Tolerable misstatement, often used in the context of auditing, refers to the maximum error or misstatement in account balances or classes of transactions that an auditor is willing to accept and still conclude that the financial statements are fairly presented. It’s a threshold that helps auditors determine the materiality of any discrepancies they identify during their audit.
Tolerable misstatement is set at a level less than overall materiality for the financial statements as a whole, ensuring that the aggregate of uncorrected and undetected misstatements in all accounts or classes of transactions doesn’t exceed materiality for the financial statements as a whole.
In practice, setting the tolerable misstatement requires professional judgment and is influenced by factors such as:
- Overall Materiality: Derived from the financial statements’ overall materiality level.
- Risk Assessment: If certain accounts or transaction classes are perceived to have higher risks of material misstatement, a lower tolerable misstatement might be set for them.
- Nature of the Account: Accounts that are more subjective and judgmental (like allowances for doubtful accounts) might have a different tolerable misstatement compared to more objective accounts.
Example of Tolerable Misstatement
Let’s delve into a practical example to better understand the concept of tolerable misstatement.
Auditing the Inventory Account of DEF Enterprises
DEF Enterprises is a manufacturer of electronic goods. The company’s total assets amount to $10 million, with inventory being a significant account valued at $2 million on the balance sheet date.
As an auditor, you’ve set the overall materiality for the financial statements of DEF Enterprises at $50,000, based on certain criteria and benchmarks.
To audit the inventory account and ensure that its value is fairly presented in the financial statements.
- Determine Tolerable Misstatement:
Given the significance of the inventory account, you decide to allocate a specific portion of the overall materiality to it. You set a tolerable misstatement for the inventory account at $15,000.
- Audit Procedures:
During your audit procedures, you engage in physical stock counts, review inventory valuation methods, and assess potential obsolescence. Through these activities:
- You identify an overvaluation due to counting errors amounting to $8,000.
- You also find that certain inventory items are obsolete, leading to an overvaluation of $10,000.
The combined misstatements total $18,000 ($8,000 + $10,000).
The total identified misstatements of $18,000 in the inventory account exceed the tolerable misstatement level of $15,000.
- Audit Implication:
Given the misstatements surpassing the tolerable misstatement:
- You’ll need to discuss the discrepancies with DEF Enterprises’ management.
- The company might be required to adjust its financial statements to correct these overvaluations.
- If the management refuses to adjust, you’ll need to consider the implications for your audit opinion.
This example highlights how the concept of tolerable misstatement works in an audit context. By setting a threshold for acceptable discrepancies, the auditor can more efficiently evaluate the materiality and significance of identified misstatements. In this case, the misstatements identified during the audit procedures exceeded the tolerable limit, suggesting that the inventory account might not be fairly presented and could impact the overall integrity of the financial statements.