What it means
Auditors cannot check every transaction, so they decide in advance how large an error would have to be before it changed a reasonable reader's view of the accounts. That threshold for the accounts as a whole is materiality, and tolerable misstatement is the slice of it applied to an individual balance such as inventory, receivables or payroll.
The reason for setting it lower than overall materiality is arithmetic rather than caution. If every account were tested against the full materiality figure, undetected errors in ten different areas could each sit just under the limit and together be far larger than the whole threshold.
Tolerable misstatement drives sample sizes directly. A tighter threshold means the auditor must test more items to gain the same confidence, so this single number quietly determines much of the cost and duration of the audit.
Finance teams meet the concept when auditors ask them to correct or explain differences that seem trivial. An error of $40,000 in a $600,000 account may be well inside overall materiality yet exceed the tolerable misstatement set for that balance, which is why it gets raised.
Auditors also distinguish tolerable misstatement from performance materiality, though many firms use the two terms interchangeably in practice. Both describe a threshold set below overall materiality, and the important idea in either case is that the margin for error is deliberately tightened at account level.
The figure is a matter of professional judgement rather than a rule. Common practice sets it somewhere between 50% and 75% of overall materiality, with the lower end used where an account has a history of errors or relies heavily on estimates.
In practice
Real-world examples.
Example
An audit team examining a $9,000,000 receivables ledger sets tolerable misstatement at $360,000 and selects a sample large enough to detect an error of that size. When projected errors come in at $95,000 they accept the balance without further work.
Example
A manufacturer's stock count produces a $410,000 discrepancy that management dismisses as rounding across thousands of parts. The auditor points to a $360,000 tolerable misstatement and requires a full recount of the three largest storage locations.
Example
A charity auditor lowers tolerable misstatement for restricted funds well below the level used for general expenditure, because misallocating restricted money carries consequences that a dollar figure alone does not capture. The trustees accept the extra testing cost as the price of confidence in how donations were spent.
Think of it
“Tolerable misstatement is the most error you'll accept-threshold for specific accounts.
Formula
Calculation
Overall materiality is usually a percentage of a benchmark such as profit before tax, and tolerable misstatement is then a percentage of that materiality figure.
A distribution company reports profit before tax of $12,000,000. The audit team sets overall materiality at 5% of that benchmark, giving $12,000,000 x 5% = $600,000.
Because the audit covers several significant balances, the team sets tolerable misstatement at 60% of materiality: $600,000 x 60% = $360,000. Testing of the inventory balance then uncovers a projected error of $410,000, which exceeds the $360,000 threshold even though it sits below the $600,000 overall figure, so the auditors ask management to investigate and adjust.Case study
Seen in the real world.
The following is an illustrative and fictional case. Brightfen Components, an invented electronics distributor, had grown quickly and its finance team was used to auditors waving through small differences. In the year under review, profit before tax was $12,000,000, materiality was set at $600,000 and tolerable misstatement at $360,000.
The audit found four separate issues: $150,000 of overstated stock, $120,000 of unrecorded rebates owed to customers, $90,000 of prepayments that had already been consumed and $70,000 of duplicated supplier credits. Management argued that each was individually immaterial, which was true against the $600,000 figure.
The auditors aggregated them to $430,000 and pointed out that the whole purpose of the lower threshold was to catch exactly this pattern. Brightfen's fictional board adjusted the accounts and, more usefully, tightened its month end review so the same four errors did not reappear the following year.
Watch out
Common mistakes.
- Treating tolerable misstatement as the same thing as materiality, when it is deliberately set lower to leave room for errors found elsewhere.
- Arguing that an individual error is immaterial without considering that auditors add errors together across the whole audit.
- Assuming the threshold is purely mathematical, when qualitative issues such as fraud, related party dealings or covenant breaches are treated as material at any size.
Questions
People also ask.
Who sets tolerable misstatement?
The audit team sets it during planning using professional judgement, and it is documented and revisited if circumstances change during the audit.
Does a lower tolerable misstatement mean a better audit?
Not necessarily, but it does mean more testing, more cost and a lower risk that errors go undetected.
Can the figure change part way through an audit?
Yes, if the entity's results differ materially from the forecast used in planning, the thresholds are recalculated and earlier work reassessed.
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