In auditing, the planning stage is one of the most crucial. During this stage, auditors must contemplate the approach they will take to tackle an audit engagement. There are several processes that auditors must perform during audit planning. Among other things, these include planning materiality and tolerable misstatement. Both of these are critical in the audit planning and execution stages.
What is Planning Materiality?
Planning materiality is a threshold for misstatement set by auditors during the audit planning stage. This materiality depends on the materiality level of the financial statements. With planning materiality, auditors can assess whether a misstatement in the financial statements can affect users’ decisions. There are several methods to determine this amount.
Planning materiality can help auditors focus on critical areas or significant misstatements in the financial statements. Without this amount, auditors cannot determine whether a misstatement is worth investigating. Therefore, it can help auditors save time and make the audit process more efficient. However, it is crucial for auditors to determine the planning materiality at a reasonable level.
Planning materiality depends on the concept of materiality. According to the ISAs, materiality is a threshold for misstatements if they, individually or in the aggregate, could reasonably be expected to influence the economic decisions of users based on the financial statements. Setting the planning materiality is one of the crucial parts of the audit planning stage.
How does Planning Materiality work?
The International Standards on Auditing require auditors to assess the materiality of the financial statements during audit planning. More specifically, ISA 320 Materiality in Planning and Performing an Audit deals with the process. The standard states that when establishing the overall audit strategy, the auditor must determine materiality for the financial statements as a whole.
However, planning materiality primarily relates to the planning stage. Auditors will use this amount to set their strategy for the audit. If auditors come across information that refutes their materiality amount later, they must recalculate it. However, if auditors believe the planning materiality will be sufficient during the performance, no changes will be necessary.
The assessment of planning materiality requires auditors to use their professional judgment. There is no set standard on how auditors should calculate the materiality for a client. However, there is guidance to help auditors in the calculation. There are several benchmarks that can provide a starting point for auditors to help them determine planning materiality.
How to calculate the Planning Materiality?
As mentioned, the International Standards on Auditing do not clarify the process for calculating planning materiality. Instead, it states that auditors should use their professional judgment. ISA 320 implies that auditors can use a chosen benchmark and apply a percentage to it to calculate the planning materiality. Usually, there are three crucial figures that auditors can use. These include profits, revenues, or total assets.
Commonly, auditors use the following percentages for these benchmarks.
0.5% to 1% of Revenues
1% to 2% of Total Assets
5% to 10% of Net Profits
In some cases, auditors may also use other benchmarks, for example, shareholders’ equity or gross profit. However, the above three are the most prevalent among these benchmarks. Furthermore, this materiality may not apply to every item. Some financial statement balances or transactions may be material by nature. Therefore, they will always be material regardless of their amounts.
The International Standards on Auditing also requires auditors to consider several factors when determining an appropriate benchmark. These include the following:
- Whether there are items on which the users of the financial statements will focus their attention.
- The nature of the entity, its current life cycle stage, the industry in which it operates and its economic environment.
- The entity’s ownership structure and its source of finance.
- The relative volatility of the benchmark
A company, ABC Co., has total assets of $100 million. Its revenues for an accounting period were $25 million while its net profits were $5 million. The company’s auditors want to determine planning materiality for the company based on these figures. Auditors calculate the materiality for ABC Co. based on the three prevalent benchmarks as follows.
$125,000 to $250,000 (0.5% to 1% of Revenues)
$1 million to $2 million (1% to 2% of Total Assets)
$250,000 to $500,000 (5% to 10% of Net Profits)
Based on an initial assessment, the auditors conclude that the planning materiality should be $1 million. The auditors consider that the company is capital-intensive, and its users will focus more on total assets. Auditors also believe the total assets to be a relatively stable benchmark and to provide better results.
What is a Tolerable Misstatement?
The basic premise behind setting planning materiality is for auditors to determine the amounts that need attention. Therefore, it helps auditors measure the value of misstatement that they should take seriously. Furthermore, it helps filter out misstatements that may they can ignore. For this process, the tolerable misstatement will also be crucial.
Tolerable misstatement is the amount by which any misstatements in the financial statements would be considered tolerable. Usually, this concept goes along with materiality. Tolerable misstatement is a threshold for which an amount for a financial statement item can differ from its true value without impacting the fair presentation of the financial statements as a whole.
In particular, tolerable misstatement closely relates to the performance materiality set by auditors. Similarly, audit sampling is also associated with tolerable misstatements. The higher the materiality in an audit assignment is, the higher the tolerable misstatement threshold will be. However, tolerable misstatement relates more to audit sampling rather than planning.
How to calculate Tolerable Misstatement?
Unlike planning materiality, tolerable misstatement does not have several benchmarks or similar thresholds. ISAs describe tolerable misstatement as to the application of performance materiality to a specific sampling procedure. Auditors must use their professional judgment to calculate the tolerable misstatement level for an engagement.
Usually, the tolerable misstatement threshold is close to the performance materiality level. However, auditors may set it to a lower amount as well. Auditing standards dictate that the tolerable misstatement level should never exceed performance materiality. There are several factors that may affect how much this threshold, including the level of assurance, materiality, performance materiality, etc.
Planning materiality is an amount set by auditors during the audit planning stage. However, there is no set standard on how to do so. Instead, auditors must use their professional judgment along with some benchmarks for this calculation.
Tolerable misstatement is a threshold set by auditors by which a financial statement item can differ from its true value without impacting the fair presentation of the financial statements. It is at the same level of performance materiality or lower.