 Hello and welcome to this session in which we will evaluate the misstatement found during the audit. This is part of completing the audit or wrapping up the engagement. In the prior session, we looked at the remaining tasks we have to complete as we are finalizing the audit, which is conduct final analytical procedures. And this is what we did in the prior session. Also, we have to evaluate all audit findings, which is what we'll do here. But in the prior session, we looked at when we, if we have to reassess materiality, and we looked at reassessing audit risk, which is part of it reassessing control risk, fraud risk, inherent risk. And basically here we make a final evaluation of the materiality and a final evaluation of the risk. In this session, we're going to be focusing on evaluating the misstatement found during the audit. Okay, so now we're at the end. Throughout the audit, we're going to find misstatements, we're going to be talking to management, and now we are looking at the end. How do we evaluate those misstatements? Before we proceed any further, I have a public announcement about my company farhatlectures.com. Farhat accounting lectures is a supplemental educational tool that's going to help you with your CPA exam preparation, as well as your accounting courses. My CPA material is aligned with your CPA review course, such as Becker, Roger, Wiley, Gleam, Miles. My accounting courses are aligned with your accounting courses, broken down by chapter and topics. My resources consist of lectures, multiple choice questions, true-false questions, as well as exercises. Go ahead, start your free trial today. The first thing we need to be familiar with is the concept of type of misstatements. We're going to have three types of misstatements, or we can classify them statements under three types. One is factual, two is judgmental, three is projected. And why do we need to know about these three? Because if you understand what type of misstatements you are dealing with, it's easier to understand how management and the auditor will agree or disagree on that misstatement. What are factual misstatements? Well, those are inaccuracies, incorrect stuff that are definitely known. So there's no one will argue about them, like maybe a computational error. You can't argue about this or clear misapplication of accounting rules. How do we find those factual misstatements? They can be identified through the use of audit data analytics, where we employ a software to analyze the whole data. So we're looking at everything. And as a result, we find some error, some computational error. Or they can be found when we're auditing in an entire population, the same concept. And this entire population have relatively small number of units. Like if we are auditing notes payable, a company could have two loans, they could have five loans, which is five notes payable, they could have 15, they could have 20 loans. Usually when you're auditing loans, you audit all of them. It's very easy. You look at the loan application, you look at the interest rate, you compute the interest rate, if it's a long term loan, you break it into its short term component, long term component. So you're looking at everything. So if you find a computational error, then guess what? You can say this is a definite error I can show you. Just take the principle times the interest, you computed the interest rate, the interest expense incorrect. So no one can argue about those. Okay? By examining an entire population, we can find those definite errors and ask the company to fix them. Those are factual misstatement. Then we have judgmental misstatement. From the word judgmental, what is that? What are we looking at here? We are making an estimate. We are making, we have some sort of uncertainty. So upon conducting the audit, the auditor might come to a different conclusion about an estimate than one that the company made. An example of it could be we're looking at allowance of doubtful account, fair value of the allowance. How did we come up with that allowance number? Well, first management gives us that number. Then we kind of take a look at it and say, well, based on the circumstances, is this allowance appropriate? Let's assume they are estimating 3% of AR as an allowance. We think it should be 5%. You know, their customer base is deteriorating. Then we have to kind of tell management to do what? To reassess their assumption and the method that they used in coming up with the 3%. Okay? Post review, management may choose to modify their estimate or retain it. After we tell them, you know, this is the issue, they might say, okay, we're going to go ahead and fix it or we're not going to fix it. If they're not going to fix it, for us, this is a misstatement. Okay? And we're going to look at it toward the end. Whether it's material or not, we'll look at that later. If it's material, you know, if it's material, it's a serious issue, usually they will fix it. But here we're dealing with basically a material misstatement. What do we do with that? So any deviation between the final figure recorded by management and the recommended value, we recommend that 5, they stuck with 3. This will be a misstatement. And this misstatement is judgmental. We think differently. We think they should increase their allowance. Now they think their customer is going to pay, they should not have a 5% allowance. An