What is a misstatement in the financial statements?

Table of Contents Show

Risk of Material Misstatement on a Financial Statement Level
Risk of Material Misstatement at an Assertion Level
Risk Assessment Procedures
Types of Risks
Material Misstatement in Audit
3 Types of Misstatement in Audit

A1. For purposes of this standard, the terms listed below are defined as follows:

A2. Misstatement – A misstatement, if material individually or in combination with other misstatements, causes the financial statements not to be presented fairly in conformity with the applicable financial reporting framework.1/ A misstatement may relate to a difference between the amount, classification, presentation, or disclosure of a reported financial statement item and the amount, classification, presentation, or disclosure that should be reported in conformity with the applicable financial reporting framework. Misstatements can arise from error (i.e., unintentional misstatement) or fraud.2/

A3. Uncorrected misstatements – Misstatements, other than those that are clearly trivial, 3/ that management has not corrected.

Risk of Material Misstatement on a Financial Statement Level

The risk of material misstatement on a financial statement level is the risk that certain risks could affect financial statements as a whole and potentially have a major impact on several assertions.

It is vital to consider the risk of material misstatement at a financial statement level because of its potential to seriously hinder the auditor’s ability to disclose an unqualified audit opinion.

Factors that can increase the risk of material misstatement on a financial statement level include:

Managerial incompetence
Poor oversight by the board of directors
Inadequate accounting systems and records
Declining economic conditions
Operation in rapidly changing industry

Risk of Material Misstatement at an Assertion Level

Generally Accepted Auditing Standards (GAAS) require the auditor to assess the risk of material misstatement at the assertion level for all transaction classes, account balances, presentation, and attached disclosures.

The auditor must develop audit objectives for each individual assertion and perform audit procedures to accumulate the required audit evidence to achieve the audit objective.

The risk of material misstatement on an assertion level is composed of an assessment of inherent risk and control risk – inherent risk being the auditor’s statement regarding the client’s susceptibility of an assertion to being materially misstated. This is before the consideration of the client’s internal controls.

For example, the inherent risk could be potentially higher for the valuation assertion of accounts that require in-depth technical calculation or rely on an accountant’s best estimate.

Control risk is the auditor’s assessment of the risk that material misstatement could be the product of an assertion, and not be properly identified and corrected by the client’s internal controls.

For example, control risk would be higher for the valuation assertion of their accounts receivables if the client fails to conduct an independent review and official verification of the calculations and estimates made by the client’s accounting staff.

Risk Assessment Procedures

An auditor attempts to better understand the client and its business environment, including the client’s internal controls. The auditor will perform risk assessment procedures to observe and assess the risk of material misstating the financial statements due to either fraud or error.

Risk assessment procedures include the following:

Inquiries of managers and relevant stakeholders
Analytical procedures
Observation and investigation
Discussing engagement with the team
Other risk assessment procedures

The risk assessment procedures are designed to enable the auditor to obtain a thorough understanding of the client’s business and its environment – specifically, the internal controls, for the purposes of understanding the risk of material misstatement in the audit planning process.

The procedures do not provide persuasive audit evidence to form an audit opinion on the financial statements.

Types of Risks

In risk assessment, auditors consider the following risks:

1. Fraud risk

The risk of the client intentionally misrepresenting financial information, often through complex and sophisticated schemes orchestrated to conceal the financial crime.

2. Economic, accounting risk, or other developmental risks

The inherent risk of the auditor’s statement regarding a misstatement at an assertion level, due to economic, accounting risk, or other developmental risks.

3. Complex transactions

Transactions can be complex if they are new transactions to the client, involve interpretation of complex accounting standards, or involve a complex business arrangement with a customer.

4. Significant transactions with related parties

Transactions with related parties are a significant risk, as the client can materially misstate the financial statements through representationally unfaithful or fraudulent transactional accounting between the parties.

5. Degree of subjectivity in measurement

Matters that require significant judgment because of the requirement to develop accounting estimates where significant measurement uncertainty exists.

6. Non-routine transactions

A transaction that is unusual, due to size or nature, and infrequent in occurrence.

Learn More

CFI is the official provider of the global Commercial Banking & Credit Analyst (CBCA)™ certification program, designed to help anyone become a world-class financial analyst. To keep advancing your career, the additional CFI resources below will be useful:

In an audit, misstatement is a difference between actual financial statement items prepared by the client and those required by applicable accounting standards. In this case, misstatement arises from the transactions or balances of the company’s accounts which is not in accordance with applicable accounting standards.

Likewise, the misstatement makes the financial statements not present fairly. Misstatement can be the result of error or fraud.

Auditors usually accumulate the misstatements during their audit work and evaluate the materiality and severity of those misstatements in order to make proposed audit adjustments to the client’s management and audit committee. Auditors need to evaluate whether small errors or omissions adding up exceed the materiality level.

Material misstatement is usually required adjustments before auditors can give a clean opinion in the audit report. On the other hand, misstatements that are trivial, individually and aggregate, are usually ignored as they do not have a material impact on the financial statements as a whole.

Material Misstatement in Audit

Material misstatement is the misstatement that could affect the economic decision making of the users of financial statements. The main purpose of the financial audit by the independent auditors is to evaluate whether the financial statements contain any material misstatement that may prevent them from a fair presentation.

In the case that material misstatement is not rectified by the client’s management, auditors are unlikely to give an unqualified audit opinion in the report. As a result, auditors may need to modify their opinion based on the severity of the material misstatement found in the client’s account. Modified audit opinion that auditors may give in this case can be qualified opinion, adverse opinion, or disclaimer of opinion.

3 Types of Misstatement in Audit

Three types of misstatement include factual misstatement, judgmental misstatements, and projected misstatements.

Types of Misstatement
Factual misstatement	Factual misstatement is a misstatement that occurs on the client’s accounts balances or transactions of which there is no doubt. In general, supporting documents are usually available for auditors to review for factual misstatements. Examples of typical factual misstatements include wrong debit or credit entry, incorrect amount of transactions or balances posted into the client’s accounting system, wrong classification of accounts and missing of disclosure, etc.
Judgmental misstatement	Judgmental misstatement is a misstatement that occurs in an audit due to the differences between the client’s judgment and auditor’s judgment. These include the accounting estimate and accounting policies on judgmental areas, where auditors consider inappropriate. Examples of judgmental misstatements include unreasonable depreciation rate and inappropriate revaluation amount of fixed assets, etc.
Projected misstatement	Projected misstatements are the auditors’ best estimate of misstatements in populations that arise from the misstatements that auditors have identified in audit samples and make a projection to the entire populations which the samples were drawn from. Auditors usually make an evaluation of projected misstatements to consider whether further audit testing is appropriate.