiality, decide whether the overall audit strategy and audit plan need to be revised.
3. Communicate all misstatements found to an appropriate level of management, and ask management to correct them.
4. If management refuses to correct, obtain its reasons and take them into account when evaluating whether the financial statements as a whole are free from material misstatement.
5. Before evaluating the effect of uncorrected misstatements, reassess materiality under ISA 320.
6. Decide whether uncorrected misstatements are material, individually or added together. The auditor considers the size, the nature and the circumstances of the misstatements, and the effect of uncorrected misstatements from prior periods.
7. Communicate to those charged with governance the effect that uncorrected misstatements may have on the auditor's report.
8. Request a written representation from management on whether it believes the effect of uncorrected misstatements is immaterial, individually or in total.
9. Document the amount below which misstatements are clearly trivial; all misstatements accumulated and whether they were corrected; and the conclusion on whether uncorrected misstatements are material, individually or in total.

Clearly trivial

"Clearly trivial" does not mean "not material". It means an amount that is clearly inconsequential, whether taken individually or together, and judged by any size, nature or circumstance criteria. Firms usually set a percentage of materiality, often around 5%. If materiality is ₦20 million and the threshold is 5%, items under ₦1 million are not accumulated, unless their nature makes them important.

Misstatements that involve illegal acts or break a legal requirement are never trivial merely because they are small.

Qualitative factors in evaluating misstatements

A small misstatement may be material because of its nature or circumstances. The auditor considers whether it:

• affects compliance with regulatory requirements or with loan covenants, such as turning a loss into a profit or a breach into compliance;
• affects the trend of earnings, or the achievement of targets, bonuses or expectations;
• involves directors or management, or is connected with fraud;
• relates to a segment or item of special interest to users;
• affects a disclosure, such as related party transactions or directors' pay, which is sensitive to users; or
• is likely to be repeated or to be a sign of a control weakness.

A series of small misstatements all in the same direction suggests bias, which may be a sign of earnings management. The effect of prior-year uncorrected misstatements, called the carry-over effect, is also considered, together with whether the current year balance sheet approach or the income statement approach is used.

A summary of unadjusted differences

Individually, no item exceeds ₦20 million. Together, the gross total is ₦16 million and the effect on profit is ₦10 million. The auditor would ask management to correct, explain the effect and decide whether the uncorrected balance is material. If management does not correct, the auditor considers the effect on the report and asks for the written representation.

Communicating and correcting misstatements

The auditor communicates misstatements on a timely basis to the right level of management, so that management can correct them, and tells those charged with governance about uncorrected misstatements and their effect. Correction of all misstatements, including those below materiality, helps lower the risk that the total of undetected and uncorrected items is material.

If management corrects, the auditor performs additional procedures to see that the correction is right and that no further misstatement exists in that area. If a misstatement shows a fraud or a weakness in internal control, the auditor reports it as the earlier topic on management letters describes.

If uncorrected misstatements, individually or together, are material, the auditor must express a qualified or adverse opinion, as explained in the topic on modified opinions. If the evidence is insufficient to decide, it is a limitation of scope.

Overall review of the financial statements

After the detailed work, the auditor carries out an overall review. The financial statements should be in final draft form. A senior member of the team, often the manager or partner, normally does this review.

General review. Check that a clear conclusion has been reached and documented for each financial statement area. Analytical procedures may be used as a last check that the draft financial statements make sense. ISA 520 requires the auditor to apply analytical procedures near the end of the audit to help form an overall conclusion that the statements are consistent with the auditor's understanding of the entity.

Specific review. The overall review covers:

• the client's compliance with the relevant accounting framework, which is the national legislation and applicable standards;
• the accounting policies adopted, assessing whether they are acceptable and comply with standards and industry practice;
• adequate disclosure of relevant information; and
• whether the information in the statements is consistent with known business facts.

Other matters at completion

At the end of the audit, the auditor also:

• reviews the working papers to see that every area has a conclusion and that the evidence supports it
• clears open points and review notes
• considers events after the reporting period up to the date of the report
• reassesses going concern
• reads other information published with the statements for inconsistency
• obtains the letter of representation
• holds a closing meeting with management and those charged with governance
• where it applies, completes the engagement quality review

Only when all these are done does the partner sign the report. Using a completion checklist makes sure that nothing is missed. If the evidence is not enough, the partner delays the report.

The review is also a chance for the reviewer to challenge. The reviewer asks whether the team has followed the plan and the ISAs, whether judgements such as estimates have been sufficiently challenged, whether the conclusions are consistent between areas, and whether the final opinion is supported. A review note answered by the team and cleared before sign-off gives evidence of the quality control that ISA 220 and ISQM 1 require.

Worked examples

1. It is below the threshold, so need not be accumulated.
2. If it hides a breach of law, it is not trivial.

1. They approach materiality in total.
2. The auditor revises the plan, asks management to correct and considers the effect if they are not.

1. The item is below materiality in size but material by nature.
2. The auditor treats it as material and asks for correction.

1. The review flags an inconsistency with known facts.
2. The reviewer returns it to the team to find out whether revenue or cost of sales is misstated.

How to score full marks

• Learn the nine requirements of ISA 450 as a numbered list.
• Say that materiality is reassessed before evaluating.
• Add qualitative factors to quantitative ones.
• Link the list of uncorrected misstatements to the letter of representation.

Common mistakes in the exam

• Confusing "clearly trivial" with "immaterial".
• Judging each misstatement alone and never in aggregate.
• Forgetting to tell those charged with governance.
• Treating the overall review as the work of the junior.

Quick revision

• Accumulate, revise plan, communicate, reasons, reassess, evaluate, tell governance, representation, document.
• Size, nature, circumstances.
• Overall review by a senior: conclusions, analytics, framework, policies, disclosure, consistency.

Practice questions

Questions 1 to 10 are multiple choice. Questions 11 to 13 are written. Try each before opening the answer.

Model answers

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