auditor will have to maintain a record and we'll talk about what record you need to maintain between management and themselves about the rationale, about all these estimates, about those suggestions. We also have projected misstatement, which is the third type of misstatement. And from the name projected, I'm pretty sure you kind of know what that means. It's coming from audit sampling. Because when you sample, you're going to project the error to the population. So if you have a whole population, you might only examine a small portion of it. And you're going to take whatever you found here and project the error to everyone else. This is part of sampling. When the auditor discover a misstatement in a sampled subset, they employ suitable statistical or non-statistical method to do what? To extrapolate the found error to the whole population. If that happens, if the material, if the state, if the misstatement is material, they're going to tell management to inspect the entire transaction population, to identify the misstatement cause and adjust the effect, the effected accounts accordingly. If it's material, we have a serious problem on our hand. Following the adjusting entries, once they fix it, auditor ought to conduct further audit procedure to verify if there's any misstatement that persists. It could be still some immaterial, but we need to find out if there's anything that persists. So during the audit, we evaluate the misstatement. We look at them. We tell management about them. As we discover them, we collected them. We ensure that management is notified to let them know to take the necessary steps. What's the necessary step? Make journal entries, adjusting journal entries to fix those errors, especially for factual misstatement. If they're not making those adjustments for factual misstatement, it is a problem. So we assume that factual misstatement, they're fixed, judgmental, judgmental and projected, they might or may not be fixed, depending on their materiality, depending on the dialogue between us and management. Now let's move forward toward the end of the audit. We're going to have a list of maybe incorrect misstatement. What is incorrect misstatement? We find an error. If it's factual, the company corrected it. If it's not factual, projected or sampling, the company might have chosen not to do it, but now we have those incorrect misstatement and we assume here they are immaterial, because if they are material, then the problem for the company will have a worst headache because we might not give them an unqualified or unmodified opinion, but here we're assuming it's not material. So during the final evaluation, auditor assess the impact of the incorrect misstatement on the financial statement. Now again, normally, material misstatement, we assume they are fixed, otherwise we will not give them a clean opinion. But the management may choose not to correct what we call and what we agree. Well, it's immaterial misstatement. They might say immaterial misstatement. Immaterial means, well, it's not really going to change the perception of the user. In case of incorrect misstatement, which is incorrect immaterial, auditors seek to understand why. Why did you not correct it? We need to know why. I mean, although it's immaterial, but why not? What's the reason behind it? Decision not to correct it. This understanding is taken into account when evaluating the overall effect on the incorrect misstatement on the financial statement as a whole. Because it could be, for the account itself, it's immaterial, but we have to take a look at the whole financial statement as a whole, whether there's an issue or not. And by doing so, we looked at both qualitative and quantitative factor. What is qualitative and quantitative factor? Well, quantitative, we're looking at numbers. We're looking at numbers. And here we're looking at strictly numbered threshold. Is it below the threshold? Is it below materiality? Well, that's fine. It's below materiality. Well, is it important? Do we have to look at qualitative context? Is it important? And what do you mean by qualitative? We're going to look at few items that we look at when we're looking at qualitative factors. Incorrected, but immaterial misstatement must be compiled. So what we do, if we have many of them, what we do is we add them up. We add up those all small misstatement. And in aggregate, we look at their sum. We look at their sum to see if they surpass materiality threshold for the financial statement as a whole, or for a specific class of transaction, or for account balance, or for a certain disclosure. So yes, by themselves, they are not material. What if we add them all up? Are they material? It's not only the current year we look at. We looked at immaterial misstatement from the prior year. Remember, if it was, if we're doing year one, and we found some immaterial misstatement, and they were not corrected, those immaterial misstatement, they might go to year two. Well, if they go to year two, well, we have to also account for that and add them to the current period. So the cumulative effect of incorrected immaterial misstatement from the prior year, if present, should be evaluated for their impact on the current financial statement. They did not go away. Now, the good thing about some mistakes is they self-correct. Incorrected immaterial misstatement from a prior period are