During any audit assignment, an auditor will have several objectives. Usually, these goals come from the type and scope of the audit engagement. Both the client and the auditor agree to what the objectives for an audit engagement are. Based on that agreement, the auditor will perform procedures to ensure that they meet the objectives.
For an external audit, the objectives come from the International Standards for Auditing (ISAs). Below is one of the objectives of the external audit.
According to ISAs, one of the objectives of the external audit is for auditors to obtain reasonable assurance about whether the financial statements are free from material misstatements.
This objective specifies that auditors must consider only material misstatements. Before understanding what material misstatements are, it is crucial to understand what misstatements mean.
What is a Misstatement?
According to the ISAs, a misstatement represents:
“A difference between the amount, classification, presentation or disclosure of a reported financial statement item and the amount, classification, presentation, or disclosure that is required for the item to be in accordance with the applicable financial reporting framework.” These misstatements can either come due to error or fraud.
In essence, a misstatement is an anomaly caused by the misrepresentation of a financial statement item. As mentioned, this may be deliberate or passive. Either way, misstatements are crucial in financial statements as they influence users’ decisions. However, not all misstatements can impact their decisions. Some misstatements may occur, which are negligible.
In most cases, auditors can discuss the misstatement with the client’s management. If the management agrees to rectify the errors that may cause these misstatements, there are no further procedures. However, some clients may not be willing to cooperate with auditors. In these cases, auditors will need to take other actions to disclose the occurrence of such misstatements in the financial statements.
What is a Material Misstatement?
As mentioned, not every misstatement can influence a financial statement user’s decision. For that to happen, these misstatements need to be material.
Material misstatements represent “misstatements, including omissions, which, individually or in aggregate, could reasonably be expected to influence the economic decisions of users taken on the basis of the financial statements.”
Therefore, any misstatements in the financial statements that influence a user’s decisions is a material misstatement. Any anomalies that don’t impact the decisions taken by the users are not material. However, they are still misstatements. The auditing standards define the rules which auditors can use to determine whether a misstatement is material.
However, it is a matter of the auditor’s professional judgment to decide on whether a misstatement is material. During the decision-making process, auditors need to consider several factors. The most significant of these is to determine whether a misstatement will influence the economic decisions of the users. Nonetheless, auditors also need to consider the size and nature of the misstatements.
What is the Importance of Material Misstatement?
Material misstatements are crucial for auditors for several reasons. Most importantly, they are critical because they can help auditors deal with time and resource constraints. It is not possible for auditors to identify and analyze every misstatement. Therefore, by eliminating immaterial misstatements from the list, auditors can perform their audits efficiently.
However, that is not the only reason why auditors need to identify material misstatements. Material misstatements are crucial because they allow auditors to establish a risk level for each engagement. By doing so, they can identify any critical areas and focus on those. As mentioned, materiality can come through either size or nature. Therefore, auditors can focus on areas of high importance.
Furthermore, materiality does not apply to specific financial statement items. Instead, auditors can also aggregate various items and check if their sum reaches the materiality level. This way, they don’t neglect any misstatements, which in aggregate could affect the users’ economic decisions. Overall, materiality and material misstatements are highly critical for auditors.
What is the Risk of Material Misstatement?
For auditors, material misstatements also accompany some risks. Therefore, they must identify these risks and take the necessary countermeasures. The risk of material misstatement comprises of two risks. These include the inherent and control risks of a client. Once these risks combine with the detection risk for an engagement, these constitute the audit risk for that engagement.
The risk of material misstatement may exist at two levels. These include the financial statement level and the assertion level. If any misstatements or errors relate to the financial statements and are pervasive, they will also influence the assertion level. However, auditors need to assess the risk of material misstatement at the assertion level to decide on further audit procedures to obtain sufficient appropriate audit evidence.
Misstatements include differences between the disclosed financial statement items and the expected representation under the accounting standards. A material misstatement is a misstatement or omission that can affect financial statement users’ decisions. It is crucial for auditors to identify material misstatements for several reasons. Some of these are available above.