Is Tolerable Misstatement the Same as Performance Materiality?

Auditors do not examine every transaction when auditing a company’s financial statements, as the volume of activity makes this impractical. Instead, they use a system of thresholds to gauge the significance of errors. This method allows them to focus on mistakes large enough to mislead someone reading the financial statements, such as an investor or a lender.

The process determines what size of error is meaningful. A small mistake in a multi-billion dollar company’s revenue is unlikely to change an investor’s decision, but that same error could be significant for a small business. Auditors establish these benchmarks at the start of their work to guide their procedures and form an opinion on the financial statements.

Defining Overall Audit Materiality

Overall materiality, or planning materiality, is the maximum misstatement that can exist in financial statements before impacting the decisions of users. This figure applies to the financial statements as a whole and serves as the primary benchmark for measuring any discovered errors.

Calculating overall materiality is a matter of professional judgment, typically based on a benchmark like a percentage of pre-tax income, total revenues, or total assets. For example, an auditor might set materiality at 5% of pre-tax income for a stable company. The choice of benchmark and percentage depends on the entity’s nature and its users’ needs.

This determination is foundational to the audit strategy, influencing the nature, timing, and extent of procedures. A lower overall materiality level signals that smaller errors are a concern, requiring more detailed and extensive testing.

Understanding Performance Materiality

After establishing overall materiality, an auditor determines performance materiality. This amount is set lower than overall materiality to act as a safety net. Its purpose is to reduce the probability that the sum of all uncorrected and undetected misstatements exceeds the overall materiality level, providing a buffer against the risk of small, accumulated errors becoming a large problem.

Performance materiality is an internal, more conservative threshold for the audit team. By planning their work to this lower number, auditors build in a cushion for potential misstatements not caught by their tests. This addresses the risk that individually insignificant errors could, in aggregate, cause the financial statements to be materially misstated.

Determining performance materiality involves professional judgment. Auditors set it as a percentage of overall materiality, often 50% to 75%. The percentage is influenced by the auditor’s assessment of the company’s risk. A company with weaker internal controls or a history of errors would warrant a lower performance materiality percentage, requiring more rigorous testing.

Explaining Tolerable Misstatement

Tolerable misstatement is the application of performance materiality to a specific account balance, class of transactions, or disclosure. It is the maximum misstatement an auditor will accept in that specific area. While performance materiality is a single threshold for the entire audit, auditors set multiple tolerable misstatement amounts for different parts of the audit.

This concept is linked to designing and executing audit procedures, particularly sampling. When testing a sample of a larger population, like accounts receivable, auditors use tolerable misstatement to define the test’s precision. It helps determine the necessary sample size and provides a benchmark for evaluating the results.

For instance, an auditor might set a tolerable misstatement of $20,000 for the inventory account. If testing a sample of inventory projects a total misstatement of $5,000, this amount is below the tolerable misstatement. This result provides evidence that the inventory account is not materially misstated.

The Relationship Between the Concepts

Performance materiality and tolerable misstatement are not the same, but they are closely related. The concepts exist in a hierarchy that flows from the broad financial statement level down to specific testing, ensuring a systematic, risk-based audit approach.

An analogy is building a house. Overall materiality is the total budget variance the client will accept for the entire project. Performance materiality is the project manager’s tighter, internal budget, set lower to prevent overages. Tolerable misstatement is the specific budget for individual tasks like plumbing or electrical work, ensuring no single part goes so far over budget that it jeopardizes the manager’s internal budget.