MATERIALITY GUIDANCE OF THE MAJOR PUBLIC ACCOUNTING FIRMS

Aasmund Eilifsen
Professor
Norwegian School of Economics (NHH)
[email protected]

and

William F. Messier, Jr.

Kenneth and Tracy Knauss Endowed Chair in Accounting at UNLV
University of Nevada Las Vegas
&
Adjunct Professor
Norwegian School of Economics (NHH)
[email protected]

Forthcoming in
Auditing: A Journal of Practice & Theory

July 2014

We thank the eight firms and their personnel who assisted with the study and for their comments
on the paper. We thank Chris Agoglia, Tim Bauer, Rick Hatfield, Karla Johnstone, Marsha
Keune, Bill Kinney, Rikke Holmslykke Kristensen, Bob Libby, Chad Simon, Jason Smith, and
participants at the Auditing Section’s Midyear meeting, 7th EARNet Symposium, and the UNLV
workshop for helpful comments. Professor Messier received financial support for this research
from the Kenneth and Tracy Knauss Endowed Chair in Accounting at UNLV and his adjunct
professorship at NHH.

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 MATERIALITY GUIDANCE OF THE MAJOR PUBLIC ACCOUNTING FIRMS

SUMMARY

This paper examines the materiality guidance for eight of the largest U.S. and

international public accounting firms. Knowledge of how materiality guidance is integrated into

a firm’s methodology is important for accounting and auditing researchers as well as for

practitioners, regulators, and educators. Our results show a high level of consistency across the

firms in terms of the quantitative benchmarks (e.g., income before taxes, total assets or revenues,

and total equity) used to determine overall materiality, the related percentages applied to those

benchmarks, the percentages applied to overall materiality for determining tolerable

misstatement, and what constitutes a clearly trivial misstatement. We also find that the firms’

guidance for evaluating detected misstatements including qualitative factors and firm guidance

for group audits is consistent across firms. However, there are differences in how the firms

consider the possibility of undetected misstatements when evaluating detected misstatements.

The results of this study provide important insights into implementation of standards and

valuable information for future research and education.

Keywords: Materiality, Tolerable misstatement, Misstatements, Group audits

Data Availability: The data used is proprietary to the firms and not available for distribution.

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 MATERIALITY GUIDANCE OF THE MAJOR PUBLIC ACCOUNTING FIRMS

INTRODUCTION

Knowledge of how materiality as specified by professional standards is applied by the

major public accounting firms can be informative for both archival and behavioral researchers.

For example, archival researchers have examined numerous accounting and auditing issues (e.g.,

audit effort, value of the audit, and restatements) where assumptions about the materiality levels

used by the audit firms are made based on AICPA guidance (Brody et al. 2005) or review papers

(Holstrum and Messier 1982; Messier et al. 2005). Recent archival studies by Acito et al. (2009)

and Keune and Johnstone (2009, 2012) provide examples where the researchers have examined

quantitative and qualitative materiality measures in the context of restatements and detected

misstatements. Acito et al. (2009, 665) state “A limiting feature of most archival research on

materiality and financial reporting decisions is that amounts deemed immaterial by management

and auditors are not typically revealed outside the firm. As a result, researchers must instead

estimate the undisclosed (and thus unobservable) immaterial item amount. Any measurement

error introduced by the researcher’s estimation process can either mask a true underlying

correlation or introduce spurious correlation with the variables of interest.” Keune and Johnstone

(2009, 20) further state “Despite many years of research on materiality judgments (see Holstrum

and Messier 1982; Messier et al. 2005, for reviews), lack of publicly available data prevented

understanding the nature of companies that do not correct misstatements (sometimes known as

“waived” misstatements or “waived” adjustments), the variation in audit firm application of

materiality thresholds, and the nature of these uncorrected misstatements.” (italics added).

Similarly, behavioral researchers have examined the materiality judgments of auditors,

managers, and users. For example, research into auditors’ materiality judgments has examined

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earnings management (Nelson et al. 2002), handling of prior year misstatements (Nelson et al.

2005), financial statement disclosures (Libby et al. 2006; Libby and Brown 2013), and client-

auditor negotiation of detected misstatements (e.g., Gibbins et al. 2001; Gibbins et al. 2005;

Hatfield et al. 2010; Kida et al. 2012). Like archival research, some behavioral research has

relied on existing auditing standards or anecdotal evidence about materiality (e.g., Messier et al.

