Audit interpretations help understand materiality and apply SAS No. 89

Michael P. Manspeaker, CPA
Smith Elliott Kearns & Company, LLC
MACPA Peer Review Committee

Statement on Auditing Standards No. 89, Audit Adjustments, is effective for audits of financial statements for periods beginning on or after Dec. 15, 1999, and therefore must be applied to audits of Dec. 31, 2000 financial statements.

SAS No. 89 requires that:

the understanding with the client (generally documented in an engagement letter) includes the fact that management is responsible for adjusting the financial statements to correct material misstatements;
management affirm to the auditor in the representation letter that the effects of any uncorrected misstatements aggregated by the auditor pertaining to the latest period presented are immaterial, both individually and in the aggregate, to the financial statements taken as a whole. A summary of such items should be included in or attached to the letter;
if applicable, the auditor must inform the audit committee about uncorrected misstatements aggregated by the auditor by providing a summary of the uncorrected misstatements. This information would be part of the communication under SAS No. 61.

In order to apply SAS No. 89, it is important to understand both the concept of materiality and the meaning of the term "misstatement."

The Audit Issues Task Force of the Auditing Standards Board recently issued interpretations of Professional Standards AU Section 312, Audit Risk and Materiality in Conducting an Audit. The interpretations are very helpful in conducting an audit and in applying the provisions of SAS No. 89. A summary of the interpretations follows:

The meaning of the term 'misstatement'

A misstatement may consist of a difference between the amount, classification or presentation in the financial statements and what would have been reported under generally accepted accounting principles (GAAP); an omission of a financial statement element, account or item; a financial statement disclosure not presented in accordance with GAAP; or the omission of information required to be disclosed in accordance with GAAP.

Misstatements may be of two types: known and likely. Known misstatements are those that have been specifically identified. Likely misstatements are the auditor's best estimate of the total misstatement in an account balance or class of transactions and are frequently identified during analytical or sampling procedures.

Evaluating differences in estimates

When determining the amount of likely misstatements regarding an accounting estimate, the auditor considers the closest reasonable estimate, which may be a range or a point estimate. If the auditor uses a range, and management's recorded estimate is within that range, there is no difference. If management's recorded estimate falls outside that range, the difference between the recorded amount and the closest end of the auditor's range would be aggregated as a misstatement.

Quantitative measures of materiality in evaluating audit findings

The quantitative evaluation of identified misstatements is a matter of professional judgment and should be based on the element or elements of financial statements that the auditor considers most likely to be important to the financial statements users. Elements of financial statements could include net income, current assets, total assets, total revenues, gross profit, equity, net working capital or cash flows from operations.

Considering the qualitative characteristics of misstatement

Qualitative considerations influence the determination of whether misstatements are material. The significance of the item to the entity, the pervasiveness of the misstatement and the effect of the misstatement on the financial statements taken as a whole are all factors to be considered in making a judgment regarding materiality.

The interpretation includes a list of qualitative factors that the auditor may consider. Examples of the qualitative factors are: the potential effect of the misstatement on the entity's compliance with loan covenants; a misstatement that has the effect of increasing management's incentive compensation; the effect of the misstatement on profitability trends; the existence of regulatory reporting requirements; the significance of a misstatement or disclosure to known user needs; the motivation of management with respect to a misstatement; and the implications of misstatements involving fraud and possible illegal acts. Refer to the interpretation, scheduled to be published in the December issue of the Journal of Accountancy, for the entire list of qualitative factors to consider.

The auditor must exercise considerable judgement in conducting an audit and determining whether misstatements are material. The recently issued interpretations of AU Section 312 provide the auditor significant guidance in exercising that judgment.

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