Tolerable Misstatement in Audit
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The risk of material misstatement of the financial statements is a fundamental underpinning to audit planning. Materiality refers to a difference that would cause a decision maker to change his or her decision. Statement of Financial Accounting Concepts No. 2 defines materiality as:
the magnitude of an omission or misstatement of accounting information that, in the light of surrounding circumstances, makes it probable that the judgment of a reasonable person relying on the information would have been changed or influenced by the omission or mis- statement. (SFAC No. 2, p. 7)
The materiality threshold for each account balance or class of transaction is called tolerable misstatement (AU 350.19, AICPA AU 312.34). The materiality threshold that relates to the number or percent of times an ICFR fails is called tolerable rate of error. For planning purposes, as long as the misstatement in an account balance is less than tolerable misstatement, the auditor does not expect the problem to be material. Similarly, if the extent of ICFR weakness is lower than the tolerable rate of error, the auditor does not expect the problem to cause a material misstatement.
The tolerable misstatement–tolerable rate of error guide is a planning concept that may also be useful for quantitative analysis evaluating audit findings. However, the auditor also evaluates whether the problem is material when qualitative factors are considered. Qualitative considerations are important even if the problem does not reach the threshold for quantitative materiality. Also, keep in mind the possibility that things may change during the course of the audit. The conclusions the auditor makes about materiality when evaluating problems discovered from audit testing may ultimately differ from what was considered to be material during planning. When ICFR deficiencies are identified, the audi- tor evaluates them to determine whether they are serious enough to be classified as significant deficiencies or material weaknesses. When the misstatements are material, either individually or on an aggregated basis, the client’s books and financial statements need to be corrected to keep them from being materially misstated.
Materiality is not determined solely on the basis of quantitative factors but is influenced by qualitative characteristics as well. For example, fraud committed by management is always considered material. In addition, any uncertainties about transactions with related parties may be considered material because the supporting evidence might be less reliable as a result of the relationship.
AS 5 directs the auditor to use a “top down” approach that applies to materiality in both the financial statement and ICFR aspects of an integrated audit. First the auditor determines what is material at the financial statement level. Next, the auditor identifies the various accounts and disclosures that are significant to the financial statements. The auditor identifies the management assertions that are relevant for those significant accounts and dis- closures. The auditor makes a professional judgment about the amount of a misstatement in that account or disclosure that would be material. The auditor’s materiality judgments also consider the aggregation of materiality in all the significant accounts that could cause the financial statements to be materially misstated.
Based on all the knowledge accumulated about the company, the auditor determines risks in the business that might cause material misstatements in each financial statement account. A significant risk is a risk of material misstatement that is important enough to require special audit consideration. The risk of material misstatement of an account is linked to the relevant assertions. One approach to determining the risks is to consider “what could go wrong” to cause the material misstatement.
For both expressing an opinion on ICFR and determining reliance on controls in the financial statement audit, the auditor looks for controls that address the significant risks. Auditors structure the audit plan to test the design and functioning of the controls that address the risks of material misstatements. If the controls are ineffective to the extent that they might not keep the financial statements from being materially misstated, then a mate- rial weakness exists in ICFR.
For planning the substantive procedures of a financial statement audit, the auditor evaluates what would be a material misstatement for an account or disclosure assertion. Substantive audit procedures are then designed to identify any such material misstatements that have occurred, whether they result from error or fraud (AS 5.21-41, AICPA AU 312.07). Exhibit 6-4 summarizes materiality considerations in a top down approach to planning. Auditors use professional judgment in setting the amount that is considered quantitatively material at the financial statement level. One factor that auditors may consider in set- ting financial statement materiality is a “rule of thumb” or benchmark. A rule of thumb might be a percentage of total revenue, gross profit, or profit before taxes for continuing operations. Auditors consider characteristics of the company such as size, nature of ownership, financing sources, and industry in considering benchmarks when setting financial statement-level materiality.
Financial statement materiality in a publicly owned entity in the retail industry might be based on a percentage of profit from continuing operations. In contrast, financial statement materiality for a not-for-profit entity might be some percentage of assets. A company in a highly regulated industry such as a bank or a brokerage firm might require a different benchmark. For instance, a stock brokerage company has minimum net capital requirements, and regardless of any other criteria used, a misstatement that caused the brokerage company to miss its minimum net capital requirements might be judged material. Other qualitative characteristics, such as whether the misstatement would move the company from a profit to a loss might be layered on top of quantitative benchmark materiality considerations.
In addition to setting a materiality threshold at the financial statement level, the audi- tor must also determine a materiality level appropriate for each individual account balance or class of transactions. An auditor is willing to accept some dollar amount of misstatement in an account balance or class or transactions based on the judgment that it is not mater- ial. Similarly, the auditor is willing to accept some number (or percent) of errors in the appli- cation of a control applied to an account balance or class of transactions. Accepting some errors is based on the conclusion that the accepted rate of control failure will not allow a material misstatement in the account balance. The auditor must set materiality for each significant account balance keeping in mind the aggregated impact of all the “less-than-material” misstatements that can occur in the financial statements. In other words, if every significant account is misstated up to, but not beyond, its materiality threshold, the resulting set of financial statements cannot be mate- rially misstated.