2005) to design experimental materials or to evaluate findings.

The current paper presents the proprietary materiality guidance of eight of the largest U.S.

public accounting firms in order to provide information for researchers that may assist in

examining issues related to materiality. Thus, the information reported in this paper provides

possible answers to the concerns raised by prior researchers (e.g., Acito et al. 2009) and should

be helpful in designing future research. The paper provides evidence on the relative consistency

of the materiality guidance among the eight firms. More specifically, it shows how firms’

determine multiple levels of quantitative materiality, the firms’ guidance on the incorporation of

qualitative factors in determining and evaluating materiality, their guidance on handling detected

and undetected misstatements, and finally how the firms’ guidance determines materiality levels

in group audits.

We analyze the materiality guidance of the eight firms by coding the data along six

research questions. Each firm then reviewed our coding for accuracy and completeness. The

overall results show the following. First, the quantitative benchmarks (e.g., income before taxes,

total assets or revenues, and total equity) used to determine overall materiality and the related

percentages applied to those benchmarks are reasonably consistent across the eight firms.1

Second, seven firms use a percentage of overall materiality for determining tolerable

1
As we note later in the paper, there are some differences as to how these benchmarks and percentages are applied
across public and non-public companies.

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misstatement that fits in a 50 to 75 percent range and one firm uses a range of 70 to 90 percent.

Third, seven of the firms establish a clearly trivial misstatement to be 3 to 5 percent of overall

materiality and one firm uses a range of 5 to 8 percent. Fourth, all of the firms provide detailed

guidance on the evaluation of detected misstatements including consideration of qualitative

factors. Fifth, applying materiality on group audits closely parallels the guidance provided in the

standards. Lastly, there are differences in how the firms consider the possibility of undetected

misstatements when evaluating uncorrected detected misstatements. In summary, our findings

provide valuable information for researchers (and educators) in how the concept of materiality is

applied by the major public accounting firms.

To our knowledge, there is no available recent information on how the major public

accounting firms integrate materiality guidance into their firm methodologies based on the

revised materiality standards and the current professional, regulatory, and business environment.

Martinov and Roebuck (1998) was the last published research that examined the major firms’

policies on materiality. Martinov and Roebuck (1998) analysis included the Australian Big 6

firms’ materiality guidance in place in 1995. Their findings indicate that although all the firms

set an overall planning materiality, diversity existed in relation to the level of guidance and

judgment involved, the actual guidelines used, and the utilization of additional materiality levels

such as an account level materiality. Our study shows substantially more consistency across

firms. Comparing Martinov and Roebuck’s with the current study shows that although the

concept of materiality remains relatively consistent, the scope (e.g., regarding qualitative

considerations, communication of identified misstatements, and on group audits) and the

application of firms’ materiality guidance (e.g., in determining thresholds for multiple materiality

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levels) are currently much more comprehensive.2

The remainder of the paper is as follows. In the next section, we provide a brief overview

of the extant materiality standards and present our research questions. We then present the

methodology followed by a section that presents the results. The last section discusses the results

and implications, and provides concluding comments.

BACKGROUND AND RESEARCH QUESTIONS

Overview of Auditing Standards Related to Materiality

The International Auditing and Assurance Standards Board (IAASB), U.S. Auditing

Standards Board (ASB), and Public Company Accounting Oversight Board (PCAOB) have

recently issued standards related to materiality. Professional and regulatory initiatives (Big Five

Materiality Task Force 1998; Securities and Exchange Commission 1999; Auditing Practice

Board 2001) as well concerns of auditor abuses of the materiality concept (e.g., Levitt 1998)

have influenced the development of these standards. Table 1 presents a list of the auditing

standards that are relevant to this study.3 These standards prescribe a more comprehensive

framework for materiality judgments than the prior standards. First, they include expanded

requirements for consideration of the needs of the users of audited financial statements. Second

they provide more guidance on determining multiple levels materiality, including how the nature

of the entity and the entity’ circumstances affect materiality. Third, there is expanded guidance

on evaluating misstatements, including revising materiality as the audit progresses if the

circumstances require and the consideration of the effect of undetected misstatements when

