The CPA Journal

Since its issuance in 1999, SAS 89 has heightened the awareness of both management and auditors to several important questions: When are audit differences material in nature? When should audit differences be booked? The authors discuss guidance that clarifies what should be addressed in engagement letters and management representation letters, and they analyze how to identify the quantitative and qualitative characteristics of potential financial statement misstatements. They provide sample wording for both engagement and management representation letters and a list of qualitative items to assess whether a misstatement is likely.

In December 1999, the Auditing Standards Board (ASB) issued Statement on Auditing Standards (SAS) 89, Audit Adjustments. Applicable to all financial statement audits, SAS 89 modifies the auditing technical literature which specifies the items that should be addressed in engagement letters, included in management representation letters, or communicated to audit committees. Although both quantitative and qualitative characteristics have long been considered when deciding whether financial statement misstatements should be booked, SAS 89 has heightened awareness of their materiality when conducting financial statement audits. The ASB's Audit Issues Task Force has issued a series of interpretations associated with risk and materiality. They clarify the guidance for determining when financial statement misstatements detected in an audit should result in audit adjustments.

As amended by SAS 83, Establishing an Understanding With the Client, SAS 1/AU Section 310, Appointment of the Independent Auditor, requires auditors to establish an understanding of the audit engagement with the client. As a practical matter, engagement letters establish this understanding. To the list of items typically included in engagement letters, SAS 89 added new items relating to management's responsibility for adjusting the financial statements to correct material misstatements. Furthermore, management must affirm in the management representation letter that the effects of any uncorrected misstatements are immaterial to the financial statements taken as a whole. The following is sample wording that may be included in an engagement letter to accomplish this objective:

You are responsible for making all financial records and related information available to us; furthermore, you are responsible for the accuracy and completeness of that information. We will advise you about appropriate accounting principles and their application and assist in the preparation of your financial statements, but the responsibility for the financial statements remains with you. This responsibility includes the establishment and maintenance of adequate records and the safeguarding of assets. You are responsible for adjusting the financial statements to correct material misstatements and for confirming to us in the management representation letter that the effects of any uncorrected misstatements aggregated by us during the current engagement, and pertaining to the latest period presented, are immaterial, both individually and in the aggregate, to the financial statements taken as a whole. You are also responsible for ensuring that the entity complies with applicable laws and regulations.

SAS 85, Management Representations, requires that the auditor obtain written representations from management as a part of a financial statement audit. SAS 89, which amended SAS 85, requires that the management representation letter include an acknowledgment that management has considered uncorrected misstatements and concluded that these misstatements are immaterial to the financial statements taken as a whole. The following is a sample representation that accomplishes this objective:

We believe that the effects of the uncorrected financial statement misstatements, summarized in the accompanying schedule, are immaterial, both individually and in the aggregate, to the financial statements taken as a whole.

The provisions of SAS 61, Communication with Audit Committees, require that certain matters related to the conduct of an audit must be communicated to the audit committee, which has responsibility for oversight of the financial reporting process. SAS 89, which amended SAS 61, requires the auditor to inform the audit committee about uncorrected misstatements where management believes the effects of the misstatements are immaterial to the financial statements taken as a whole. Essentially, when uncorrected misstatements are included in the management representation letter, these misstatements must also be communicated to the audit committee.

The interpretative guidance indicates that, in the absence of materiality considerations, misstatements are items that cause the financial statements not to conform with generally accepted accounting principles (GAAP) or an other comprehensive basis of accounting (OCBOA). Misstatements may relate to any of the following:

Misstatements are categorized as either known or likely. Exhibit 1 provides descriptions and related examples of the types of misstatements discussed in the technical literature. An evaluation of whether the known and likely misstatements are immaterial (both individually and in the aggregate) to the financial statements taken as a whole is a necessary audit step. SAS 47, Audit Risk and Materiality in Conducting an Audit, requires that the misstatements be aggregated in a manner that allows the evaluation of whether the misstatements in individual amounts, subtotals, and totals in the financial statements materially misstate those financial statements taken as a whole. For example, the aggregated effect of misstatements on amounts such as current assets, current liabilities, and other key financial statement totals and subtotals should be considered when assessing whether the financial statements taken as a whole are misstated.

Although analytical procedures can be primary substantive tests, specific misstatements are typically not identified when analytical procedures are used to test account balances or classes of transactions. In practice, such procedures generally only provide an indication of whether a misstatement might exist.
If significant differences arise between the expected and actual results of analytical procedures, this should trigger an evaluation of whether those differences are indicative of a misstatement in the financial statements. When properly designed, analytical procedures that indicate the possible existence of a misstatement should generate procedures to determine the amount of the known misstatement. Any unexplained difference between the expected and actual results identified with analytical procedures may be considered a likely misstatement. Keep in mind that it is generally not reasonable to treat the entire difference between the expected and actual results of analytical tests as a misstatement because: 1) the expectation for the procedure may not properly capture all of the pertinent information (e.g., changes in industry, economic, or business conditions), and 2) the difference relates to only one side of the entry needed to adjust the financial statements.