typically expected, certain ones are self-correct. For instance, if purchases were underestimated, you did not report all the purchases due to a car off error in the prior period, that's fine. This statement would be perceived to correct itself, not will be perceived to correct itself in the next period when purchasing might be overestimated. So over a period of two years, it's self-correct itself. So we don't have to worry about this. So two immaterial mistake would balance out each other over a two year period. So at the end, we're going to look at a schedule, a schedule of likely misstatement that are incorrected. So if we brought the under misstatement from the prior year, the over misstatement this year, the impact is zero. So those will self-correct itself. The issue is when we have an incorrect immaterial misstatement from the prior year that does not self-correct itself, then it has to be added to the schedule. It has to be combined with the current year. An example will be accumulated depreciation. If we have a problem with depreciation, with specifically accumulated depreciation, it does not self-correct itself. So we have to take a look at when we have incorrected misstatement, are they reaching materiality? When we add them all up, for example, if materiality is 100,000 and we find out we are all of them together combined at 99,000, well, we are below materiality. We'd say, well, good to go. Well, are you sure you want to take that chance? There's only a $1,000 basically a buffer zone, safety zone. What if you missed a mistake that's a $1,000, then you are above materiality. So what you have to do, if incorrected immaterial misstatement do not surpass materiality threshold, that's good. I mean, it did not, whether it's for the financial statement or specific laws of transaction or account balances, but we still have to look at those misstatements in a context, which is qualitative characteristic, because we're almost there. I mean, we have to be very careful because we're almost going to have materiality. So let's take a look at qualitative factor. We always have to look at qualitative factor as well, because mistakes, quantitatively, it's okay, but qualitatively, it might be dangerous, how we're going to see in a moment. For instance, and we all have to keep in mind, if fraud is involved and materiality is not an issue, if the error of the misstatement due to fraud, well, throw materiality out, it's a serious problem. It's a material, unquote, a material issue. Because as we mentioned in the prior session, fraud is seldom isolated to one account. And it's especially important when fraud is conducted by top management, because if they are booking revenue, they might be also, they are cooking revenue, they might also be cooking liabilities, they might be underestimating liabilities, underestimating expenses, misclassifying certain expenditure. However, it's very important to look at the qualitative characteristic for a material misstatement. So a misstatement could be immaterial, but the question is, does it have any impact on regulatory compliance? If it does, then well, it is, I would say it becomes material in the sense that it's important. From a numeric perspective, it's immaterial, but it's helping you avoid legal consequences or penalties from an environmental agency, then it's a problem. A misstatement and a calculation of environmental liabilities may result in a non-compliance with environmental regulation. So it's below the threshold, but it's a serious problem because it involves regulatory compliance. What if the misstatement influenced management compensation? Well, it's a misstatement, well, it's not a big deal because it's not material. Well, yeah, it's not material, but it's influencing how much management is being compensated. An example will be how a company valued stock options, the expense for stock options. Well, it's granted to executives and you have to estimate the expense. How did you do that? Well, the amount itself is not material, but it's influencing your compensation. So is it material now? That's what you have to look at. So are they doing this on purpose to get their compensation? Well, that's a different ball game then. What if the misstatement involved specific parties and specifically we are dealing with parties that are associated with management and we call those related party transactions? Well, if we're buying from related party transactions and or they are given us some services, you know, for example, company who are related to the company's executives, husband's wife, children, nephews, nieces, boyfriend, girlfriend, this is going to raise concern about the potential conflict of interest and transparency. So we look at the misstatement, not from a numerical perspective, from a context. What if that misstatement altered a loss into an income or an income into a loss? Usually it's a loss and it's, you know, so simply put, this is zero and you are right here in the negative, almost you're going to break even. And this misstatement, it will take you from breaking even to being positive, to showing positive. What does that mean? Well, now you're a profitable company. It's a totally different look. The misstatement is small, but it's changing how the company is being perceived. Now, sometimes who knows, you might be positive and you might want to go to negative for this year because you