Planning Materiality and Tolerable Misstatement

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Audit Manual Excerpt: Materiality Guidelines--
Planning Materiality and Tolerable Misstatement

Planning Materiality
This section provides general guidelines for determining planning materiality and tolerable misstatement for audits performed by Willis & Adams. The application of these guidelines requires professional judgment and the facts and circumstances of each individual engagement must be considered.

Statement of Financial Accounting Concepts No. 2, “Qualitative Characteristics of Accounting Information,” defines materiality as follows:

Materiality is the magnitude of an omission or misstatement of accounting information that, in the light of surrounding circumstances, makes it probable that the judgment of a reasonable person relying on the information would have been changed or influenced by the omission or misstatement.

The “reasonable person,” approach means that the magnitude and nature of financial statement misstatements or omissions will not have the same influence on all financial statement users. For example, a 7 percent misstatement with current assets may be more relevant for a creditor than a stockholder, while a 7 percent misstatement with net income before income taxes may be more relevant for a stockholder than a creditor.

While qualitative factors need to be considered, it is not practical to design audit procedures to detect all misstatement that potentially could be qualitatively material. Therefore, as a starting point, we typically compute a quantitative materiality determined as a percentage of the most relevant base (e.g., Net Income Before Taxes, Total Revenue, Total Assets). Relevant financial statement bases and presumptions on the effect of combined misstatements or omissions that would be considered immaterial and material are provided below:

Profit Oriented Entity:
▪ Net Income Before Income Taxes - combined misstatements or omissions less than 3 percent of Net Income Before Income Taxes are presumed to be immaterial and combined misstatements or omissions greater than 7 percent are presumed to be material. For publicly traded companies, materiality is typically not greater than 5 percent of net income before income taxes.

If pretax net income is stable, predictable, and representative[1] of the entity’s size and complexity, it is typically the preferred base. However, if net income is not stable, predictable, representative, or if the entity is close to breaking even or experiencing a loss, then other bases may need to be considered. If the entity has volatile earnings, including negative or near zero earnings, it might be more appropriate to use the average of 3 to 5 years of pretax net income as the base. Other possible bases to consider include: ▪ Total Revenue (less returns and discounts) – combined misstatements or omissions less than 0.5 percent of Total Revenue are presumed to be immaterial, and combined misstatements or omissions greater than 1 percent are presumed to be material. ▪ Current Assets or Current Liabilities – combined misstatements or omissions less than 2 percent of Current Assets or Current Liabilities are presumed to be immaterial, and combined misstatements or omissions greater than 5 percent are presumed to be material. ▪ Total Assets - combined misstatements or omissions less than 0.5 percent of Total Assets are presumed to be immaterial, and combined misstatements or omissions greater than 1 percent are presumed to be material. (Note: Total Assets may not be an appropriate base for service organizations or other organizations that have few operating assets.) Not-for-Profit Entity

▪ Total Revenue (less returns and discounts) – combined misstatements or omissions less than 0.5 percent of Total Revenue are presumed to be immaterial, and combined misstatements or omissions greater than 2 percent are presumed to be material. ▪ Total Expenses – combined misstatements or omissions less than .5 percent of Total Expenses...
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