If the auditor believes that there is an unacceptably high risk that the current period's financial statements may be materially misstated when (the) prior period likely misstatements that affect the current period's financial statements are considered along with likely misstatements arising in the current period, he (or she) should include in aggregate likely misstatement the effect on the current period's financial statements of those prior-period likely misstatements.

A footnote to par. 30 states:

The measurement of the effect, if any, on the current period's financial statements of misstatements uncorrected in prior periods involves accounting considerations and is therefore not addressed...

How should an auditor evaluate audit findings when carryover misstatements exist from a prior period?

A Simple Example

An auditor is evaluating audit findings at the conclusion of the 1993 audit of ABC Company. The only uncorrected misstatements in ABC's current and prior period accounts relate to sales cutoff errors, that 1) understate beginning-of-period receivables by $50,000, and 2) overstate end-of-period receivables by $70,000. If a $100,000 misstatement of pretax income is material, is 1993's income materially misstated?

Yes, pretax income is materially misstated in 1993, since the end-of- period overstatement of receivables, $70,000, when combined with the beginning-of-period understatement of receivables, $50,000, produces a $120,000 overstatement of current-period pretax income. Both sales and pretax income would be $120,000 lower in 1993 if 1) revenues from the end-of-period cutoff error were correctly recorded in 1994, and 2) revenues from the beginning-of-period cutoff error were correctly recorded in 1992.

Two points are relevant concerning this example. First, ABC's auditor would have reached a different conclusion, and an incorrect conclusion according to SAS No. 47, if he or she only considered the end-of-period misstatement of $70,000 when evaluating audit findings. Second, even if ABC adjusts for the entire amount of the end-of-period sales cutoff error, current-period pretax income will still be overstated by $50,000, the amount of the beginning-of period understatement of receivables. Of course, this observation is consistent with the following important generalization:

Errors in the opening balance sheet may have, dollar-for-dollar, just as much of an impact upon the mismeasurement of current-period results as errors in the closing balance sheet.

In fact, this generalization explains the existence of par. 30 of SAS No. 47 in the first place. Uncorrected misstatements in the prior-period balance sheet may carry over to the current-period income statement, and these carryover error effects are to be considered when evaluating the fairness of current-period amounts.

A More Realistic Example

The preceding example, while useful conceptually, does not illustrate the complexities encountered in measuring and evaluating combined-error effects in practice. Assume an auditor is evaluating audit findings at the end of the 1993 audit of XYZ Company. Shown in Exhibit 1 are all likely misstatements detected during the 1993 and 1992 audits. Misstatement No. 1 relates to an improperly capitalized fixed-asset addition in the prior period. Misstatement No. 2 illustrates a so-called "recurring" error. Recurring errors typically occur when a non-GAAP method of accounting is consistently applied to a particular class of transactions or items (e.g., excluding certain overhead costs from inventories, failing to reserve for product returns, etc.). Misstatement Nos. 3 and 4 illustrate other errors of a more routine nature. How should XYZ's auditor evaluate and measure the effects of these misstatements in 1993?

Under par. 30, an auditor considers carryover-error effects on a conditional basis, i.e., when he or she believes there is an unacceptably high risk that the current period's financial statements may be materially misstated by the prior-period likely misstatements.

One important reason for this conditional application is illustrated by the prior-period misstatement relating to the fixed asset addition (see misstatement no. 1). If par. 30 were applied unconditionally, auditors might have to maintain elaborate carryforward schedules of depreciation and amortization differences due to prior-period capitalization errors. Common sense, however, suggests that if the entire effect of a capitalization error for a long-lived asset is immaterial in the period in which it arose, it would also be sensible to assume offsetting depreciation misstatements in the future would be immaterial as well. Accordingly, XYZ's auditor probably should disregard misstatement no. 1 when evaluating audit findings for 1993 and future years, especially if the asset is relatively long-lived and future income levels are not expected to be significantly lower. Finally, note that this principle applies to other clearly insignificant misstatements detected in a prior period. Auditors are not required under par. 30 of SAS No. 47 to continue to evaluate the carryover-error effects of clearly insignificant prior-period misstatements.