don't need the profit, you can defer it. So you have to look at those, but usually you're like almost breaking even and you go into positive. Your small loss, you'll turn it into a small gain. Well, the misstatement is important because it's changing the perception of the company, of the user. Now you're a profitable company. Also, you could, you want to look at the misstatement and the context of debt covenants, adherence to debt covenant or adherence to contractual obligation. So the misstatement is small, okay, but it's affecting some key financial ratios, such as debt to equity ratio, that if we looked at it from a debt covenant perspective, it is relevant because this issue could trigger a problem with the bank. It could trigger default on the loan or renegotiation with the lenders. Also, you know, this is the third time we mentioned this, if the issue deals with fraud, again, it's always material. It's always material. It doesn't matter how much, how much is the misstatement. Three, and what's fraud? It's your cooking the books purposefully with an aim of doing something bad, okay. If it relate to incorrect application of an accounting policy that have impact on future period, you also have to take into account that. So in other words, right now, it's not an important issue. It's immaterial. But this misstatement might affect future period. Then, well, you have to look at it from that perspective. For example, a misstatement and the capitalization of the development cost where expenditure should be expense are capitalized. What you did, you know, this cost should be expense, but it's capitalized, but it's a small amount. Yes, but it might lead to distorted financial statement on overstate asset in subsequent period. So it becomes, well, it becomes material. How about if the misstatement influence the company ability to meet certain financial benchmarks, simply put Wall Street analyst expectation such as analyst forecast for earnings per share. So a misstatement that affect EPS and basically most misstatements affect EPS that fall short of analyst expectation may affect investor confidence, the stock price and the company reputation. So you have to look at the misstatement in the context of how is it affecting its EPS and what's the company's perception? What's the community investment community perception of the company's EPS? This is an example of analysis of aggregate likely misstatement that are incorrected. So here they could have many. Here I'm given only two just to illustrate the point. So what happened is the company would have a list scheduled could have five, 15, 10, three, it doesn't matter. And what they would do, they would look at, they would list those incorrected known misstatement. Okay, though, it's a problem. For example, here we have a problem with depreciation, overstatement of depreciation expense, we overstated our depreciation. We have to list its impact on balance sheet account, list its impact on income statement account. For example, accumulated depreciation is overstated. Depreciation expenses overstated as a result, equity is understated. Depreciation expenses overstated, pre-tax earnings is understated because we have more expenses. Obviously, if we reported more expenses, we're going to report less taxes. Why? Because if we have more expenses, less taxes payable, our income will go up if we are reporting our income depreciation, we are overstating depreciation expense, our income will go down. So it's going to reduce, it's going to debit, it's going to reduce, you know, debits and credits, it's going to reduce our net income. It's going to reduce our income tax, it's going to reduce our income tax expense, because we are reporting more income. And we'll do the same thing here. We have an overstatement of ending inventory based on projected statistical sampling. We see its effect on cost of goods, sold inventory, pre-tax, income tax is payable. And what we do then, so individually, each one of them, the depreciation is not an issue, the inventory is not an issue, we might want to take a look at all of them, net them out and see if they are issue over all. Okay? And we can see here, for example, they don't meet the thresholds that we want, that's a violation of the threshold. Then we can conclude the likely misstatement listed above are deemed to be immaterial, either individually, because each one of them is immaterial or under aggregate effect on the individual account, the financial statement categories or the financial statement as a whole. So this is what we do. What did we do in this session specifically? I evaluated the misstatement found during the audit. And I said this, this topic merit its own, its own, its own session. And this is exactly what I did. In the next session, we're going to still completing the audit because completing the audit is an important step in the audit itself. We're going to look at finalizing work paper, we're going to performing engagement quality review, and finalizing the audit documentation. What should you do now? Go to Farhat Lectures, look at additional resources, lectures, multiple choice, true or false. That's going to help you understand this important concept, completing the audit or complete the audit as a step in your auditing and attestation course, or an important step in your CPA exam preparation. Good luck, study hard, and of course, stay safe.