AU-C section 450, Evaluation of Misstatements Identified During the Audit, covers what the auditor does with every misstatement found in a GAAS audit of a nonissuer: accumulate it, decide whether it points to more problems, ask management to fix it, and evaluate whether what is left uncorrected is material. The output most firms know is the summary of uncorrected misstatements, often called the SUM or the schedule of passed adjustments.
This page paraphrases the standard. The authoritative text is AU-C 450 in AICPA Professional Standards.
What is the objective of AU-C 450?
The auditor's objective is to evaluate the effect of identified misstatements on the audit, and the effect of uncorrected misstatements, if any, on the financial statements.
What counts as a misstatement?
A misstatement is a difference between the amount, classification, presentation or disclosure of a reported item and what is required for it to be presented fairly under the applicable financial reporting framework. Misstatements can come from error or fraud.
That definition covers more than wrong numbers. A balance in the wrong line item, a missing disclosure, or a disclosure that does not say what the framework requires are all misstatements.
What is the clearly trivial threshold?
The auditor accumulates misstatements identified during the audit, other than those that are clearly trivial.
Clearly trivial is not another way of saying "not material". Clearly trivial matters are of a wholly different, much smaller order of magnitude than materiality, and are clearly inconsequential whether taken individually or in aggregate, judged by size, nature or circumstances. When there is any uncertainty about whether something is clearly trivial, it is not.
The standard sets no percentage. Firms set the threshold under their own policy, often as a small percentage of overall materiality. Any such percentage is practice, not part of AU-C 450 (the $4,500 in the example below is 5% of the illustrative materiality). The amount goes in the file.
Factual, judgmental and projected misstatements
The application guidance sorts misstatements into three types. Keeping them separate on the SUM helps the conversation with management and the final evaluation.
| Type | What it is | Example |
|---|---|---|
| Factual | No doubt about the misstatement | A December invoice for $22,000 recorded as revenue though goods shipped in January |
| Judgmental | Differences from management's judgments about estimates that the auditor considers unreasonable, or about the selection or application of accounting policies | The allowance for doubtful accounts is below the auditor's range |
| Projected | The auditor's best estimate of misstatement in a population, projected from a sample | Pricing errors found in an inventory sample, projected to the whole inventory |
For a judgmental misstatement on an estimate, if the auditor has developed a range and management's estimate falls outside it, the misstatement is usually measured to the nearest end of the auditor's range, not to the midpoint (see AU-C 540 on ranges).
When do misstatements change the audit plan?
The auditor determines whether the overall audit strategy and audit plan need to be revised when:
- the nature of identified misstatements and the circumstances of their occurrence indicate that other misstatements may exist that, combined with those found, could be material, or
- the aggregate of misstatements accumulated during the audit approaches materiality.
If accumulated misstatements are close to materiality, the risk that undetected misstatements push the total over the line may be more than acceptably low. Performance materiality exists for exactly this reason. See AU-C 320 materiality.
If management, at the auditor's request, examines a class of transactions or a balance and corrects the misstatements it finds, the auditor performs more procedures to determine whether misstatements remain.
Communicating with management
The auditor communicates all accumulated misstatements on a timely basis to the appropriate level of management, and requests that management correct them. The request covers all accumulated misstatements, including those that are not material on their own.
If management refuses to correct some or all of them, the auditor obtains an understanding of management's reasons and takes that into account when evaluating whether the financial statements as a whole are free from material misstatement. The application material treats management's reasons as relevant to whether bias is present.
Evaluating uncorrected misstatements
Before the evaluation, the auditor reassesses materiality under AU-C 320 to confirm it is still appropriate given the entity's actual financial results. Planning materiality based on budgeted or interim figures often needs updating.
The auditor then determines whether uncorrected misstatements are material, individually or in aggregate, considering:
- the size and nature of the misstatements, both in relation to particular classes of transactions, account balances or disclosures and the financial statements as a whole, and the particular circumstances of their occurrence
- 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
Points from the application guidance that matter on most files:
- Offsetting. An individually material misstatement is unlikely to be offset by other misstatements. Offsetting within the same account balance or class of transactions can be appropriate, but the auditor considers the risk that further undetected misstatements exist.
