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What happens when an Auditor finds a Material Error?



The ability of the auditor to express an opinion as to whether or not the financial statements reflect a true and fair view (or present fairly in all material respects) of the company's financial situation is the fundamental objective of the audit.



During the course of their work, the auditor is required to maintain a certain level of professional scepticism, always bearing in mind the possibility that the financial statements may include a material misstatement as a result of either fraudulent activity or an error.


As soon as the auditor finds a material misstatement, they are obligated to determine whether or not this misstatement is either material or both material and pervasive.


When we talk about errors being "pervasive," we indicate that they are not isolated to a single component, account balance, or disclosure.


The following is how the ISA 705 Modifications to the Opinion in the Independent Auditor's Report defined the word "pervasive":

A term used, in the context of misstatements, to describe the effects on the financial statements of misstatements or the possible effects on the financial statements of misstatements, if any, that are undetected due to an inability to obtain sufficient appropriate audit evidence. Pervasive effects on the financial statements are those that, in the auditors' judgment:

  • Are not confined to specific elements, accounts or items of the financial statements;

  • If so confined, represent or could represent a substantial proportion of the financial statements; or

  • In relation to disclosures, are fundamental to users' understanding of the financial statements.’

Example

XYZ Pharmaceutical Company has prepared its financial accounts in accordance with IFRS up to the 31st of January, 2014, which indicates a profit before taxes.

Additionally, during the course of the year, XYZ Pharmaceutical Company has capitalised on research expenditures of $500,000.


This number is considered significant to financial accounts, although it does not play a crucial role.


IAS38 Intangible Assets states that any and all research expenses shall be deducted from the company's profit or loss as soon as they are incurred. This rule forbids the practice of capitalising on research expenses.


In this scenario, assets and profitability have been grossly exaggerated, while costs have been underestimated.


Suppose XYZ Pharmaceutical Company does not correct the financial statements to comply with IAS 38.


In that case, the auditors should express a modified audit opinion (a qualified 'except for' opinion) because they disagree with the accounting treatment specified in IAS 38.

You CANNOT capitalise any research expenditure.
You need to expense it in profit or loss as incurred.
This applies to both internal research and research conducted by external providers.

Example

ABC Lighting Company has completed its financial accounts in accordance with IFRS up to the 31st of January, 2014, revealing a profit before taxes.

The accounting records for the first six months of the company's financial year were lost in a fire during this financial accounting period.


The auditor has been unable to collect sufficient appropriate audit evidence to satisfy themselves that the financial statements are free from material misstatement.


The auditor has concluded that the potential impact of undetected misstatements (if any) on the financial statements might be both substantial and pervasive if they were to occur.


In such a circumstance, the auditor will conclude that a qualified audit opinion is insufficient to convey the circumstance's seriousness.


In such circumstances, ISA 705 require that the auditor either:

  1. Withdraw from the audit, provided that doing so is both practicable and permitted under the applicable law or regulation; or

  2. Disclaim an opinion on the financial statements, provided that withdrawing from the audit before issuing the auditor's report is neither practicable nor permitted.

Summary of possible effects of misstatements

In any event, the auditor must communicate with those charged with governance about the effects of such material (and pervasive) misstatements.


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