As to misstatement no. 2, note the current-period income effect of a recurring error can be measured by the net change between the end-of- period error and the beginning-of period reversing error. An auditor may confront a dilemma when TABULAR DATA OMITTED TABULAR DATA OMITTED evaluating an established recurring error. An adjustment to correct the entire year-end error in the balance sheet may materially misstate current period income statement amounts. However, if nothing is done, the misstatement may continue to grow and become quite troublesome. It is also possible for the increase or decrease in the recurring error to materially misstate current-period income (either individually or when combined with other misstatements). Finally, the recurring error may become so large that it materially misstates balance sheet totals. Certainly, one of the best ways to deal with recurring errors is to prevent them from growing to significant amounts in the first place.

Measuring Misstatement Effects

Since the requirement to consider carryover error effects under SAS No. 47 is conditional, the auditor's calculation of error in a company's current-period income statement depends upon his assessment of the likelihood that prior-period errors may materially affect current-period results. Assume XYZ's auditor assessed carryover error risk to be low in 1993, e.g., he considers the prior-period errors to be quite insignificant in relation to current-period income. Under this assumption, the auditor would include in aggregate likely error of the current period only the effects of misstatements detected during the current-period audit. That is, XYZ's auditor would calculate 1993 pretax income to be overstated by $75,000, the sum of the effects of misstatement nos. 2 and 4 in Exhibit 1, which overstate end-of-period equity, and hence current-period income.

Alternatively, assume the auditor cannot conclude carryover-error risk is low in 1993. (As a matter of policy, many auditing firms require carryover error effects be considered when evaluating audit findings on all engagements, unless the effects are clearly inconsequential.) Under the assumption carryover error risk is not low, XYZ's auditor would still probably disregard misstatement no. 1 in evaluating audit findings for 1993. (As discussed above, the error's effect on current and future- period income is presumed to be inconsequential.)

The remaining misstatements could be combined as illustrated in Exhibit 2, which illustrates a simple, understandable method to calculate combined-error effects. The schedule begins with the uncorrected income statement amount. It then computes the net effect on income of end-of- period balance sheet misstatements. Next, the reversing effect of beginning-of-period misstatements is scheduled. In Exhibit 2, the sign of the reversing effect in the opening balance sheet is the opposite of its sign when it originated. The combined effects of the year end and reversing misstatements can then be summed, as illustrated in Exhibit 2.

Evaluating Combined-Misstatement Effects

Assume again a $100,000 misstatement of pretax income is material. Under this assumption, the income effects of the end-of-period misstatements, $75,000, are below the materiality threshold. However, as shown in Exhibit 2, the beginning and ending balance-sheet errors combine to produce a $120,000 misstatement of income, a material amount. Hence, XYZ's auditor should propose one or more adjustments to XYZ's accounts. Following are a few factors XYZ's auditor may wish to consider in discussing potential adjustments with XYZ's management.

First, as noted previously, the best way to deal with recurring errors is to keep them from accumulating to significant amounts in the first place. Hence, 1993 may be a good year to remove the entire $35,000 effect of the end-of-period recurring error related to Misstatement No. 2. Second, note that if the only adjustment made is for this $35,000 amount, the combined effect of the remaining detected misstatements is $85,000, an amount less than the materiality threshold of $100,000. Some may therefore conclude no further adjustments need be made to XYZ's statements. However, this conclusion should be reconsidered in light of par. 32 of SAS No. 47. In effect, this paragraph states that if unadjusted differences are "just barely" immaterial, the presence of undetected misstatements may make the risk of material misstatement much higher than the auditor planned. Hence, the auditor may request XYZ's management to adjust for other differences detected during the current- year audit. Finally, even if the auditor concludes unadjusted differences are immaterial in the current year, he still may wish to remove some misstatements in the current year to reduce the likelihood that next year's results will be materially misstated by this year's carryover misstatements. This might be especially wise if income levels are expected to be significantly lower in future years.

Doing what comes naturally

When evaluating audit findings, it is only natural for auditors to focus principally upon end-of-period misstatements. Nonetheless, misstatements in the opening balance sheet may have, dollar for dollar, just as much of an impact upon the mismeasurement of current-period income as misstatements in the closing balance sheet. SAS 47 requires auditors to consider this fundamental fact of accounting life when evaluating audit findings.

Thomas R. Craig, PhD, CPA, is professor of accounting at Illinois State University and a frequent contributor to professional journals.