Due to various factors, such as time or costs, auditors do not apply audit procedures on all items when auditing the financial statements of a company. Therefore, they apply procedures on some items, which they select using audit sampling. There are several audit sampling techniques that auditors may use. However, it may cause some auditors to miss some items that may have material misstatements. It is a risk that comes when selecting a sample of items from a population. There are two main procedures in which auditors use sampling.
Firstly, auditors use sampling in the test of controls. Tests of controls are procedures auditors use to evaluate the effectiveness of internal controls in detecting and preventing errors, or correcting errors when found. Through the evaluation of the internal control systems of a company, auditors can further decide the extent to which they must use further audit procedures. The second procedure in which auditors utilize sampling is the test of details. These are procedures specific to balances or transactions to detect material misstatements.
What is Tolerable Misstatement?
When auditors use sampling techniques, they must face two types of risks. Firstly, they must confront the risk that when using sampling, they will not select the whole population of items, thus, missing items with material misstatements. Therefore, these misstatements might go undetected and may negatively impact the auditor’s opinion of the financial statements.
Secondly, they face the risk that misstatements that are immaterial when taken individually, but when aggregated can cause financial statements to be considered materially misstated. These are two risks that auditors must face but cannot fully address unless using the whole population of items. However, auditors cannot do so due to the reasons stated above.
Therefore, auditors establish an amount by which any misstatements in an amount they would consider tolerable. It is known as a tolerable misstatement. In other words, tolerable misstatement is the amount by which a financial statement item can differ from its true value without impacting the fair representation of the financial statements as a whole. Auditors use this concept when designing audit procedures in examining financial statements.
The auditing standards – ISA 530 define tolerable misstatement as follows.
“A monetary amount set by the auditor in respect of which the auditor seeks to obtain an appropriate level of assurance that the monetary amount set by the auditor is not exceeded by the actual misstatement in the population.”
How does Tolerable Misstatement Apply in Practical?
Tolerable misstatement allows auditors to use their professional judgment based on the proportion of materiality of an audit. The higher the tolerance materiality of an audit assignment is, the more auditors will be tolerable to misstatements. However, it does not mean auditors will neglect material misstatements when they find them.
Establishing a level of tolerable misstatement allows auditors to save time and costs of an audit assignment. ISA 530 – ‘Audit Sampling’ further elaborates on tolerable misstatement. It suggests that when auditors are designing a sample, auditors must determine:
“Tolerable misstatement in order to address the risk that the aggregate of individually immaterial misstatements may cause the financial statements to be materially misstated and provide a margin for possible undetected misstatements”.
According to the standard, tolerable misstatements is closely related to and an application of performance materiality to a particular sampling procedure. The standard further suggests that tolerable misstatement can be the same amount as performance materiality or even lower than it. Similarly, it elaborates on other aspects of audit sampling in relation to audit sampling.
For example, the standard suggests what auditors should do in evaluating the results of audit sampling. The standard implies that in case of a test of details, the projected misstatements plus any abnormal misstatement is the auditor’s best estimate in the audit population. When the sum of these misstatements exceeds tolerable misstatement, the sample does not provide a reasonable basis for conclusions about the tested population.
Similarly, the closer the sum of these misstatements is to the tolerable misstatement, the more likely that actual misstatement in the population may exceed tolerable misstatement. Auditors may also conclude that there is an unacceptable sampling risk that the actual misstatement in the population exceeds the tolerable misstatement if the projected misstatement is greater than the auditor’s expectation of misstatement used in the determination of sample size.
How Auditor Set Tolerable Misstatement?
The best answer to how auditors set tolerable misstatement comes from the auditing standard ISA 530. As mentioned above, the standard suggests that tolerable misstatement is the application of performance materiality to a specific sampling procedure. Therefore, auditors, using their professional judgment, can determine the tolerable misstatement to use for the audit.
The standard also suggests that tolerable misstatement can be the same as the performance materiality of an audit. However, it also allows auditors to set it at an amount lower than performance materiality. Through this, the standard suggests that auditors must establish tolerable misstatement equal to or below performance materiality and never above it.
Therefore, auditors must determine the tolerable misstatement when designing an audit sample for any particular financial statement line item, whether it be a transaction account or a balance. It is because they need to address the risk of material misstatement in financial statements that could occur due to the aggregation of individual misstatements.
Several factors determine whether auditors will use a tolerance misstatement level equal to or lower than performance materiality. As mentioned above, the lower the tolerance misstatement level is for a particular line item, the higher the assurance that auditors get from their procedures is. Therefore, one factor in determining the tolerance misstatement level is the level of assurance that auditors require. Other factors may include materiality, performance materiality, level of perceived risk, etc.
Materiality vs Tolerable Misstatement
Materiality is a concept related to financial reporting, which also has application in auditing. ISAs require auditors to obtain reasonable assurance about whether the financial statements as a whole are free from material misstatements. Therefore, the concept of materiality is an essential part of auditing. Auditors determine materiality in the planning stage. After that, they use it when performing audit procedures and evaluating the effect of misstatements on the audit.
To determine materiality, auditors must first choose a benchmark. For that, they can use profits, revenues, or total assets. After establishing a benchmark, they must determine the level for it. Throughout the process, auditors must use their professional judgment, keeping into account the level of risk involved in the audit.
Auditors use materiality as a threshold in determining the items they must focus on and which ones to ignore. Materiality plays a critical role in helping auditors choose the best course for an audit, saving time and cost, while also not compromising the quality of the audit. With the help of materiality, auditors can provide reasonable assurance that any material misstatements affecting the decisions of users of financial misstatements can be detected.
When determining materiality, auditors also calculate performance materiality. ISAs define performance materiality as follow:
“The amount or amounts set by the auditor at less than materiality for the financial statements as a whole to reduce to an appropriately low level the probability that the aggregate of uncorrected and undetected misstatements exceeds materiality for the financial statements as a whole.”
Based on the performance materiality, auditors can set a tolerable misstatement level for each financial statement line item they test. A tolerable misstatement is an example of performance materiality that auditors use in the selection and evaluation of the results of sampling rather than using it to determine the sample from a population.
Therefore, materiality and tolerable misstatement are substantially different. Auditors use materiality for an engagement as a whole. They use it to select items they must test and check for misstatements based on their values or nature. Tolerable misstatement, on the other hand, comes at a lower level. Auditors use it when evaluating the result of tests performed using materiality and performance materiality.
Audit sampling is a tool that auditors use to select only a few items from a population to test. However, it may come with some problems such as ignoring items that may have misstatements. To tackle these problems, auditors use a tolerable misstatement level.
A tolerable misstatement is an amount by which a financial statement item can differ from its true value without impacting its fair representation as a whole. Auditors use their professional judgment in setting tolerable misstatement, which can be equal to or below performance materiality.