In What Circumstances the Material Misstatements of Financial Statements May Arise ?

ISA 700 requires the auditor, in order to form an opinion on the financial statements, to conclude as to whether reasonable assurance has been obtained about whether the financial statements as a whole are free from material misstatement. This conclusion takes into account the auditor’s evaluation of uncorrected misstatements, if any, on the financial statements in accordance with ISA 450.

ISA 450 defines a  misstatement as a difference between the amount, classification, presentation, or disclosure of a reported financial statement item and the amount, classification, presentation, or disclosure that is required for the item to be in accordance with the applicable financial reporting framework.

Accordingly, a material misstatement of the financial statements may arise in relation to :

1. The appropriateness of the selected accounting policies;
2. The application of the selected accounting policies; or
3. The appropriateness or adequacy of disclosures in the financial statements

Appropriateness of the Selected Accounting Policies

In relation to the appropriateness of the accounting policies management has selected, material misstatements of the financial statements may arise when :

1. The selected accounting policies are not consistent with the applicable financial reporting framework; or
2. The financial statements, including the related notes, do not represent the underlying transactions and events in a manner that achieves fair presentation

Financial reporting frameworks often contain requirements for the accounting for, and disclosure of, changes in accounting policies. Where the entity has changed its selection of significant accounting policies, a material misstatement of the financial statements may arise when the entity has not complied with these requirements.

Application of the Selected Accounting Policies

In relation to the application of the selected accounting policies, material misstatements of the financial statements may arise :

1. When management has not applied the selected accounting policies consistently with the financial reporting framework, including when management has not applied the selected accounting policies consistently between periods or to similar transactions and events (consistency in application); or
2. Due to the method of application of the selected accounting policies (such as an unintentional error in application).

Appropriateness or Adequacy of Disclosures in the Financial Statements

In relation to the appropriateness or adequacy of disclosures in the financial statements, material misstatements of the financial statements may arise when :

1. The financial statements do not include all of the disclosures required by the applicable financial reporting framework;
2. The disclosures in the financial statements are not presented in accordance with the applicable financial reporting framework; or
3. The financial statements do not provide the disclosures necessary to achieve fair presentation.

Source : ISA 705 – Modifications to the Opinion in the Independent Auditor’s Report paragraphs A2 - A7

The requirements of an independent auditor in forming an opinion on the audited financial statements

ISA 700 states that the objectives of the auditor (independent auditor) are :

1. To form an opinion on the financial statements based on an evaluation of the conclusions drawn from the audit evidence obtained; and
2. To express clearly that opinion through a written report that also describes the basis for that opinion

In this ISA, the meaning of financial statements is a complete set of general purpose financial statements, including the related notes, which ordinarily comprise a summary of significant accounting policies and other explanatory information.

Regarding the financial statements, the auditor (independent auditor) shall form an opinion on whether the financial statements are prepared, in all material respects, in accordance with the applicable financial reporting framework.

As stated in para. 11 of ISA 700, in order to form that opinion, the auditor shall conclude as to whether the auditor has obtained reasonable assurance about whether the financial statements as a whole are free from material misstatement, whether due to fraud or error. That conclusion shall take into account :

1. The auditor’s conclusion, in accordance with ISA 330, whether sufficient appropriate audit evidence has been obtained;
2. The auditor’s conclusion, in accordance with ISA 450, whether uncorrected misstatements are material, individually or in aggregate; and
3. The evaluations required by paragraphs 12-15.

Then, para. 12 states that the auditor shall evaluate whether the financial statements are prepared, in all material respects, in accordance with the requirements of the applicable financial reporting framework. This evaluation shall include consideration of the qualitative aspects of the entity’s accounting practices, including indicators of possible bias in management’s judgments.

Following, para. 13 states that in particular, the auditor shall evaluate whether, in view of the requirements of the applicable financial reporting framework :

1. The financial statements adequately disclose the significant accounting policies selected and applied;
2. The accounting policies selected and applied are consistent with the applicable financial reporting framework and are appropriate;
3. The accounting estimates made by management are reasonable;
4. The information presented in the financial statements is relevant, reliable, comparable, and understandable;
5. The financial statements provide adequate disclosures to enable the intended users to understand the effect of material transactions and events on the information conveyed in the financial statements; and
6. The terminology used in the financial statements, including the title of each financial statement, is appropriate.

Further, para. 14 of ISA 700 prescribes that when the financial statements are prepared in accordance with a fair presentation framework, the evaluation required by paragraphs 12-13 shall also include whether the financial statements achieve fair presentation. The auditor’s evaluation as to whether the financial statements achieve fair presentation shall include consideration of :

1. The overall presentation, structure and content of the financial statements; and
2. Whether the financial statements, including the related notes, represent the underlying transactions and events in a manner that achieves fair presentation.

While, para. 15 requires the auditor to evaluate whether the financial statements adequately refer to or describe the applicable financial reporting framework (Hrd).