What are Material Misstatements? How do Material Misstatements work in the context of Auditing?

What are Material Misstatements?

Material Misstatements can be defined as inconsistencies in the accounting system, which are significant enough to influence the decision-making ability of the user of the financial statements. Material Misstatements imply that the financial figures that have been disclosed in the financial statement, including the income statement (or the balance sheet), are not a true representative of the actual position of the business.

These misstatements are either overstated or understated to the extent that they majorly influence the decision of the financial statements. Misstatement is not limited to quantitative and qualitative missed information that could miss leading users’ decisions.

Any information that is represented on the financial statements might not be 100% accurate. However, some of these misstatements are significant, whereas the other ones are not as significant. For the misstatements that are insignificant, it can be seen that they can be looked over since they are unlikely to impact the decision-making power of the user of financial statements.

However, significant or material misstatements tend to be fixed and disclosed by the auditors since they are in a position that significantly impacts the user’s decision-making ability.

Hence, it can be seen that material misstatements tend to be checked for by auditors, and this tends to be included as a part of the Audit Opinion. In the Audit Report, where the auditors are supposed to give their opinion regarding the accuracy and precision of financial statements, they declare that to the best of their knowledge and evidence. The financial statements are or (are not) materially misstated.

This gives a sense of security to the shareholders (and potential investors) that it is safe to invest in the company since their financial statements are, in fact, a true depiction of their actual financial position.

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Therefore, material misstatements can be defined as information presented in incorrect financial statements to the extent that they can change the decision maker’s ability to invest in the company.

Materiality and Auditing

Year-end financial statements tend to be mandatory for all publicly listed companies because they tend to give resourceful insights regarding the accuracy and the presentation of the financial statements. In this regard, the core function of auditing is to ensure that the financial statements are not ‘materially misstated.’

Materiality is a concept that is very important in the auditing context. It can be defined as a threshold that, if exceeded, calls for action or inquiry on the part of auditors. Basically, it measures the extent of accuracy with which the financial statements have been prepared.

Materiality is not a ballpark figure across all organizations, regardless of their scope and size. In fact, materiality tends to change across different organizations, depending on the scope of work and the relative scale of operations involved.

Auditors tend to incorporate materiality across all audit assertions to ensure that they can execute the financial audit after gaining reasonable evidence regarding the declarations made in the financial statements.

How do Auditors decide materiality?

As mentioned earlier in this article, it can be seen that materiality differs from organization to organization. It is also important to consider that materiality needs to be gauged by the auditors after looking at several factors. These factors include:

  • The industry standards: Different industries have a different scope of operations. For companies that are highly capital intensive in nature, a CAPEX worth $10 Million would not generally be extraordinary. Examples include oil and gas exploration companies. However, for relatively smaller companies, like a snacking unit, a CAPEX of $10 Million might cause concern for the auditors. Therefore, materiality highly differs across different industries. 
  • The scale of operations: The overall line balances in the Income Statement and the Balance Sheet are also contingent on the scale of operations within the business. For some businesses that operate at a smaller level, a payment to a vendor worth $500,000 might be significant compared to a larger corporation, which has quite expansive operations.
  • Level of transactions: The respective level of transactions also helps define and set the overall materiality in the auditing context. If there are sundry expenses on the Income Statement worth $250,000, where the company’s Net Revenue is around $500,000, it would not be considered normal.
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Therefore, it can be seen that materiality is something that needs to be gauged from context to context. There are no stringent requirements about a transaction being material or not. Eventually, it all boils down to company-specific transactions, which need to be independently checked for materiality.

Example of Material Misstatements

The concept of material misstatements is illustrated via the following example.

Feliz Corporation has issued financial statements for the year 2019. In those financial statements, they have declared the following balances.

  • Net Revenue: $80,000
  • Purchases: $600,000
  • Opening Stock: $300,000
  • Closing Stock: $50,000
  • Accounts Receivables: $400,000
  • Accounts Payable: $10,000
  • Misc. Expenses: $400,000

Similarly, inventory amounting to $200 were lost as a result of fire.

In the example above, we can note a couple of inconsistencies in the financial statements. It can be seen that Net Revenue is recorded as $80,000, but purchases have been recorded at $300,000. The closing inventory is also $50,000. There is a difference of $80,000 that needs to be reconciled. It is important to note that since this is a material misstatement, this needs to be further investigated.

Similarly, there was also an inventory loss as a result of the fire. Since the number of goods amounted to $200, they might not be considered material enough to be further investigated by the auditors. Therefore, it is going to be considered immaterial.

However, it must be reinstated that different companies have different materiality thresholds in place depending on the nature and size of financial transactions. For companies with a smaller scale of operations, the threshold will be different for companies with significant operations. The best way to determine materiality to curb this is to work with percentages. A 10% misstatement in revenue, for example, might not be considered as material as a 20% misstatement in revenue.

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What do auditors do in case of material misstatements?

After the primary step of identifying material misstatements, the first course of action by auditors is to try finding a suitable remedy to revert those material misstatements. This might require them to talk to the management about these concerns and then get them reverted to publish the correct set of financial statements for the public.

In the same manner, it is also useful if the auditors can get in touch with the accountants to determine why this happened in the first place. This tends to be the first course of action that needs to be taken by the auditors. If this does not render any good, in that case, the auditors are then supposed to issue a qualified opinion in this regard.

This implies that the auditors will then declare in their opinion that the financial statements have been materially misstated. Consequently, it will impact the credibility of the company, as investors will eventually realize that since the financial statements are not a true representative of the company’s actual financial position, their investment might not be altogether safe.

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