Question

During the course of the audit of Nature Sporting Goods, the auditor discovered the following:

The accounts receivable confirmation work revealed one pricing misstatement. The book value of $12,955.68 should be $11,984.00. The total misstatement based on this difference is $14,465, which includes a $972 known misstatement and an unknown projected misstatement of $13,493.

Nature Sporting Goods had understated the accrued vacation pay by $13,000. A review of the prior-year documentation indicates the following uncorrected misstatements:

Accrued vacation pay was understated by $9,000.

Sales and accounts receivable were overstated by an estimated $60,000 because of cutoff errors.

Prepare a summary of a possible adjustments schedule and draw your conclusion about whether the aggregate effect of these misstatements is material. Use the trial balance numbers shown in Exhibit 14.1, but ignore the misstatements shown in the exhibit. The income tax rate is 40% for the current and prior year. (Note: Materiality must be considered in developing your answer.)

Answer 1

The term 'misstatement' is not defined in ISA 315, but in ISA 450, Evaluation of Misstatements Identified During the Audit, which contains this definition: '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.

Misstatements can arise from fraud or error.' In other words, a misstatement arises where there is a difference between the reported figures, and what is expected to be reported in order for the financial statements to be fairly presented (or show a true and fair view). Misstatements can be factual, in the case of a clear breach of a requirement of a financial reporting standard, or could be judgmental, arising from unsuitable estimation techniques or the selection of inappropriate accounting policies.

ISA 315 requires that the engagement partner and other key engagement team members discuss the susceptibility of the entity's financial statements to material misstatement, and that the engagement partner determines which matters are to be communicated to the rest of the audit team. The discussion should place emphasis on any indicators that the financial statements may be at risk of material misstatement due to fraud. (ISA 240.15) This discussion, and the significant decisions reached must be documented.

Obtaining and documenting an understanding of the entity

Without an in-depth understanding of the audited entity, it is impossible to properly assess the risk of material misstatement. ISA 315 requires that the auditor obtains an understanding relating to five aspects of the audited entity:

1. relevant industry, regulatory and other external factors including the applicable financial reporting framework
2. the nature of the entity including its operations, its ownership and governance structures, the types of investments it makes, and the way the entity is structured and financed
3. the entity's selection and application of accounting policies
4. the entity's objectives and strategies, and business risks that may result in risks of material misstatement, and
5. the measurement and review of the entity's financial performance. (ISA 315.11)

In determining whether a control is relevant to the audit, matters such as the significance of the related risk, materiality, and the complexity of operations should be considered. In relation to control activities, the ISA specifically states that 'an audit does not require an understanding of all of the control activities related to each significant class of transaction, account balance and disclosure in the financial statements or to every assertion in them'. (ISA 315.20)

It is tempting to think that in a simple system operating in a small company there is little risk of material misstatement, but of course there are specific risks associated with this type of company, especially the risks posed by opportunities for management override, and the limited scope for segregation of duty and authorisation controls. In a smaller company, the extent and nature of management's involvement in internal control is likely to be a key aspect in the documentation of internal control.

Auditor's should not underestimate the importance of ISA 315, as its requirements relating to risk assessment help to ensure that audits are responsive to individual audit clients' circumstances, and when applied properly should help to reduce audit risk. Though the requirements of the ISA can seem onerous, careful application of the standard and appropriate use of auditor's judgment should mean that compliance with documentation requirements is relatively straightforward.