Audits of Special Purpose Frameworks: Error Analysis
Practice aids purchased from major publishers normally include a form designed to facilitate the aggregation of known and likely errors for comparison to tolerable misstatement and the recorded amounts for material financial statement classifications. Attached to this article is an illustrative form I've titled Error Analysis Form. While some auditors have used this or a similar form only to determine if any known but unadjusted errors should be included proposed as adjustments, its primary purpose is to enable engagement leaders to perform both quantitative and qualitative error analysis and, during engagement completion, to determine that the financial statements contain an acceptable level of error.
An analysis form should include these three categories of known and likely error:
- Known but unadjusted error (passed adjustments) less than the lower limit for individually significant items and greater than any "paper pass" limit set by an engagement leader.
- Projected error from sampling applications.
- Estimated error from tests of accounting estimates and other procedures, such as predictive analytical procedures that may provide most of the substantive evidence for certain financial statement classifications.
The reversing effects of the prior year's errors must also be reflected in the current year's aggregation, at least by material financial statement classifications, to support the engagement leader's conclusion about an acceptable level of error in the financial statements. Aggregated known and likely error should be compared with tolerable misstatement by financial statement classification to determine if detection risk has been reduced to an acceptably low level. The purpose of this comparison is to determine if "good error analysis" has been performed.
Good Error Analysis
Good error analysis should be performed during engagement performance as an auditor evaluates the results of specific auditing procedures. It should contain both quantitative and qualitative analysis by the person performing the work or an in-charge accountant. The comparison of aggregated known and likely errors to tolerable misstatement by financial statement classification (normally performed by the engagement leader during the completion phase of the engagement) may indicate, however, the need for additional analysis when aggregated error exceeds tolerable misstatement. Additional substantive procedures may then be necessary to reduce detection risk to an acceptable low level.
Aggregated known and likely error should also be compared with the balances of material financial statement classifications (such as various current assets and current liabilities balances, equity, revenues, expenses, net income, etc.) to determine if the level of known and likely error is acceptable. Sometimes called "accounting materiality," this process includes comparing aggregated uncorrected audit differences and likely error as a percentage of the financial statement classifications. Acceptable percentages of known and likely error will vary according to risk at the financial statement and assertion levels. The auditor will make these final materiality decisions based on estimates of how the user of the financial statements would evaluate the level of error.
Qualitative error analysis, discussed further below, is the process of "carving out" the causes of significant error for further investigation during the performance of auditing procedures and finally during the completion phase of an engagement. After appropriate qualitative error analysis has been performed, the auditor may propose adjusting journal entries to correct certain known errors that have a material effect, individually or in the aggregate, on financial statement classifications.
Performing Error Analysis
Contrary to the practices of some auditors, the primary purpose of an error analysis form is not just to make the numbers come out right. The purpose is to make sure effective error analysis has been completed. Error analysis, as discussed above, should be both quantitative and qualitative and includes:
- Requesting the client make adjustments for some or all of the actual errors.
- Considering the nature of the projected or estimated errors to isolate causes for further investigation and corrective action.
- Expanding substantive procedures in the areas that resulted in large amounts of projected or estimated errors.
The error evaluation process will result in some combination of making adjustments for actual errors and "carving out" the causes of projected or estimated errors for further investigation. For example, suppose a price test of inventory reveals a 5 percent error rate that, when multiplied times the dollar amount of the sampling population, results in an unacceptable estimated amount of known or likely error in the inventory account classification. A first step in qualitative error analysis would be to make sure the inventory items selected for testing are representative of all the items in the sampling population. It may be that the dollar amounts of inventory items vary significantly, indicating a need to stratify the sampling population before selecting items for testing. The need to stratify, however, should be considered when planning sampling applications.
If the inventory items selected for price testing are representative of the sampling population, the next step in qualitative error analysis would be to ask the question, "Who made these pricing errors?" If a majority of the errors were made by one person, the auditor may suggest further testing of other inventory items priced by this person. If additional errors are discovered, in a worst case scenario, all the inventory items priced by this individual may need to be re-priced. If no additional significant errors are found, the error rate in the expanded sample may be used for a new projection to the sampling population. This usually will result in a lower amount of estimated error.
From an efficiency standpoint, the last thing an auditor wants is to increase sample sizes and perform more sampling procedures. The error analysis process, therefore, should be performed at the time the results of the auditing procedures are applied. The in-charge accountant, and the engagement leader, should also review the error analysis form as part of their final quality control procedures.
Good error analysis should include consideration of both the error itself and the condition it may represent. Qualitative factors may cause small, seemingly isolated errors to have a material effect on the financial statements as a whole. Below are qualitative factors that should be considered when evaluating error conditions:
- Related-party transactions.
- Errors resulting from conflicts of interest.
- Errors arising from fraud or illegal acts.
- Error effects that could be material in some future period.
- Errors with psychological impacts, such as changing earnings from a small profit to a loss or changing cash in bank to an overdraft.
- Errors symptomatic of larger problems, such as numerous sales returns, extensive product warranty claims.
- Errors affecting contractual obligations, such as covenants in debt agreements.
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