Willis & Adams, CPAs

AUDIT MANUAL EXCERPT: MATERIALITY GUIDELINES-Planning Materiality and Tolerable Misstatement

Planning Materiality
This section provides general guidelines for determining planning materiality and tolerable misstatement for audits
performed by Willis & Adams. The application of these guidelines requires professional judgment and the facts and
circumstances of each individual engagement must be considered.
Statement of Financial Accounting Concepts No. 2, Qualitative Characteristics of Accounting Information, defines
materiality as follows:
Materiality is the magnitude of an omission or misstatement of accounting information that, in the light of surrounding
circumstances, makes it probable that the judgment of a reasonable person relying on the information would have
been changed or influenced by the omission or misstatement.

The reasonable person, approach means that the magnitude and nature of financial statement misstatements or
omissions will not have the same influence on all financial statement users. For example, a 7 percent misstatement
with current assets may be more relevant for a creditor than a stockholder, while a 7 percent misstatement with net
income before income taxes may be more relevant for a stockholder than a creditor.
While qualitative factors need to be considered, it is not practical to design audit procedures to detect all
misstatement that potentially could be qualitatively material. Therefore, as a starting point, we typically compute a
quantitative materiality determined as a percentage of the most relevant base (e.g., Net Income Before Taxes, Total
Revenue, Total Assets). Relevant financial statement bases and presumptions on the effect of combined
misstatements or omissions that would be considered immaterial and material are provided below:
Profit Oriented Entity:
Net Income Before Income Taxes - combined misstatements or omissions less than 3 percent of Net Income
Before Income Taxes are presumed to be immaterial and combined misstatements or omissions greater than
7 percent are presumed to be material. For publicly traded companies, materiality is typically not greater than
5 percent of net income before income taxes.
If pretax net income is stable, predictable, and representative 1 of the entitys size and complexity, it is typically
the preferred base. However, if net income is not stable, predictable, representative, or if the entity is close to
breaking even or experiencing a loss, then other bases may need to be considered. If the entity has volatile
earnings, including negative or near zero earnings, it might be more appropriate to use the average of 3 to 5
years of pretax net income as the base. Other possible bases to consider include:
Total Revenue (less returns and discounts) combined misstatements or omissions less than 0.5 percent of
Total Revenue are presumed to be immaterial, and combined misstatements or omissions greater than 1
percent are presumed to be material.
Current Assets or Current Liabilities combined misstatements or omissions less than 2 percent of Current
Assets or Current Liabilities are presumed to be immaterial, and combined misstatements or omissions
greater than 5 percent are presumed to be material.
Total Assets - combined misstatements or omissions less than 0.5 percent of Total Assets are presumed to be
immaterial, and combined misstatements or omissions greater than 1 percent are presumed to be material.
(Note: Total Assets may not be an appropriate base for service organizations or other organizations that have
few operating assets.)
By stable, predictable, and representative we mean that pretax net income does not wildly or dramatically change from profit to
loss from year to year. If investors still view pretax net income as a reliable measure of the entitys performance then pretax net
income should be used to determine materiality.
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Not-for-Profit Entity
Total Revenue (less returns and discounts) combined misstatements or omissions less than 0.5 percent of
Total Revenue are presumed to be immaterial, and combined misstatements or omissions greater than 2
percent are presumed to be material.
Total Expenses combined misstatements or omissions less than .5 percent of Total Expenses are presumed
to be immaterial, and combined misstatements or omissions greater than 2 percent are presumed to be
material.
Mutual Fund Entity
Net Asset Value combined misstatements or omissions less than .5 percent of Net Asset Value are
presumed to be immaterial and combined misstatements or omissions greater than 1 percent are presumed to
be material.
Balance Sheet Materiality Even if the planning materiality is based on the income statement, a balance sheetbased calculation is useful for evaluating the materiality of misclassifications between balance sheet accounts. For
current assets and current liabilities, the balance-sheet materiality guidelines are 3 to 8 percent. For total assets, the
guidelines are 1 to 3 percent.
The specific value within the above ranges for a particular base is determined by considering the primary users as
well as qualitative factors. For example, if the client is close to violating the minimum current ratio requirement for a
loan agreement, a smaller planning materiality amount should be used for current assets and liabilities. Conversely, if
the client is substantially above the minimum current ratio requirement for a loan agreement, it would be reasonable
to use a higher planning materiality amount for current assets and current liabilities.
Planning materiality should be based on the smallest amount established from relevant materiality bases to provide
reasonable assurance that the financial statements, taken as a whole, are not materially misstated for any user.

