Risk of material misstatement is the risk that any misstatements that exist in the financial statements being audited, could be material either individually or in aggregate.
Misstatement
Misstatement is a difference of an amount, classification, presentation or disclosure between:
- an item in the financial statements; and
- the requirement of the accounting standards in this regard
In other words, misstatement includes any difference between what is required by accounting standards and what is included in or omitted from the financial statements.
Material Misstatement
Misstatements in financial statements are material when they can reasonably be expected to influence the decisions taken based on those financial statements. Misstatement can be material either by magnitude or due the nature of the item. For example, an asset would typically be considered material if it is 1% or more of the total assets. Some misstatements are not significant by magnitude but are material by their nature. For example, a loan advanced to a director of a company, however small, is material because the users of financial statements will value such information for decision making purposes.
Misstatements arise from either fraud or error. Intentionally misstating financial statement items for whatever reason is fraudulent financial reporting. However making unintentional misstatments is not fraud.
Some misstatements are factual i.e. when the requirement of accounting standards is clear but not followed. For example, when LIFO inventory method is used under a financial reporting framework that does not allow LIFO or when a figure is incorrectly calculated. Other misstatements are judgmental i.e. when misstatement results from poor or biased judgments regarding estimates, accounting policies etc. For example, when management uses accelerated depreciation method for an asset which generates benefits evenly over its useful life.
Why Focus on Material Misstatements?
Since it is not practical for auditors to detect all the misstatements, they focus their work on detecting material misstatements only. Auditors will first assess the risk of material misstatement during the planning stage of an audit by familiarizing themselves with the company being audited and its environment and controls in place. As the audit progresses, the auditors update their assessment of the risk of material misstatement as they obtain new information. Auditors also consider, the risk that individually immaterial misstatements might add up to have a material impact on the financial statements as whole by using performance materiality.
Different areas of financial statements have varying risks of material misstatements and therefore the auditors will assess the risk at assertion level as well as financial statement level as a whole. The detail with which auditors test various aspects of financial statements depends on their assessment of the risk that material misstatements might exist in a given assertion. The auditors will test an item more thoroughly when their assessment of the risk of material misstatement in that assertion is high.
Components of Risk of Material Misstatement
Risk of material misstatement is a product of the following two risks:
- Inherent Risk
- Control Risk
Inherent risk is the susceptibility of a transaction or account balance to material misstatement due its nature. Certain items are by their very nature more likely to be misstated. For example, estimate of a legal obligation.
Control risk is the risk that controls implemented to prevent or correct misstatements will be ineffective in preventing or correcting the misstatements.
This is often represented using the following equation:
Risk of Material Mistatement = Inherent Risk × Control Risk
Risk values are based on auditor’s best judgement and are not quantifieable. Therefore, the above equation is just a means for auditor's understanding of the relationship between risks and not actually used to ‘calculate’ risks.
The risk of material misstatement is the risk that the financial statements of an organization have been misstated to a material degree. This risk is assessed by auditors at the two levels noted below. When the risk of material misstatement is high, the level of detection risk is lowered (increases the amount of evidence obtained from substantive procedures). Doing so reduces the overall audit risk.
Risk of Material Misstatement at the Assertion Level
This risk is further subdivided into inherent risk and control risk. Inherent risk is the susceptibility of an assertion to misstatement because of error or fraud, before considering controls. Control risk is the risk of misstatement that will not be prevented or detected by a reporting entity's internal controls.
Risk of Material Misstatement at the Financial Statement Level
This risk relates to the financial statements as a whole. This risk is more likely when there is a possibility of fraud.