Accounting estimates do not result in amounts that are accurate or certain. There may be reasonable differences between the estimates supported by audit evidence and the estimates included in the financial statements that would, therefore, not constitute likely misstatements. When an estimate in the financial statements is unreasonable, however, the difference between it and the closest reasonable estimate is a likely misstatement that should be aggregated with other likely misstatements. The interpretative guidance addresses factors to consider in determining the amounts of such likely misstatements and deciding whether the financial statements are materially misstated.

Auditors typically use the closest reasonable estimate to evaluate the reasonableness of recorded estimates. For example, suppose a regional commercial bank had total loans of $1,770,755,000 and a related loan loss reserve of $28,630,000 on the financial statement date. Analyses of problem loans, charge-off trends, regulator reports, and other relevant information indicate that the acceptable range for the loan loss reserve is between $27,446,000 and $29,217,000. Generally, no difference would be aggregated as a misstatement since the recorded estimate falls within the acceptable range. However, a difference would be aggregated when the recorded estimate is outside the range of acceptable amounts. For example, if the recorded estimate for the loan loss reserve were $26,988,000, then $458,000 ($27,446,000 minus $26,988,000) would be aggregated as a misstatement. The aggregated difference is generally determined using the amount at the closest end of the range for an acceptable estimate.

In other instances, a point estimate to evaluate the reasonableness of recorded estimates could be helpful. In the case above, suppose that analyses of the bank's problem loans, charge-off trends, regulator reports, and other relevant information indicate that the loan loss reserve should be $28,155,000, or approximately 1.59% of total loans. The $28,155,000 audit estimate would be compared to the recorded estimate of $28,630,000 to determine the reasonableness of the recorded amount. The difference would be included in the aggregated misstatements.

Deliberate bias could also affect the estimation of recorded amounts, especially if the estimator knows that estimates will be compared to a range of acceptable amounts. For example, recorded estimates may be clustered at one end of the range of acceptable amounts in the current year, whereas the previous year's recorded estimates were clustered at the other end. This could indicate that estimates are being used to push earnings in one direction or the other, in which case the audit committee should be informed.

It is generally understood that determining and applying materiality thresholds in a financial statement audit is a matter of professional judgment. Furthermore, audit decisions related to materiality should be influenced by the information needs of users relying upon those financial statements. Aggregate uncorrected misstatements should be considered when the financial statements are materially misstated, whether individual amounts, subtotals, or totals.
The new interpretative guidance discusses what factors to consider in assessing the quantitative impact of identified misstatements. Specifically, the quantitative evaluation of aggregated misstatements should reflect a measure of materiality based on the elements of the financial statements that are expected to affect the judgment of a reasonable person relying upon the financial statements. Importantly, the degree of emphasis placed on certain elements will vary based on the particular, and perhaps varying, needs of financial statement users. For example, if revenue growth is likely to affect the judgment of a reasonable user, then total revenues should be an element utilized in the quantitative analysis of financial statement misstatements. Exhibit 2 provides a list of financial statement elements that may be considered.

The new interpretive guidance indicates that the quantitative evaluation must consider the nature of the reporting entity as well as specific circumstances. For example, it is generally recognized that income from continuing operations is typically of greatest significance to the financial statement users of publicly traded entities. Regardless of the entity's nature or circumstances, the elements selected should reflect the measures most likely to be considered important by financial statement users.

In this context, planning materiality differs from the materiality thresholds for evaluating misstatements in final review. Planning materiality is based on a preliminary judgment about materiality and, as a practical matter, is calculated as a single amount, typically the smallest materiality level associated with all of the basic financial statements. In the final review stages of the audit, however, different materiality levels for each of the different financial statement elements are typically used in evaluating misstatements.

The new guidance also discusses other quantitative measures that could be considered if income from continuing operations is nominal or fluctuates widely from period to period because of unusual or infrequently occurring items of income or expense. In these circumstances, income from continuing operations as a quantitative measure of materiality may not be appropriate. Consequently, it may be necessary to either select an alternative that is appropriate for the situation or adjust current-year income from continuing operations to exclude unusual or infrequently recurring items. Factors to consider when selecting an alternative measure include the following:

Aside from the quantitative ramifications of financial statement misstatements, qualitative issues must also be considered before passing on an audit adjustment. The new interpretative guidance on risk and materiality issues should be very helpful. Some examples of the qualitative factors that should be considered in evaluating financial statement misstatements, and some practical examples that should be helpful in qualitative analysis, are shown in Exhibit 3.

It is important to remember that disclosure deficiencies may also materially affect financial statements. Deficiencies in disclosures related to unusual transactions and amounts may be considered material even though similar transactions and amounts for more common items may be considered immaterial. For example, the omission of related-party disclosures about an account receivable may be material to the financial statements even though similar amounts arising from routine transactions may not be considered material. Consequently, the consideration of qualitative issues should typically include an evaluation of the adequacy of disclosures in the financial statements.

Thomas A. Ratcliffe, PhD, CPA, is the Eminent Scholar in Accounting and Finance and dean of the Sorrell College of Business, Troy State University, Troy, Ala.
John Stephen Grice, Sr., PhD, CPA, is an assistant professor of accounting and finance, Sorrell College of Business, Troy State University, Troy, Ala.

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Evaluating Audit Differences