Combining Prior and Current Misstatements When Evaluating Audit Findings
Although the evaluation of audit findings is a matter of professional judgment, Statement on Auditing Standards no. 47, Audit Risk and Materiality in Conducting an Audit (AU section 312 of AICPA Professional Standards), codifies practice in this area. The SAS made one rather significant change to established practices. It concerns the so-called combined effects of current-period and prior-period misstatements. According to SAS no. 47, paragraph 30: "In prior periods, likely misstatements may not have been corrected by the entity because they did not cause the financial statements for those periods to be materially misstated. Those misstatements might also affect the current period's financial statements. If the auditor believes that there is an unacceptably high risk that the current period's financial statements may be materially misstated when those prior-period likely misstatements that affect the current period's financial statements are considered along with likely misstatements arising in the current period, he should include in aggregate likely misstatements the effect on the current period's financial statements of those prior-period likely misstatements." Paragraph 30 deals with the combined effects uncorrected misstatements in an entity's opening and closing real accounts have on its current-period reported accounts. In its most important application, paragraph 30 requires an auditor to consider whether current-period reported income is materially misstated by the combined effects of originations of current-period misstatements and reversals of prior-period misstatements. This article presents two cases that illustrate auditing issues related to combined-misstatement analysis. CASE 1 An auditor is evaluating audit findings at the conclusion of the December 31, 1990, audit of XYZ Corp. The only uncorrected misstatements noted in the current and prior-period audits are sales cutoff errors. Beginning-of-period receivables are understated by $70; end-of-period receivables are overstated by $60. If a $100 misstatement of XYZ's pretax income is considered material, is 1990 pretax income materially misstated? Discussion. Yes. Applying paragraph 30, the auditor combines the end-of-period overstatement of receivables ($60) with the beginning-of-period understatement of receivables ($70). This produces a $130 overstatement of current-period pretax income. In other words, both reported sales and pretax income would have been $130 lower in 1990 if XYZ had properly recorded revenue associated with the end-of-period cutoff error in 1991 and the revenue associated with the beginning-of-period cutoff error in 1989. Note that XYZ's auditor would have reached a different conclusion--and a wrong one--if he or she considered only the $60 end-of-period misstatement when evaluating the audit findings. Uncorrected misstatements in the prior-period's closing balance sheet carry over to the current-period income statement, and the auditor should consider these carryover effects. In other words, a client does not start a new period with a "clean slate" because prior-period misstatements were deemed immaterial. CASE 2 An auditor is evaluating audit findings at the conclusion of the December 31, 1990, audit of RST Corp. Exhibit 1 at left shows the uncorrected misstatements the auditor detected in the current- and prior-year audits. What's the aggregate likely misstatement of RST's 1990 pretax income? The answer to this question depends on the auditor's risk assessment, which is the key to applying paragraph 30. …