Material Misstatement

A Material Misstatement is a premeditated or unintentional misrepresentation of financial information that has the power to potentially influence parties using an organization’s financial statements for decision-making. They may stem from fraud or errors and usually trigger serious repercussions like regulatory action, reputational damage, etc.

Investors, creditors, and regulators, among other parties, may receive incorrect information that results in unsound decision-making. The risks of material misstatement include business disruptions and internal control problems. It is a crucial element of audit reports since it helps auditors identify the areas susceptible to fraud or errors. Though internal controls can reduce the chances of misstatements, they cannot eliminate them.

• Material misstatements occur when incorrect financial information is presented to stakeholders, based on which they may make crucial business or financial decisions. Such inaccurate information can lead to faulty decision-making and unfavorable results.
• Detection risks arise when auditing procedures cannot identify issues inherent in a company’s distorted financial statements.
• Material facts in these statements can affect a company's business, reputation, financial position, and overall industry standing.
• Misstatements can be categorized into three types—projected, factual, and judgmental.

Material misstatement in auditing refers to reporting false figures that deviate significantly from the actual numbers. This results in non-compliance with the Generally Accepted Accounting Principles (GAAP). Such inaccuracies arise from intentional fraud or unintentional mistakes. They introduce audit risks that warrant a detailed examination by auditors since misleading information can damage a company’s reputation, harm stakeholder interests, or may have other serious consequences.

Identifying and outlining these risks requires an in-depth study of the business and the entities involved in it. Auditors must assess relevant risks and identify all potential areas of misstatements to prevent fraud or errors. They must thoroughly examine and determine the accuracy or validity of the details mentioned in financial statements to dodge inherent detection risks.

International Standards on Auditing (ISA) 450 prescribes a standard protocol for evaluating misstatements during audits and communicating them to management. Only if such communication is prohibited by law should auditors withhold such information.

Material misstatements can arise from internal and external factors. Internal factors include the nature of business, the accounting and reporting standards followed by companies, industry norms, skill levels of control staff, etc. External factors include macroeconomic conditions, government policies, geographical location, etc. It is important to note that pervasive material misstatement is a different concept, which indicates deliberate manipulation of financial information. It also indicates system-level failures.  

While material misstatements influence business decisions, pervasive material misstatements have a damaging impact as many areas are affected simultaneously. All pervasive misstatements are material, but not all material misstatements are pervasive.

Material misstatements are visible in different parts of financial statements, with the majority of them seen under assets and liabilities. Some examples include improper valuation of investments and tangible assets. Improper classification or application of incorrect accounting procedures or standards may also result in misstatements. On a more serious level are firms that deliberately overvalue assets to hide fraud.

Auditing Standards

The auditing standards that can help detect these misstatements include the following:

• ISA 450: It refers to the evaluation of misstatements identified during audits. 
• ISA 240: It outlines the auditor's responsibilities in the event of fraud.
• ISA 315, Standards on Auditing (SA) 315, and Auditing Standards (AS) 2110: It covers identifying, assessing, and responding to material misstatements.
• AS 2301: It talks about an auditor's response to risks arising from misstatements and guidance on resolving them.

In this section, we study the types of misstatements.

#1 - Factual Misstatement

It refers to inaccuracies in the facts or figures stated in financial statements. Auditors are required to conduct in-depth research to reduce inherent or detection risks in such cases. Examples include incorrect account balances (of items), improper valuation (overvaluation or undervaluation) of balance sheet items, etc.

#2 - Projected Misstatement

When auditors find misstatements in an audit sample, they apply it through extrapolation to the entire population. This is done to detect inaccuracies in a large population using a sample.

Projected Misstatement = (Evidence collected * Number of items in the population)/ Number of items in the sample                                                               

#3 - Judgmental Misstatement

It refers to differences between the judgments of auditors and companies, which typically arise from differences in accounting methods, procedures, or estimates. For example, the depreciation rate a company considers might seem unreasonable to its auditor. Auditors may state that it does not comply with accounting standards.

Let us study some examples in this section.

Example #1

Suppose Sandra, an external auditor, has been appointed to audit Madit Corporation. During the audit, she noticed various misstatements. At the time, Madit Corporation was pursuing a merger deal, which was due for execution in the next six months.

The success of this merger depended on the company’s financial results. If the results were not found favorable, the deal was likely to be called off. Sandra discovered that the firm had recorded improper asset values in its balance sheet. She also found several other misstatements.

In this case, Sandra must do the following:

• Evaluate the misstatements to determine whether they were truly material in nature and understand if fraud was the intention of such actions.
• Outline the implications or effects of not addressing any misstatements found in the company’s financial statements.
• Study Madit’s internal controls, accounting procedures, and other systems to identify control-level shortcomings.
• Check management’s logic or rationale that led to such misstatements and examine the supporting evidence.

This shows the importance of carefully analyzing financial information during audits to detect the many risks arising from misstatements.

Example #2

A March 2023 report talks about Credit Suisse’s troubles—the organization, already fighting several battles, had come face to face with material weaknesses that could lead to misstatements at the time.

Though the initial evaluation revealed that the problems indicated material weaknesses, management concluded that they could lead to material misstatements. Hence, in the annual report of the company stated that the management had no role in designing and maintaining an effective risk assessment process to detect the misstatements.

At the time, the matter revolved around the efficacy of internal controls and ineffective risk assessment processes, both of which are key to ensuring reliable financial reporting. When the US Securities and Exchange Commission (SEC) got involved, the organization postponed the publication of its annual report. This was primarily due to the inquiries about its cash flow records pertaining to the previous three years.

From the above example, it is evident that misstatements typically lead to several problems that need to be addressed on priority for the benefit of every stakeholder.

Material misstatements involve a lot of risks and hence they must be identified at different levels. The risks with respect to the levels are as follows:

#1 - Material Misstatement at the Financial Statement Level

Material misstatements at the financial statement level are critical since they can mislead stakeholders. To prevent this, auditors must assess and address these risks. By doing this, auditors can improve the reliability of financial statements. If such risks are left unaddressed, auditors may find it challenging to form and present a reliable audit opinion.

#2 - Material Misstatement at the Assertion Level

Material misstatements at the assertion level refer to what has been reported in a company’s financial statements based on the internal controls and accounting standards it follows or what a company claims (asserts) is true. It involves an evaluation of the following:

• Whether reported assets or liabilities exist
• Are all transactions relevant to such items complete?
• Have they been recorded correctly and for the right amounts?
• Have they been given the correct accounting treatment?
• Have all items been correctly classified, accounted for, and reported in financial statements?

The following table explains the differences between misstatements and material weaknesses.

This article has been a guide to what is Material Misstatement. We explain the concept along with its risks, examples, types, and comparison with material weakness. You may also take a look at the useful articles below –

• Materiality Concept
• Forensic Audit
• Reasonable Assurance