Good Error Analysis--A Key to Audit Quality
Good error analysis should be performed when an auditor evaluates the results of specific auditing procedures. It should contain both quantitative and qualitative analysis by the person performing the work. The comparison of aggregated known and likely error to tolerable misstatement by financial statement classification (normally performed by the in-charge accountant) may indicate, however, the need for additional analysis when aggregated error exceeds tolerable misstatement. It is possible that additional auditing procedures may even be necessary to reduce detection risk to an acceptable low level.
Aggregated known and likely error should also be compared with the totals of material financial statement classifications (such as current assets, current liabilities, equity, revenues, expenses, net income, etc.) to determine if the level of known and likely error is acceptable. Some call this accounting materiality, i.e., evaluating 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. Ultimately, the auditor will make these final materiality decisions based on how the user of the financial statements would evaluate the level of error. After appropriate qualitative error analysis has been performed, the auditor may propose general journal entries to correct certain known errors that have a material effect, individually or in the aggregate, on financial statement classifications.
Common acceptable percentages of error may be 1-2% of assets, liabilities, revenues and expenses and 5% for equity and net income; however, these percentages may vary depending on the use of the financial statements. The higher the risk associated with the use of statements, the lower are the acceptable percentages.
Contrary to the practices of some auditors, the use of an Audit Difference Evaluation Form from Practitioners Publishing Company or other publisher of practice aids, is not to make the numbers come out right. The purpose is to make sure effective error analysis has been done. As mentioned above, error analysis should be both quantitative and qualitative. It may include:
- 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 auditing procedures in the areas that resulted in large amounts of projected or estimated errors.
Most commonly, our error evaluation process will result in some combination of making adjustments for actual errors and "carving out" the causes of our projected or estimated errors. From an efficiency standpoint, the last thing an auditor wants is to increase sample sizes and perform more sampling procedures.
Good error analysis includes 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. Here are some 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, e.g., changing earnings from a small profit to a loss or changing cash in bank to an overdraft.
- Errors symptomatic of larger problems, e.g., numerous sales returns, extensive product warranty claims.
- Errors affecting contractual obligations such as covenants in debt agreements.
The banner for audit quality truly reads, "Do Good Error Analysis!" What's in your audit?