- Classification. A misstatement of classification between balance sheet lines may not be material even when it exceeds materiality, for example if it does not affect a debt covenant or key subtotals, but the auditor still evaluates it qualitatively.
- Qualitative factors. A small misstatement can be material because of its nature. Examples include a misstatement that affects compliance with a debt covenant or regulatory requirement, turns a loss into a profit or the reverse, changes a trend, increases management compensation, involves a related party, or results from fraud.
Prior-period misstatements
Uncorrected misstatements from prior years can reverse into the current year's income statement or accumulate on the balance sheet. Two methods are used to measure their effect: the rollover method, which focuses on the current-year income statement effect, and the iron curtain method, which focuses on the cumulative balance sheet effect at year end. For SEC registrants, SEC Staff Accounting Bulletin No. 108 requires evaluating both. For nonissuers AU-C 450 sets no method, so firms set a policy.
A worked example
Overall materiality is $90,000, performance materiality $58,500 and the clearly trivial threshold $4,500. Management has corrected some items. Three remain uncorrected:
| # | Description | Type | Pretax income | Assets | Liabilities |
|---|---|---|---|---|---|
| 1 | January shipment recorded as December revenue (cutoff) | Factual | −$22,000 | −$22,000 (AR) | |
| 2 | Allowance for doubtful accounts below auditor's range | Judgmental | −$18,000 | −$18,000 (AR) | |
| 3 | Inventory pricing errors projected from sample | Projected | −$31,000 | −$31,000 (Inventory) | |
| Total uncorrected | −$71,000 | −$71,000 |
(Negative amounts mean the books overstate income and assets.) A $3,200 accrual difference is below clearly trivial and is not accumulated.
The evaluation:
- Total uncorrected misstatements of $71,000 are below materiality of $90,000, so they are not material on size alone.
- But $71,000 is about 79% of materiality and well above performance materiality. The allowance for undetected misstatement is only $19,000. The auditor considers whether further procedures are needed, especially for item 3, which came from a sample, and asks management to correct items 1 and 3.
- Qualitative check: if the entity has a loan covenant on current assets, the $71,000 overstatement of receivables and inventory may matter even below materiality.
The auditor would ask management to correct the factual and projected items before the report is released.
Written representations and communication with governance
The auditor requests a written representation from management, and where appropriate those charged with governance, on whether they believe the effects of uncorrected misstatements are immaterial, individually and in aggregate, to the financial statements as a whole. A summary of those items is included in or attached to the representation letter. See AU-C 580.
The auditor also communicates uncorrected misstatements, and their effect individually or in aggregate on the opinion, to those charged with governance, and requests that they be corrected. Material uncorrected misstatements are identified individually. AU-C 260 covers that communication.
What must be documented?
AU-C 450 asks the auditor to document:
- the amount below which misstatements are regarded as clearly trivial
- all misstatements accumulated during the audit and whether they have been corrected
- the auditor's conclusion on whether uncorrected misstatements are material, individually or in aggregate, and the basis for that conclusion
A good SUM shows each item's type, source workpaper, effect on income, assets, liabilities and equity, the current-year and prior-year effect, and a column showing which items management corrected. See AU-C 230 audit documentation.
File checks on misstatements
These are practice checks, not requirements of the standard. Weaknesses to look for:
- No clearly trivial threshold documented, or one set close to performance materiality
- Projected misstatements from samples left off the SUM
- Uncorrected misstatements not attached to the representation letter
- Materiality not reassessed against final results before the evaluation
- No qualitative analysis when the total is below materiality
- Prior-year passed adjustments ignored in the current-year evaluation
Related
- AU-C 320 materiality
- AU-C 530 audit sampling
- AU-C 315 risk assessment and SAS 145
- AU-C 230 audit documentation
- Materiality calculator (AU-C 320)
Sources
- AICPA, AU-C Section 450, Evaluation of Misstatements Identified During the Audit (AICPA Professional Standards)
- AICPA, AU-C Sections 230, 260, 320, 530, 540 and 580 (cross-referenced sections)
- SEC, Staff Accounting Bulletin No. 108 (SAB Topic 1.N), Considering the Effects of Prior Year Misstatements when Quantifying Current Year Misstatements, https://www.sec.gov/interps/account/sab108.htm
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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