What is a Tolerable Misstatement in Accounting?
In audit terminology, the tolerable misstatement is the level or amount of misstatement that affect the value of an audited statement without affecting the true value and fair representation of audited financial statements.
As a matter of practice and practicality, auditors cannot apply their audit procedures to all areas that they are responsible to audit.
The simple fact is that doing so will require significant manpower and time, and the ends will not justify the use of so many resources.
As a practice, audit teams apply their procedures to a set of specific samples that they pick on basis of audit sampling techniques.
Audit Sampling Techniques
Different sampling techniques are applied, but the purpose is the same, they offer a selection of data on which audit processes can be applied.
This selection from an overall group leads to the risk of missing out on something that could raise audit concerns. This risk of material misstatement is something that all audits face.
The sampling techniques are used to test the internal controls of a business. These are tests used to assess the effectiveness of internal controls in detecting errors and stopping them from occurring again.
Internal controls are assessed to see how deep of an audit will be needed for an organization.
Sampling is also used in testing details. This is when auditors are examining transactions to see their flow and reporting accuracy.
Where Tolerable Misstatement comes in
The main risk in all sampling techniques is that a true representation of all the types of data will not be selected.
This means that if you have 2 bad, 2 weak, 3 average, 1 okay, and 2 perfect transactions, and you pick 3 from the lot, there will be a misrepresentation of some sort.
It could be that the samples are of the 1 okay and 2 perfect transactions and the items with weak documentation or accuracy are completely missed.
In this case, the audit ends up missing the problem and its review ends up having misstatements about the accuracy of the business’s performance or working process.
Another set of problems occurs when the misstatements are minor when taken singly but can be significant if they are multiple in number.
This is a standard risk with sampling from a population and auditors make a rational decision to live with such a risk.
This decision sets parameters for misstatements that will be acceptable. These are known as tolerable misstatement parameters.
As said before a tolerable misstatement is the level or amount of misstatement that affect the value of an audited statement without affecting the true value and fair representation of audited financial statements.
Auditors use this concept to design their audit plan for financial statement audits.
The Practical Implication of Tolerable Misstatement
The tolerable misstatement principle lets auditors apply professional judgment based on the specified level of tolerable misstatement of an audit.
This level allows both auditor and auditee to save on time and the costs of an audit project. Auditing rules advise that during sample selection, auditors must determine the tolerable misstatement levels appropriate for the type of audit assignment starting.
This helps to let the auditors and the auditee know how much of a risk misstatement can present. This allows both parties to keep the misstatements within tolerable levels suited to the scope of the audit.
Audit standards also specify how auditors should evaluate the results of an audit sample set. In samples of test of details, for example, if the sum of misstatements is higher than the tolerable misstatement level, the sample is not viable to offer reasonable conclusions about the tested population.
Auditors can also determine that there is a high level of sample risk that the misstatement in the selected data is higher than the specified tolerable misstatement.
The simplest use of tolerable misstatement is as a level or parameter to determine actual misstatement risk in selected samples.
How to Specify the Tolerable Misstatement Level
The procedure for specifying acceptable misstatement levels is laid out in one of the many auditing standards that determine audit tasks. According to the standard, the tolerable misstatement is determined by applying the principle of performance materiality to a sampling process.
Defining performance materiality will take a long time, so just understand that performance materiality is used to determine tolerable misstatement levels.
Depending on the sensitivity of the audit task, the tolerable misstatement levels can be kept below or at par with the performance materiality level requirements.
Auditing standards require that the tolerable misstatement levels stay below performance materiality requirements. This means that before setting tolerable misstatement levels, audit managers need to specify or determine the performance materiality level.
This is needed before they select audit samples for any financial statement item. Knowing the materiality is the first step in setting tolerable misstatement levels and picking audit samples.
The more important a financial statement item, the lower the tolerance for material misstatement will be. In simple terms, we can say that the greater the surety needed, the lower the tolerable misstatement level will be for any financial statement item. Other factors that influence it are materiality, performance, and level of risk.
To sum up, the process of audit sampling is a built-in part of the audit process as it is not possible to audit entire populations of data sets.
Sampling raises challenges regarding data accuracy and appropriate representation of all variations in a data set. To handle the problems of data representation and accuracy, auditors use the tolerable misstatement levels to guide their audit process.
The tolerable misstatement level limits the level of variation that a financial statement item can have from the true representative value on the whole.
There are a set of standards that help guide the process and auditors use their professional judgment to set the tolerable misstatement levels.
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