Combining prior and current misstatements when evaluating audit findings.

Although the evaluation of audit findings is a matter of professional judgment, Statement on Auditing Standards no. 47, Audit Risk and Materiality in Conducting an Audit (AU section 312 of AICPA Professional Standards), codifies practice in this area. The SAS made one rather significant change to established practices. It concerns the so-called combined effects of current-period and prior-period misstatements.

According to SAS no. 47, paragraph 30: "In prior periods, likely misstatements may not have been corrected by the entity because they did not cause the financial statements for those periods to be materially misstated. Those misstatements might also affect the current period's financial statements. If the auditor believes that there is an unacceptably high risk that the current period's financial statements may be materially misstated when those prior-period likely misstatements that affect the current period's financial statements are considered along with likely misstatements arising in the current period, he should include in aggregate likely misstatements the effect on the current period's financial statements of those prior-period likely misstatements."

Paragraph 30 deals with the combined effects uncorrected misstatements in an entity's opening and closing real accounts have on its current-period reported accounts. In its most important application, paragraph 30 requires an auditor to consider whether current-period reported income is materially misstated by the combined effects of originations of current-period misstatements and reversals of prior-period misstatements.

This article presents two cases that illustrate auditing issues related to combined-misstatement analysis.

CASE 1

An auditor is evaluating audit findings at the conclusion of the December 31, 1990, audit of XYZ Corp. The only uncorrected misstatements noted in the current and prior-period audits are sales cutoff errors. Beginning-of-period receivables are understated by $70; end-of-period receivables are overstated by $60. If a $100 misstatement of XYZ's pretax income is considered material, is 1990 pretax income materially misstated?

Discussion. Yes. Applying paragraph 30, the auditor combines the end-of-period overstatement of receivables ($60) with the beginning-of-period understatement of receivables ($70). This produces a $130 overstatement of current-period pretax income. In other words, both reported sales and pretax income would have been $130 lower in 1990 if XYZ had properly recorded revenue associated with the end-of-period cutoff error in 1991 and the revenue associated with the beginning-of-period cutoff error in 1989.

Note that XYZ's auditor would have reached a different conclusion--and a wrong one--if he or she considered only the $60 end-of-period misstatement when evaluating the audit findings. Uncorrected misstatements in the prior-period's closing balance sheet carry over to the current-period income statement, and the auditor should consider these carryover effects. In other words, a client does not start a new period with a "clean slate" because prior-period misstatements were deemed immaterial.

CASE 2

An auditor is evaluating audit findings at the conclusion of the December 31, 1990, audit of RST Corp. Exhibit 1 at left shows the uncorrected misstatements the auditor detected in the current- and prior-year audits. What's the aggregate likely misstatement of RST's 1990 pretax income?

The answer to this question depends on the auditor's risk assessment, which is the key to applying paragraph 30. Two outcomes are possible.

Paragraph 30's requirement to consider the current-period effect of prior-period misstatements is conditional. It applies "[i]f the auditor believes that there is an unacceptably high risk that the current period's financial statements may be materially misstated when those prior-period likely misstatements...are considered along with likely misstatements arising in the current period...." [Emphasis added.]

Thus, an auditor may ignore prior-period misstatements when evaluating audit findings if he or she concludes the risk of material misstatement due to combined-misstatement effects is not "unacceptably high." Reaching that conclusion, RST's auditor computes the aggregate likely misstatement of RST's pretax income as $150. This is the sum of all end-of-period misstatements arising in the current period (that is, errors 1, 2 and 3).

If the auditor concludes the risk of material misstatement is unacceptably high, he computes the combined effect on current-period results of all reversals of beginning-of-period misstatements and originations of end-of-period misstatements. As exhibit 2 on page 104 shows, RST's auditor thus calculates an aggregate likely misstatement of $175 for pretax income.

Once the auditor has estimated the aggregate likely misstatement of the financial statements, he then evaluates whether the financial statements are materially misstated. Assume a $200 misstatement of RST's pretax income is considered material. Since this threshold exceeds the aggregate likely error of $175, some auditors may conclude no adjustment to RST's 1990 financial statements is necessary. These auditors, however, should consider paragraph 32 of SAS no. 47: "If the auditor concludes that the aggregation of likely misstatements does not cause the financial statements to be materially misstated, he should recognize that they could still be materially misstated due to further misstatement remaining undetected. As aggregate like misstatement increases, the risk that the financial statements may be materially misstated also increases."

Thus, using the $200 materiality threshold, it may be prudent for the auditor to ask the client to adjust for some of the misstatement. Otherwise, the risk of material misstatement may turn out to be higher than the auditor desires.

Also, if the auditor concludes the aggregate likely misstatement is immaterial in the current year, he still may wish to ask the client to adjust for some misstatements to reduce the likelihood that next year's reported results will be materially misstated.

This article has shown prior-period misstatements compounding current-period misstatements. But prior-period misstatements may mitigate current-period misstatements. For example, it cutoff errors cause end-of-period receivables to be overstayed by $100 and beginning-of-period receivables to be overstated by $80, current-period pretax income is overstated by only $20.

A FINAL WARNING

Misstatements in the opening balance sheet have, dollar for dollar, just as much effect on the measurement of current-period income as misstatements in the closing balance sheet. Paragraph 30 of SAS no. 47 simply requires auditors to consider this fundamental fact: Current- and prior-period misstatements can combine to produce a material misstatement, even when neither misstatement is material when considered individually.