What is the Tolerable Misstatement in an Audit of Financial Statements?

When auditors perform an audit, they do not check 100% of the transactions and balances. Instead, they will perform audit procedures on a sampling basis. The samples selected will be quantitatively or qualitatively material to the financial statements.

Today, we will talk about a criterion that helps auditors determine whether a financial line item is quantitatively material to the financial statements: tolerable misstatement.

What is a tolerable misstatement?

The definition of tolerable misstatement is stated by ISA 530 as a monetary amount the auditor determined to be giving an “appropriate level of assurance” so long that the actual misstatement of a population stays below the monetary amount.

As its name implied, a tolerable misstatement is an acceptable difference that a financial statement line item is from its actual amount. This acceptable difference will still allow the financial statements to be determined as true and fair.

When determining which financial statement line items to examine, auditors will look at the tolerable misstatement. A tolerable misstatement is calculated based on a proportion of the planning materiality, depending on the risk of auditing the entity. We will discuss this later.

Individually, a few of the financial statement line items can have tolerable misstatements that will become a material misstatement in aggregate. These misstatements could also be either positive or negative, effectively canceling each other out or lower the actual impact that it may cause to the financial statements.

This is essentially a risk of using tolerable misstatement and sampling basis when auditing an entity. But due to the consideration of factors such as time, costs, and resources, it is almost impossible for auditors to perform a full check. Hence, there might be a chance that auditors may miss a material misstatement.

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Therefore, most auditors do not rely fully on just quantitative criteria to select their samples. They will also use qualitative criteria to examine and perform audit procedures on higher-risk areas below the threshold.

How to set tolerable misstatement?

ISA 530 mentioned that a tolerable misstatement could be determined using performance materiality. It can be the same or be lower than performance materiality but never above it. Hence, the auditors will normally apply their judgment in setting the tolerable misstatement.

Typically, an entity with a higher audit risk will use a lower proportion of the performance materiality, while an entity with a lower audit risk will use a higher proportion. The exact proportion is determined by the internal practice of an audit firm and its risk appetite.

How performance materiality is set is another topic on its own. In short, performance materiality varies from one entity to another based on their businesses’ nature and profitability. Again, auditors have to apply their judgment in identifying the suitable performance materiality for an entity being audited.

Tolerable misstatement in practice

Audit procedures can be categorized into tests of controls and substantive procedures. Tolerable misstatement is only used as a sampling method when performing substantive procedures. When testing on a sampling basis, there are two risks that the auditors face.

One of the risks is that the auditors will not be selecting all items in a population. That means some items will be left out. If these items are, by any chance, misstated, the misstatements will go undetected and will cause the financial statements to be not true and fair. This is what is normally known as the detection risk.

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Another risk is that the individual misstatements detected by the auditors may not be material but become material when they are added up. These two risks can only be addressed when the auditors test all the items in a population. But this is not possible in practice due to constraints on time, costs, and resources.

With this tolerable misstatement, auditors will know at which level a misstatement can be accepted without affecting the “true and fair” statement, even when they are aggregated and looked at as a whole. Audit procedures will be designed with the tolerable misstatement threshold taken into consideration.

Based on the audit risk presented by each financial statement line item, the auditors will determine the appropriate tolerable misstatement. Then, samples will be selected either systematically, haphazardly, or randomly based on the threshold.

The auditors will test these samples by checking the evidence gathered. They will then decide if the samples allow the population of a financial statement line item as a whole to be identified as truly and fairly stated.

If a misstatement is identified, they will first assess if it is a one-off misstatement or a systematic misstatement. This can be determined by performing further audit procedures on the rest of the population. This is important as there is a risk that the sample selected may not represent the entire population.

There is also a possibility that the total misstatements discovered within the samples are below but very close to the tolerable misstatement. In this situation, the auditors will have to determine how likely the actual misstatements in the entire population may be higher than the tolerable misstatement.

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They may need to design further procedures to assess the entire population as a whole.

If that is not possible due to the voluminous size of the population, the auditors will have to design a procedure that will allow them to identify the aggregate misstatement that may be present in the entire population. This could include calculating a projected misstatement amount.

Either way, if the misstatement found or calculated exceeds the tolerable misstatement, they will then require the management to make an adjustment accordingly.

Summary

Auditors will perform audit procedures on a sampling basis due to time, cost, and resource constraints during an audit. The samples are selected based on quantitative and qualitative criteria. One of the quantitative criteria is by using the tolerable misstatement.

Tolerable misstatement is determined by using a proportion of performance materiality and the auditors’ judgment. It can be either below or the same as the performance materiality but not above it.