Finance & Accounting

Risk of Material Misstatements- Brief Overview

Misstatement in financial statements refers to the difference of an amount, classification or disclosure between items in the financial statements. Generally, misstatements can be termed as the difference between what is required by the accounting standards and what is added or omitted from the financial statements. Material misstatement risk refers to the vulnerability of the financial statements and accounts and the apprehension that a company’s present internal controls are ineffective in identifying and rectifying the misstatements.

What is Material Misstatement?

Misstatements are termed material when the misstatements in the financial statements are expected to influence the decision taken on the basis of such financial statements. 

A misstatement can be material by the magnitude or by the nature of the item in the financial statements. However, some misstatements might not have the magnitude aspect, but they tend to be material by their nature.

Fraud or error is the root cause behind the occurrence of misstatements. Fraud occurs when there is intentional misstating of the financial statement items. The commission of such an act falls under the ambit of fraudulent financial reporting, but if there is anyunintentional misstatement, it is not a fraud.

However, it depends upon the professional judgment of an auditor to determine whether a misstatement is material or not. While determining whether a misstatement is a material, auditors have to consider various factors. One of the most important factors is determining whether a misstatement influences the economic decisions of the users.

How is material misstatement different from material inconsistency?

As discussed above, material misstatements are information included in the financial statements. In contrast, material inconsistency arises because of the conflict between the information included and the information already in the financial statements. Such discrepancies raise doubts in the mind of the auditor about the audit.

Another differentiating factor between material misstatement and material inconsistency is that Material misstatements cause an impact on the economic decisions of the users of the financial statements. Still, material inconsistency affects the conclusion that an auditor reaches at the end.

Risk of Material Misstatements- Components

The risk of material misstatements comprises two main risks, which are inherent risk and control risk. Both risks have been discussed below-

Control risk refers to the risk of failure of the controls that are implemented by businesses. If a business has gaps in internal controls, it will be exposed to the risk of misstatement and fraud. Businesses can even incur heavy losses or misappropriation of assets and resources if the business is not conducted according to proper workflow and processes.

In order to ensure that effective controls are implemented in the business operations, the management of the company should take up the responsibility for the same. Moreover, controls should reflect the changes in the operational and strategic activities of the business. Internal controls need to be updated if there is a change in the operational business area.

Inherent risk is the risk of error or omission occurring naturally in financial statements. It may happen because of the financial or operational aspects of a business. Chances of inherent risk are more the process of financial reporting as it involves complex transactions. The parameter of risk may vary from one business to the other. A business having simple accounting may have low inherent risk and vice versa. 

How does an auditor assess the risk of material misstatements?

Before we analyze how the auditor assesses the risk, we need to know the different risks that an auditor needs to assess.

• An auditor must assess the risk of misrepresenting financial information, which is carried out intentionally. Such activities are carried out through complex schemes, which help in the concealment of a crime.
• The auditor also assesses transactions with related parties. It also poses a huge risk as the client can misstate the financial statements by engaging in fraudulent transactional accounting between parties.
• The auditor should analyze unusual transactions that have unusual size or nature.

Now coming onto the process of conducting risk assessment, an auditor performs the risk assessment process to assess the risk of material misstatements in the financial statements. Such misstatements can be the result of either fraud or error. Therefore, the auditor goes through the process whereby the auditor inquires managers and stakeholders. The auditor also adopts analytical procedures to assess risk. The auditor discusses engagement with other teams as well.

Auditors frame guidelines that help them to identify risks. The engagement team, which comprises auditors and the board audit committee^[1], discusses risk. They understand the business environment, including the regulatory factors. They also analyze the business’s nature and the strategies it adopts.

The risks and misstatements must be documented. This can help in resolving the issue. Documentation of risks and misstatements means documenting the date and key minutes of the discussion with the engagement team.

One of the crucial parts of assessing the risk of material misstatements is that the identified risks must be prioritized. Through judgment, the auditor analyses whether a risk is a significant one or not. It is a matter of judgment to know if there is a risk of fraud or if there is any involvement of related parties.

By going through the risk assessment process, the auditor gets a proper understanding of the client’s business environment, including internal controls.

Takeaway

One can reduce the risk of material misstatements by putting in place a program that reviews the evidence used to support the operating effectiveness of controls that auditors would use. Such review must be an ongoing process and a part of identifying and assessing risks of material misstatements.

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