Almost every audit ends with a list of journal entries. Some are recorded, some are reclassifications that only affect presentation, and some are left uncorrected because management and the auditor agree they are immaterial. How those entries are classified, approved and documented matters for the opinion, for independence and for peer review.
This guide explains adjusting journal entries in the context of a nonissuer audit under GAAS. The key standard is AU-C 450, Evaluation of Misstatements Identified During the Audit, supported by AU-C 260 on communication with those charged with governance and AU-C 580 on written representations. The guide paraphrases these sections and is not a substitute for them.
What are adjusting journal entries?
In bookkeeping, adjusting journal entries are period-end entries that bring the accounts to an accrual basis: accruals, deferrals, depreciation, reserves. In an audit, the term usually means something narrower: entries the auditor proposes to correct misstatements identified during the audit, and entries management makes as a result.
Firms use slightly different labels. A common set is:
| Label | What it means | Effect |
|---|---|---|
| AJE (adjusting journal entry) | An entry to correct a misstatement that management has agreed to record | Changes account balances and usually net income or equity |
| PAJE (proposed adjusting journal entry) | An entry the auditor proposes; it becomes an AJE when management accepts it, or a passed adjustment when management declines | Not yet recorded |
| RJE (reclassification journal entry) | An entry that moves amounts between line items for presentation, without changing net income or total equity | Changes classification only |
| Passed adjustment (waived or unrecorded) | A misstatement management has decided not to correct, typically because the effect is considered immaterial | Stays in the summary of uncorrected misstatements |
| Client JE (client-prepared entry) | An entry management records itself after the trial balance was provided, sometimes called a "late" or "top-side" entry | Must be tested like any other journal entry |
Whatever labels the firm uses, define them in the methodology and use them consistently.
Where adjustments come from
Misstatements are identified throughout the audit:
- Tests of details: a cutoff test finds a December shipment recorded as January revenue; a search for unrecorded liabilities finds an unrecorded invoice.
- Substantive analytical procedures: a difference from the expectation that the auditor investigates and quantifies.
- Accounting estimates: the auditor's point estimate or range for the allowance for credit losses differs from management's.
- Sampling: a misstatement found in a sample is projected to the population under AU-C 530.
- Disclosure review: an omitted or incorrect disclosure is also a misstatement under AU-C 450.
AU-C 450: types of misstatements
AU-C 450 describes misstatements in three categories. Using them in the summary schedule makes the evaluation clearer.
Factual misstatements
Misstatements about which there is no doubt. Illustrative example: an invoice for $18,000 was recorded twice.
Judgmental misstatements
Differences arising from judgments about accounting estimates that the auditor considers unreasonable, or about the selection or application of accounting policies the auditor considers inappropriate. Illustrative example: management's inventory obsolescence reserve falls outside the auditor's range of reasonable amounts.
Projected misstatements
The auditor's best estimate of misstatement in a population, projected from misstatements identified in an audit sample. Illustrative example: a sample of payroll transactions shows an overstatement that, projected to the population, is $42,000.
Accumulating misstatements and the clearly trivial threshold
AU-C 450 requires the auditor to accumulate misstatements identified during the audit, other than those that are clearly trivial. "Clearly trivial" is not another word for "not material." It means amounts of a wholly different (smaller) order of magnitude than materiality, inconsequential individually or in aggregate by any criteria. When there is uncertainty about whether something is clearly trivial, it is not.
Firms usually set the threshold as a small percentage of overall materiality and document it alongside materiality under AU-C 320. The materiality calculator shows the three amounts side by side.
Reassess materiality and scope as misstatements build
AU-C 450 requires the auditor to determine whether the overall audit strategy and audit plan need to be revised if:
- the nature of identified misstatements and the circumstances of their occurrence indicate other misstatements may exist that, aggregated with the identified ones, could be material, or
- the aggregate of misstatements identified approaches materiality.
A sampling error that projects close to tolerable misstatement is a signal to extend testing, not to accept the result.
Communicating misstatements and asking for correction
The auditor must communicate all accumulated misstatements to the appropriate level of management on a timely basis and request that management correct them.
If management examines a class of transactions at the auditor's request (for example, after a projected misstatement) and makes corrections, the auditor performs additional procedures to determine whether misstatements remain.
If management refuses to correct some or all of the misstatements, the auditor obtains an understanding of management's reasons and considers that understanding when evaluating whether the financial statements as a whole are free from material misstatement. Refusals can also inform the auditor's assessment of management bias and fraud risk.
Evaluating uncorrected misstatements
Before forming an opinion, the auditor reassesses materiality to confirm it is still appropriate based on actual results, and then determines whether uncorrected misstatements are material, individually or in the aggregate. The auditor considers:
- Size and nature of the misstatements, both for particular classes of transactions, account balances or disclosures and for the financial statements as a whole
- The particular circumstances of their occurrence
- Qualitative factors, for example whether a misstatement affects compliance with debt covenants, masks a change in earnings trend, changes a loss into income, relates to related parties, or affects segment or other information management considers important
- The effect of uncorrected misstatements related to prior periods on the relevant classes of transactions, balances or disclosures and the financial statements as a whole
Prior-period misstatements
A misstatement left uncorrected last year can affect this year's income statement when it reverses, or the current balance sheet if it carries forward. The auditor considers the effect of prior-period uncorrected misstatements on the current financial statements. Evaluating both the current-period income statement effect and the cumulative balance sheet effect helps keep small carried-forward errors from accumulating unnoticed. Document which approach the firm uses and apply it consistently.