2
See Holstrum and Messier (1982), Leslie (1985), and Messier et al. (2005) for reviews of materiality research.
3
The effective dates for the IAASB, ASB, and PCAOB standards are December 15, 2009, December 15, 2012,
December 15, 2010, respectively. Throughout the paper, we will generally only refer to the PCAOB and recent ASB
(clarified) standards because the guidance we reviewed was U.S. based. Many of the firms also make reference to
the IAASB standards in their guidance. The ASB standards are virtually identical to the IAASB standards as a result
of the convergence project (see AICPA (2008) and Morris and Thomas (2011) for a discussion of the clarity and
convergence project). All of the firms in the study had updated their guidance to reflect the recent standards.

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considering uncorrected detected misstatements. Lastly, a separate group audit standard was

developed which includes materiality guidance for such audits. Audit firm guidance is an

important source for determining how firms apply current materiality standards.

[Insert Table 1 here]

Materiality is applied by the auditor in planning and performing the audit; evaluating the

effect of identified and uncorrected misstatements; considering the possibility of undetected

misstatements; and in forming the opinion in the auditor's report. We briefly discuss the relevant

standards based on the three phases of the materiality process: (1) establish a materiality level for

the financial statements as a whole (referred to as overall or planning materiality), (2) determine

an amount less than overall materiality that should be used as a basis for designing audit tests for

accounts and disclosures for the purpose of appropriately limiting the sum of the undetected

misstatements (referred to as tolerable misstatement or performance materiality), 4 and (3)

evaluate audit results (see Messier et al. 2014, 84-89). Lastly, we discuss materiality as it relates

to group audits.

The PCAOB, ASB, and IAASB follow a user perspective in considering what is material

although the PCAOB takes a narrower view and focuses on reasonable investors. The PCAOB

uses the Supreme Court of the United States interpretation of the federal securities laws. In AS11,

the PCAOB refers to the statement that a fact is material if there is “a substantial likelihood that

the …fact would have been viewed by the reasonable investor as having significantly altered the

‘total mix’ of information made available” (¶ 2). AS11 further notes that the Supreme Court has

stated that the determination of materiality requires “delicate assessments of the inferences a

‘reasonable shareholder’ would draw from a given set of facts and the significance of those

4
The standards and firm guidance use different terms to describe phases (1) and (2). For consistency purposes, we
use the terms “overall materiality” and “tolerable misstatement” throughout the paper to describe phase (1) and (2),
respectively.

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inferences to him …” (¶ 2).5 The ASB standard states that “misstatements, including omissions,

are considered to be material if they, individually or in the aggregate, could reasonably be

expected to influence the economic decisions of users made on the basis of the financial

statements” (AU-C 320.02). The standard further provides guidance on what an auditor should

assume about users (see AU-C 320.04).

The auditor’s ultimate objective is to obtain reasonable assurance about whether the

financial statements are free of material misstatement. This requires the auditor to plan and

perform audit procedures to detect misstatements that, individually or in combination with other

misstatements, would result in material misstatement of the financial statements (AS11, ¶ 3).

Determining what is a material misstatement requires consideration of quantitative and

qualitative factors.

Overall Materiality

Auditing standards require the auditor to establish a materiality amount for the financial

statements as a whole, but they provide limited specific guidance (i.e., specific benchmarks) on

how to determine overall materiality. For example, the PCAOB’s guidance states that the auditor

should consider “the company’s earnings and other relevant factors” (AS11, ¶ 3). The ASB, on

the other hand, provides more specific benchmarks – “depending on the circumstances of the

entity, include categories of reported income, such as profit before tax, total revenue, gross profit,

and total expenses; total equity; or net asset value. Profit before tax from continuing operations is

often used for profit-oriented entities. When profit before tax from continuing operations is

volatile, other benchmarks may be more appropriate, such as gross profit or total revenues” (AU-

5
These quotes are taken from TSC Industries v. Northway, Inc., (1976).

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C 320.A6).6 None of the standards provide percentages to be applied to the relevant benchmarks.

