Meaning of Risk of Material Misstatement

The risk of material misstatement is the susceptibility of the financial statements, accounts, and assertions to material misstatement, and the risk that the client’s current internal controls would be ineffective in proactively identifying and correcting the misstatements. The inherent risk and control risk in the obligations form the risk of material misstatement. The risk of being susceptible to misstatement due to the nature of the debt is the inherent risk. Control risk occurs when the internal control system of the auditee fails to prevent or detect a material misstatement.

To name some risks, unauthorized transactions, wrong recording of debt, and non-confirmation with accounting standards are material misstatements. An unauthorized transaction is a case where someone other than a person authorized and responsible for transaction-related affairs deals with either within an entity or with outsiders.

Such risks generally create the risk of fraud which is itself material misstatement. The audit client shall correctly record transactions as per applicable accounting standards. The proper classification shall be done. Further, the breach of policies and covenants would also lead to material misstatements.

This risk is assessed by auditors at the following two levels:

  1. At the assertion level: This is further divided into inherent risk and control risk. Inherent means the transaction already would be vulnerable to threats.
  2. At the financial statement level: This would mean risk on the company as a whole. The risk of going concerned about being impacted and not disclosed may fall under this.

Risk of Material Misstatement at the financial statement level

Such risks mean that that certain risks can affect financial statements as a whole and potentially have a major impact on several assertions. Various factors affecting the risk of material misstatement include incompetent management, Inadequate accounting systems and records, Operation in a rapidly changing industry, and poor governance by the board of managers.

The following are some of the pervasive risks at financial statement level:

  • Absence of financial reporting expertise
  • Absence of segregation of duties and safeguarding assets
  • The decision to terminate or curtail the plan
  • Absence of oversight and monitoring of plan operations and service providers
  • Absence of communication about plan events between the preparer of the financial statements
  • Changes in key personnel
  • Plan transfers (plan mergers, spin-offs, or other transfers)

Risk of material misstatement at the assertion level

The various risks related to assertion level include the following:

CompletenessThe financial transaction has been incurred and recorded up to date of reporting
Cut-offBusiness transactions have been differentiated as per the accrual system and recorded in the proper accounting period.
AccuracyEvents are recorded accurately for the amount
OccurrenceThe expenses, assets and liabilities have been actually incurred and related to the business.
ClassificationThe assets, liabilities, expenses, and income have been properly classified into their various sub-divisions. Assets need to be divided into current and non-current assets.
ExistenceOn the date of balance sheet, all the assets and obligations of the company have been reported.
ValuationThe balances of the assets and liabilities accounts correctly reflect the actual economic value.
Rights and obligationThe company owes sum of money on the date of reporting of balance sheet.
Presentation and disclosureThe applicable accounting standards are being followed to disclose all the transactions.

Let’s take a short example of how risks can be materially misstated in the case of accounts receivable. The risk for accounts receivable would be internal control risk and inherent risk. The risk of being susceptible to misstatement due to the nature of the debt is the inherent risk of the accounts receivable.

Control risk occurs when the internal control system of the client fails to prevent or detect material misstatement in the accounts receivable. Some of the risks associated are unauthorized transactions, wrong recording, and non-compliance with accounting standards on assets and accounts receivables.

An unauthorized transaction is a case where someone other than a person authorized and responsible for accounts receivable deals with the related matters either within the entity or with the outsiders. Such risks generally create the risk of fraud which is itself material misstatement. The audit client shall correctly record debtors as per applicable accounting standards. The proper classification of debtors shall be done. Further, the breach of Sales terms and conditions may lead to material misstatements.

There are two major risks of material misstatement associated with accounts receivables. The first would be the non-existence of accounts receivables. For instance, fictitious invoices are generated to increase sales, and receivables are recorded in the current year when they are actually made after the year-end. Another risk would be that accounts receivables do not reflect true economic value. This generally happens during the creation of allowance for doubtful accounts based on probabilities and aging analysis.