What is Planning Materiality and Tolerable Misstatement? (Example and Explanation)

The audit process involves some cumbersome tasks that need to be executed after a fair degree of planning on the part of auditors. External auditors are supposed to ensure that they are able to plan the audit process in an effective manner so that the main underlying purpose of auditing is not compromised upon.

Hence, a lot of strategic insights are combined in the planning phase of the audit, which ensures that the best outcome is made possible for all the stakeholders, to say the least.

Materiality in Accounting

Materiality tends to be one of the most important concepts in accounting, as well as auditing. Materiality can be defined as the ability of a certain fluctuation in the financial statement line item to influence the decision of the user of the financial statements. In simple terminology, the materiality of a certain line item is the propensity of a particular balance to influence the decision-making ability of the user of the financial statements.

This is a very important concept in accounting simply because of the fact that it tends to impact the overall outlook of the financial statements. The concept of materiality is used with misstatements in financial statements. Misstatements can either be material or immaterial.

Material Misstatements imply that the misstatements are of a magnitude such that they can possibly impact the decision-making ability of the end-user of the financial statements. On the other hand, immaterial misstatements are not of a significant nature, and this means that these misstatements are unlikely to influence the decision-making ability of the final user of the financial statements.

Materiality, in itself, is a subjective concept, and hence, it differs from organization to organization. It also differs across industries. For some organizations, a certain amount might be material, whereas, for other organizations, the same amount might be immaterial.

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This threshold is determined by the accountant when preparing the financial statements. Accountants can’t exactly incorporate each and every transaction.

Although they attempt for the highest accuracy and precision, some discrepancies are still not accounted for properly. Therefore, there are some estimations, approximations, and rounding-offs involved in the preparation of the financial statements.

However, accountants are supposed to ensure that even if there are some minor misstatements in the financial statements, they are not material enough to impact the decision-making ability of the final user of the financial statements.

Once the accountants have prepared the financial statements, the auditors’ role comes into play. In this regard, auditors are supposed to approach and audit the financial statements with professional skepticism.

This involves setting up the audit process and planning all the phases of the audit so that they are able to get the evidence that can eventually help them gather reasonable assurance regarding the audit process.

Planning Materiality – An explanation

Planning materiality is one such step that auditors take in the initial stages of the audit process. This involves studying the business and then deciding on a materiality threshold that would enable them to carry out the audit process in a smooth manner.

In this aspect, they are not supposed to rely on the judgment of the accountants solely. In fact, they are supposed to set their own judgments. They can properly gauge the financial statements pertaining to financial accuracy and the extent to which the financial statements are reliable.

How Do Auditors Plan Materiality?

Materiality planning is one of the initial important steps in accounting, and it inculcates the following approach by the auditors:

  • Industry Standards: Comparing industry standards to check the materiality threshold of other organizations in the same industry.
  • Previous year’s auditing papers: This is a very resourceful tool that can help auditors gauge materiality applicable in the existing organization.
  • Professional Insight: This is by far the most important tool that is used by the auditors. It includes a holistic approach of the situation, as well as the risk assessment that is undertaken by the auditors in order to determine the risk profile of the given organization. This is used in order to help auditors decide on planning materiality, as well as tolerable misstatement.  
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Tolerable Misstatement

Once the auditors have decided the planning materiality, then auditors go on and calculate the tolerable misstatement.

Tolerable misstatement is the monetary amount that the auditors set to seek an appropriate level of assurance pertaining to the financial statements.

In other words, tolerable misstatement is the acceptable amount of fluctuation, which the auditors can choose to overlook as immaterial or insignificant when it comes to the financial statements.

Auditors determine the tolerable misstatement using the planning materiality that they set after rigorous research. This amount is always lower than or equal to the actual performance materiality in the greater population of accounts or balances. The level of assurance that is required from the sample is mostly used to determine the amount of tolerable misstatement.

The tolerable misstatement threshold that is set is purely a judgment call by the auditor, which is based on the proportion of planning materiality across the phase of the audit. In the case where the overall perceived risk is higher, tolerable misstatement might be equivalent to a smaller percentage of the planning materiality.

On the other hand, if the perceived risk by the auditors is low, in that case, the tolerable misstatement might be a higher percentage of the planning materiality.

This implies that setting the tolerable misstatement is primarily at the discretion of the auditor. This depends on several different auditing observations, like the extent of internal control and other related inspections within the company.

Example of Planning Materiality

The concept of Planning Materiality is illustrated in the following example:

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From the financial statement extract, the total assets amounted to $500,000, whereas total revenues amounted to $250,000. Based on previous year records and industry standards, auditors decided to set the planning materiality at 1% of the revenue. The tolerable Misstatement threshold was set at 90% since the perceived risk was relatively low.  

Based on this, the planning materiality for all the line items in the financial statements was set at $2500. In the same manner, the tolerable misstatement was set at $2250. This amount is set to assess the materiality of the financial statements to find out if the amount is immaterial or not. If transactions lie above or below the threshold of planning materiality, then an adjustment is required in the financial statements.

In the example given above, it can be seen that both planning materiality and tolerable misstatement are used simultaneously in the planning process to ensure that the company’s financial statements are not materially misstated.

This step is undertaken in the initial planning stages of the audit process because it tends to help auditors in subsequent audit processes.

Both planning materiality and tolerable misstatement threshold should be decided after proper research since it might impact the overall reliability and the accuracy of the financial statements.

Hence, these metrics can be termed as one of the most crucial steps, which determine not only the audit’s overall trajectory but also the audit’s efficacy.