In establishing an amount for overall materiality, auditing standards allow the auditor to

use prior period amounts, preliminary or estimated amounts, budgets, adjustments for significant

changes in the circumstances of the entity, and relevant changes of conditions in the industry or

economic environment. Standards require the auditor to reevaluate the established level of

overall materiality (and tolerable misstatement) as the audit progresses. If information comes to

the auditor’s attention during the audit that would have caused the auditor to initially determine a

different level of overall materiality, the auditor should reevaluate overall materiality.

Tolerable Misstatement

AS11 provides the following guidance for determining tolerable misstatement for

accounts or disclosures:

Establishing Materiality Levels for Particular Accounts or Disclosures

7. The auditor should evaluate whether, in light of the particular circumstances, there are
certain accounts or disclosures for which there is a substantial likelihood that
misstatements of lesser amounts than the materiality level established for the financial
statements as a whole would influence the judgment of a reasonable investor. If so, the
auditor should establish separate materiality levels for those accounts or disclosures to
plan the nature, timing, and extent of audit procedures for those accounts or disclosures.

Determining Tolerable Misstatement

8. The auditor should determine the amount or amounts of tolerable misstatement for
purposes of assessing risks of material misstatement and planning and performing audit
procedures at the account or disclosure level. The auditor should determine tolerable
misstatement at an amount or amounts that reduce to an appropriately low level the
probability that the total of uncorrected and undetected misstatements would result in
material misstatement of the financial statements. Accordingly, tolerable misstatement
should be less than the materiality level for the financial statements as a whole and, if
applicable, the materiality level or levels for particular accounts or disclosures.

The ASB and IAASB standards provide similar guidance (see AU-C 320.10-11) except that they

use the term performance materiality. Our reading of the standards suggests that the meaning of

6
Keep in mind that ASB standards only apply to non-public companies.

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the PCAOB's tolerable misstatement and the ASB/IAASB's performance materiality are

equivalent. The PCAOB standard provides no guidance on how to actually implement tolerable

misstatement while the ASB standards provide limited guidance (AU-C 320.A12-A14).

Evaluating Audit Results

The PCAOB’s standard on evaluating audit results (AS14) is a broader standard than the

ASB standard (AU-C 450). It contains a discussion of issues beyond detected misstatements.

Both PCAOB and ASB standards require the auditor to accumulate misstatements identified

during the audit except those that are “clearly trivial.” In accumulating misstatements, the auditor

includes factual misstatements, misstatements related to accounting estimates, and projected

misstatements from substantive procedures that involve audit sampling. The PCAOB's guidance

on clearly trivial states, “The auditor may designate an amount below which misstatements are

clearly trivial and do not need to be accumulated. In such cases, the amount should be set so that

any misstatements below that amount would not be material to the financial statements,

individually or in combination with other misstatements, considering the possibility of

undetected misstatement” (AS14 ¶ 11). Similar guidance is provided by the ASB. The amount

that would be clearly trivial is usually established at the same time as overall materiality and

tolerable misstatement.

The PCAOB standard states “The auditor should communicate accumulated

misstatements to management on a timely basis to provide management with an opportunity to

correct them” (AS14 ¶ 15). The ASB provides similar guidance but goes a step further by stating,

“The auditor should7 request management to correct those misstatements” (AU-C 450.07). If

management refuses to correct some or all of the misstatements, the auditor should obtain an

7
The word "should" indicates a presumptively mandatory requirement for the auditor. Auditors must comply with a
presumptively mandatory requirement in all cases in which such a requirement is relevant except in rare
circumstances (AU-C 200.25).

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understanding of management's reasons for not making the corrections and should take that

understanding into account when evaluating whether the financial statements are free from

material misstatement (AU-C 450.09). Any uncorrected misstatement must be communicated to

the audit committee or those charged with governance (PCAOB AS16; AU-C 260).

