Auditing involves examining an entity’s financial statements. The primary purpose of this process is to ensure the underlying subject matter is free from material misstatements. However, auditors cannot investigate every amount with discrepancies. Usually, they work with time and resource constraints. In these cases, establishing an amount for acceptable levels of misstatement is crucial.
Auditors can limit the work they perform through two techniques. These include planning materiality and tolerable misstatement. Although they seem similar, there are some differences between them. To understand those differences, it is crucial to know what planning materiality and tolerable misstatement are.
What is Planning Materiality?
Planning materiality represents an amount set by auditors during the audit planning stage. It refers to the misstatement amount that auditors must investigate. Essentially, it depends on the materiality concept in accounting. This concept represents the influence an amount has on the decisions made by the users of the financial statements. Planning materiality sets that limit.
Planning materiality helps auditors determine the critical areas during an audit. However, it only serves to provide an initial expectation for the process. Planning materiality only helps auditors during the audit planning stage. At this stage, auditors have limited information to conclude the audit materiality. This materiality may change during the fieldwork performed by the auditors.
Planning materiality follows a similar process for calculation as audit materiality. Auditors determine the best benchmark for a given client. Usually, these benchmarks include revenues, total assets, and net income. Based on that, the establish how much the planning materiality should be. This process requires the auditor’s judgment. Auditing standards can also provide some guidance for planning materiality.
What is Tolerable Misstatement?
Misstatements may occur within the financial statements regardless of the auditing process. On top of that, auditors may also encounter some misstatements during their work. However, they cannot investigate or discuss every instance with the management. Usually, auditors establish a tolerable misstatement level. It represents any discrepancies in items that auditors will consider passable.
Tolerable misstatement also requires the auditor’s judgment. It sets the amount that auditors consider not to impact the decisions made by the users of the financial statements. Usually, auditors establish this amount when designing the auditor procedures to use in their work. Like materiality, tolerable misstatement allows auditors to focus on crucial areas only.
Setting the tolerable misstatement level is similar to establishing performance materiality. Auditing standards state that auditors can use the same amount for both areas. Therefore, auditors can use the performance materiality to determine the tolerable misstatement. However, auditing standards also allow auditors to set it lower than the performance materiality.
What is the difference between Planning Materiality and Tolerable Misstatement?
The above explanations for both concepts should help differentiate between them. Usually, auditors use both in their work. However, planning materiality comes during the audit planning stage. On the other hand, tolerable misstatement is crucial when designing audit procedures. It occurs after the planning stage.
On top of that, tolerable misstatement relates to the performance materiality concept. However, this concept applies to specific areas. On the other hand, planning materiality covers the auditing process as a whole. Although the amount may change later, it sets the initial expectations for the audit. Auditors use planning materiality for financial statement items. Tolerable misstatement occurs at a lower level.
Planning materiality and tolerable misstatement are two concepts commonly used in auditing. The former refers to the limit set by auditors for the financial statements. Usually, it depends on their judgment of how a misstatement impacts users’ decision-making. On the other hand, tolerable misstatement is for a level for each discrepancy discovered.