Offsetting misstatements
Be cautious about netting. An overstatement of revenue offset by an overstatement of expenses may leave net income unchanged but still be material to revenue. Misstatements within the same account balance or class of transactions may be offset in some cases, but the auditor considers whether undetected misstatements may exist before doing so. Classification misstatements also need evaluation on their own, considering qualitative factors such as covenant ratios.
Summary of uncorrected misstatements
The summary of uncorrected misstatements (often called the SUM, or schedule of passed adjustments) is the workpaper that brings this together. A useful layout:
| Column | Content |
|---|---|
| Reference | Workpaper where the misstatement was identified |
| Description | What happened and why |
| Type | Factual, judgmental or projected |
| Current assets / liabilities / equity | Debit or (credit) effect on each |
| Revenue / expenses / pre-tax income | Effect on the income statement |
| Prior-year carryforward | Effect of prior-period uncorrected misstatements |
| Total vs materiality | Aggregate compared with overall and, where relevant, specific materiality |
Below the schedule, document the conclusion: whether uncorrected misstatements are material individually or in aggregate, with the qualitative considerations.
Written representation
Under AU-C 580, the auditor requests a written representation from management (and, where appropriate, those charged with governance) about whether they believe the effects of uncorrected misstatements are immaterial, individually and in the aggregate, to the financial statements as a whole. A summary of those items is included in, or attached to, the representation letter. Management's belief does not relieve the auditor of forming their own conclusion.
Communication with those charged with governance
Under AU-C 260 and AU-C 450, the auditor communicates uncorrected misstatements and their effect on the opinion to those charged with governance, identifying material uncorrected misstatements individually, and requests that they be corrected. The auditor may also communicate corrected misstatements, and some firms list all recorded AJEs in the governance letter.
Independence: who prepares the entries
Proposing standard, adjusting or correcting journal entries is a nonattest service under the AICPA Code of Professional Conduct's nonattest services interpretation (ET 1.295). The auditor can propose entries without impairing independence, provided the general requirements for nonattest services are met: management takes responsibility for the entries, oversees the service through someone with suitable skill, knowledge or experience, evaluates the adequacy and results of the service, and accepts responsibility for the results.
In practice, that means:
- management reviews and approves each AJE in writing before it is recorded
- the auditor does not have authority to post entries to the client's general ledger
- the engagement file shows that management understood the entries, not just signed a page
Many proposed entries can also indicate control deficiencies. If the auditor proposes entries that management's own processes should have caught, consider whether there is a significant deficiency or material weakness to communicate under AU-C 265.
What to document
AU-C 230 and AU-C 450 together expect the file to show:
- the clearly trivial threshold
- all misstatements accumulated during the audit and whether they were corrected
- the auditor's conclusion on whether uncorrected misstatements are material, individually or in aggregate, and the basis for it
- management's approval of recorded entries
- the trial balance roll from unadjusted to final, with each AJE and RJE posted to the lead schedules
- communication with management and those charged with governance
Common documentation gaps
- Misstatements noted in testwork but never carried to the summary schedule.
- Projected misstatements omitted from the summary because "only the known error was corrected."
- No evaluation of qualitative factors.
- Summary of uncorrected misstatements not attached to the representation letter.
- Prior-year passed adjustments ignored in the current-year evaluation.
- AJEs recorded with no evidence of management approval.
Frequently asked questions
What is the difference between an AJE and a reclassification entry?
An AJE corrects a misstatement in amount and usually changes net income or equity. A reclassification entry moves amounts between financial statement line items for presentation and does not change net income or total equity, though it can still be material, for example to a covenant ratio.
What does "passed adjustment" mean in an audit?
A passed adjustment is a misstatement that management has decided not to correct. It stays on the summary of uncorrected misstatements, is evaluated for materiality individually and in aggregate, and is covered by management's written representation.
Does the auditor have to propose an entry for every misstatement?
The auditor must accumulate and communicate all misstatements above the clearly trivial threshold and request that management correct them. Whether to record them is management's decision, but the auditor evaluates the effect of any that remain uncorrected.
Can a projected misstatement be recorded?
Management generally records known misstatements; projected amounts are estimates. If a projected misstatement is significant, the usual response is for management to examine the population and correct the actual errors, followed by additional audit procedures.
CORAA prepares ready-to-review audit files for US CPA firms from QuickBooks books; you review and sign. See /us.
Sources
- AICPA, AU-C Section 450, Evaluation of Misstatements Identified During the Audit
- AICPA, AU-C Section 320, Materiality in Planning and Performing an Audit
- AICPA, AU-C Section 230, Audit Documentation
- AICPA, AU-C Section 260, The Auditor's Communication With Those Charged With Governance
- AICPA, AU-C Section 265, Communicating Internal Control Related Matters Identified in an Audit
- AICPA, AU-C Section 530, Audit Sampling
- AICPA, AU-C Section 540, Auditing Accounting Estimates and Related Disclosures
- AICPA, AU-C Section 580, Written Representations
- AICPA Code of Professional Conduct, ET 1.295 (nonattest services)
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AU-C references are to AICPA Professional Standards, paraphrased here; read the standard itself before relying on a requirement. This page is guidance, not professional advice. Report an error