Audit Materiality Explained: Planning Materiality, Tolerable Error and Summary of Audit Difference

In an audit, the goal is to provide reasonable assurance that financial statements are free from material misstatement, rather than absolute assurance. Materiality helps the auditor to determine magnitude of omission or misstatement that reasonably influence the economic decision of the users of financial statement.

Key Materiality Terms

Planning Materiality (PM)

Planning Materiality (PM) is the maximum amount of misstatement that auditors believe would not affect users' economic decisions. When a misstatement is identified, the auditor compares the total misstatements with the PM. If total misstatements exceed PM, the auditor concludes that the financial statements are materially misstated and must be corrected, or the audit opinion is modified. Therefore, PM acts as the final benchmark for evaluating all identified and uncorrected misstatements.

It is calculated as a percentage of a relevant financial benchmark, such as profit, revenue, net assets, or total expenditure. PM is usually set at 1% - 5% of the financial benchmark, based on what is important to users of the financial statement.

For example, a non-profit organization may use total revenue or total expenditure as the base to determine the percentage of PM, as profit is not the main focus for these organizations. The auditor sets the percentage as low or high depending on various factors, including the nature and size of the entity, stability of financial results, sensitivity of users, and level of audit risk. When PM is chosen as a lower percentage, it signifies that even small misstatements are treated as material, and vice versa when a high PM percentage is chosen.

Tolerable Error (TE)

TE is used to reduce the aggregation risk, which is the probability that the aggregate of uncorrected and undetected misstatements exceeds PM.

TE is used to determine:

• Significant accounts
• Sample size,
• Key items,
• Setting testing scope, and
• Threshold variance.

TE is generally set at 50% to 75% of PM. The TE percentage depends on the auditor's assessment of anticipated misstatements in the financial statements, the control environment within the organization, and other relevant considerations. TE is usually set at 50% of PM when there is a higher likelihood of misstatements in the financial statements or the control environment is weak.

"TE at 50%-75% of PM"; builds a safety cushion to ensuring that the sum of detected and undetected errors combined do not exceed the overall materiality for the financial statement.

A lower TE signifies more items are tested, more audit evidences are collected, higher audit efforts and time are needed, - resulting in greater assurance that the statements are fairly presented.

In contrast, a higher TE may be selected for smaller or privately held entities where the risk of material misstatement is lower, transactions are simple and controls are reliable.

Summary of Audit Difference (SAD):

SAD is a schedule or list where the auditor records all identified misstatements found during the audit. It tracks each misstatement identified, whether management agreed to adjust or not, and the cumulative total of uncorrected misstatements.

SAD thresholds are generally set at 5%-10% of PM. Misstatements above this threshold are recorded in the Summary of Audit Differences.

Treatment of Misstatements:

Example: XYZ Ltd.

• Profit Before Tax (PBT): Rs 10,00,00,000
• PM: 5% * Rs 10,00,00,000 = Rs 50,00,000
• TE: 75% * Rs 50,00,000 = Rs 37,50,000
• SAD: 5% * Rs 50,00,000 = Rs 2,50,000

a. Any unadjusted difference above Rs 2.5L found during the audit must be tracked in the SAD schedule for evaluation of aggregate misstatements at the end of audit.

b. Any individual account balance or transaction class can have an error up to Rs 37.5L (i.e., the TE limit).

c. If the difference at account level is ≥ Rs 37.5L, the auditor should reperform or extend testing for that area, investigate causes (error/fraud), and request correction by management.

• If uncorrected, the specific account may be materially misstated, even if the aggregate misstatement is below PM.
• The aggregate of all misstatements recorded in the SAD list above Rs 50L could still influence the user's decisions.

Example:

If a misstatement is Rs 20L, which is above SAD but below TE is identified, it should be recorded in the SAD schedule, a correction should be requested, and if uncorrected it must be aggregated for final evaluation against overall materiality (PM).

Qualitative factors that may make an item material even if totals are below PM include:

• Evidence of management bias or fraud,
• Misstatements affecting covenants or regulatory compliance,
• Related party transactions,
• Pervasive misstatements affecting multiple accounts, or
• Events that may influence users' economic decisions.

If any of these exist, the auditor may require correction or modify the audit opinion, even if the aggregate misstatement being below PM.