Tolerable Misstatement
In addition to establishing planning materiality for the overall financial statements, materiality for individual financial
statement accounts should be established. The materiality amount established for individual accounts is referred to
as tolerable misstatement. Tolerable misstatement represents the amount an individual financial statement account
can differ from its true amount without affecting the fair presentation of the financial statements taken as a whole.
Establishment of tolerable misstatement for individual accounts enables the auditor to design and execute an audit
strategy for each audit cycle.
Tolerable misstatement should be established for all balance sheet accounts (except retained earnings because it is
the residual account). Tolerable misstatement need not be allocated to income statement accounts because many
misstatements affect both income statement and balance sheet accounts and misstatements affecting only the
income statement are normally less relevant to users.
The objective in setting tolerable misstatement for individual balance sheet accounts is to provide reasonable
assurance that the financial statements taken as a whole are fairly presented in all material respects at the lowest
cost. Factors to consider when setting tolerable misstatement for accounts include:
The maximum tolerable misstatement to be allocated to any account is 75 percent of planning materiality.

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The combined tolerable misstatement allocated to all accounts should not exceed four times planning
materiality.2 The aggregated sum of tolerable misstatements should be lower as the expectation for
management fraud increases.
Tolerable misstatement should not exceed an amount that would influence the decision of reasonable users.
Tolerable misstatement normally will be higher for balance sheet accounts that cost more to audit (e.g., larger
accounts that are difficult to audit).
Tolerable misstatement normally will be higher for accounts with a higher expectation of misstatement.3
Tolerable misstatement normally will be higher if the principle substantive evidence to be obtained for an
account will be obtained via substantive analytical procedures.
Tolerable misstatement is an important input in determining the nature, timing and extent of audit procedures. The
above guidelines are based on important considerations such as:
The lower the tolerable misstatement, the more extensive the required audit testing.
As a planning tool, tolerable misstatement can be viewed as a precious resource that should be carefully
allocated. If an account is relatively easy to audit and the expected misstatement is little to none (e.g., Notes
Payable or Stockholders Equity), then we would allocate a small amount of tolerable misstatement to such an
account in order to have a greater amount available to allocate to other accounts that are more difficult and
costly to audit.
In no case will we allocate more tolerable misstatement to an account than an amount that would influence the
decision of reasonable users.

In the textbook, a more general approach to allocate no more than 75% of planning materiality to accounts as tolerable
misstatement is followed. However, as noted in the discussion on materiality in Chapter 3 of the text, some firms do use a
multiple approach. This mini-case uses the multiple approach so that students get hands-on practice at allocating tolerable
misstatement to accounts.
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This assumes the expected misstatements are not due to fraud. If we have an increased fraud risk, we would utilize fraudrelated procedures, see fraud policy guidelines. The reason we will normally utilize a higher tolerable misstatement for accounts
with higher expectation of misstatement is related to the costliness of auditing such accounts. For example accounts like
accounts receivable, inventory, or accounts payable will often have some degree of misstatement in them and they typically
are large balances. Tolerable misstatement is basically a reasonable margin for error. If we set tolerable misstatement too low it
can increase sample sizes dramatically. However, as noted in the policy, in no case will we allocate more tolerable misstatement
to an account than an amount that would influence the decision of reasonable users.
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