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Wednesday, March 21, 2012

Tolerable Error and Materiality



As auditors we need to understand that tolerable error can differ from each account because some accounts are more susceptible to error or are more significant to the overall financial results of the organization. Since we do not have formal rules for determining tolerable error for account balances two generally accepted guidelines that we will use are: tolerable error should be less than the overall materiality level, and the sum of tolerable error across all accounts may equal materiality or may exceed materiality.

Materiality is subject to a great deal of judgment so as auditors we have to develop numerous rules of thumbs for setting an initial quantitative materiality level. Since every person looking at financial statements will have a different idea to what constitutes as a material misstatement we will use what is generally suggested for net income or net assets as the base for establishing quantitative materiality with percentages between 5 and 10 for net income and 1 and 3 for percent of net sales.

As auditors, rather than increase the sum of allocated tolerable errors and tolerating a larger error in some accounts we will instead decrease the sum of allocated tolerable errors because we want to decrease the overall risk that a material misstatement will remain undetected. So when all audit procedures are considered, we can conclude with reasonable assurance that the financial statements are not materially misstated. Looking at the audit documentation requirement we see that we have complied with most of them, therefore we should not have as many errors since we have documentation that would support our conclusions with respect to financial statement assertions and documentation that show that accounting records agree with financial statements, etc. Since our audit team also uses ACL to detect potential fraud, material misstatements and weaknesses this should also help keep the tolerable error and materiality low.

The tolerable error level for an account reflects the maximum size of a misstatement that could exist before the auditor would conclude that the account is materially misstated. As auditors we can set tolerable errors in one of two ways: by directly allocating a portion of overall materiality to the account in dollar terms; or calculating TEL as a specified percentage of the account where the smaller values of TEL are associated with lower detection risk.



References:
·         Auditing Assurance & Risk by Knechel, Salterio and Ballou

 

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