Magazine article The CPA Journal

Evaluating Audit Findings When Carryover Misstatements Exist

Magazine article The CPA Journal

Evaluating Audit Findings When Carryover Misstatements Exist

Article excerpt

Just because an auditor considered a misstatement to be immaterial in a prior period doesn't mean the misstatement can be ignored when evaluating audit findings in a subsequent period. That's the easily overlooked implication of par. 30 of SAS No. 47, Audit Risk and Materialily in Conducting an Audit (AU 312), which requires auditors to consider whether current period results are materially misstated by the combined effects of misstatements in a company's opening and closing balance sheets. Paragraph 30 of SAS No. 47 reads in part as follows:

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 ends-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. (Exhibit omitted) Misstatement No. 1 relates to an improperly capitalized fixed-asset addition in the prior period. Misstatement No. 2 illustrates a so-called 'recurring" error. …

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