The auditor must evaluate whether uncorrected misstatements are material, individually

or in combination, with other misstatements. Our reading of both standards suggests that there is

ambiguity in how to judge the materiality of uncorrected misstatements.8 For example, if an

auditor detects a misstatement (regardless of type) in a specific account, should the amount of the

misstatement be compared to overall materiality or tolerable misstatement to determine if it is

material? The PCAOB standard (AS14) seems to allow the auditor to compare the misstatement

to both overall materiality and tolerable misstatement by stating “In making this evaluation, the

auditor should evaluate the misstatements in relation to the specific accounts and disclosures

involved and to the financial statements as a whole, taking into account relevant quantitative and

qualitative factors (italics added)” (¶ 17). However, the ASB’s application guidance states that

the auditor is to evaluate the effect of each individual misstatement “on the relevant classes of

transactions, account balances, or disclosures, including whether the materiality level for that

particular class of transactions, account balance, or disclosure, if any, has been exceeded”

(italics added) (AU-C 450.A19). The auditor must also consider the effect of uncorrected

misstatements related to prior periods and relevant qualitative factors (a list of such factors is

discussed later). The standards also provide guidance on offsetting various types of

misstatements.

Lastly, both standards require that the auditor consider the amount of accumulated

8
Libby and Brown (2013) reach the same conclusion.

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misstatements identified as the audit progresses. The auditor should determine whether the

overall audit strategy or audit plan needs to be modified because of the higher risk of uncorrected

and undetected misstatements if (1) the nature of identified misstatements and the circumstances

of their occurrence indicate that other misstatements may exist and could approach overall

materiality and (2) the aggregate of misstatements accumulated during the audit approaches

overall materiality (AS14 ¶14).

Group Audits

How the auditor performs the three phases of the materiality process for a group9 (or

multi-location) audit is an important issue (Messier et al. 2005; Messier 2010). PCAOB includes

a section in AS 14 on determining materiality for multiple locations or business units for group

audits. The ASB has a separate standard for group audits (AU-C 600) and how this process

should occur. The group audit standard deals with special materiality considerations that apply to

group audits.

The group engagement team10 is responsible for determining (1) the materiality for the

group financial statements as a whole, (2) tolerable misstatement for classes of transactions,

account balances or disclosures in the group financial statements, (3) component materiality and

tolerable misstatement for those components where component auditors will perform an audit or

a review for purposes of the group audit, and (4) a threshold for misstatements that are clearly

trivial to the group financial statements. Component materiality must be lower than materiality

for the group financial statements as a whole and different component materiality may be set for

9
The group financial statements include component financial statements. A component is defines as “An entity or
business activity for which group or component management prepares financial information that is required by the
applicable financial reporting framework to be included in the group financial statements” (AU-C 600.11).
10
The group engagement team is defined as “Partners, including the group engagement partner, and staff who
establish the overall group audit strategy, communicate with component auditors, perform work on the consolidation
process, and evaluate the conclusions drawn from the audit evidence as the basis for forming an opinion on the
group financial statements” (AU-C 600.9 (i)).

10

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different components. AS 14 states that tolerable misstatement at an individual location should

be less than the materiality level for the group financial statements as a whole.

Research Questions
Given the lack of information about how firms have implemented the extant materiality

standards, we investigate the following research questions (RQ):

RQ1: What benchmarks do firms use for determining overall materiality?

RQ2: What percentages are applied to the benchmarks for determining overall

materiality?

RQ3: How do firms determine tolerable misstatement?

RQ4: What amounts are used to determine what is a “clearly trivial” misstatement?

RQ5: How is materiality used to evaluate misstatements?

RQ6: How is materiality determined and applied on group audits?

In reporting the results, we limit information to profit oriented companies. Generally, the firms

have additional guidance for not-for-profit firms and employee benefit plans.

METHOD

Firm Participants

Eight of the largest U.S. public accounting firms agreed to participate in the study.11 The

firms’ guidance was provided to the researchers through a partner contact who held a senior

position in each firm’s assurance/audit group. Seven firms required the authors to sign a non-

disclosure agreement (NDA) before releasing the firm materiality guidance. The other firm was

provided with oral assurance.

11
These firms are BDO USA, LLP; Crowe Horwath LLP; Deloitte & Touche LLP; Ernst & Young LLP; Grant
Thornton LLP; KPMG LLP; McGladrey LLP; and PricewaterhouseCoopers LLP. At the time we started this
research, these were the eight firms subject to annual inspections by the PCAOB and eight of the nine largest firms
in the U.S. based on revenues (The Platt Consulting Group 2011). The numbers used for the firms throughout the
paper do not correspond to the order listed in this footnote.

11

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Research Procedures

The firm contacts were sent a research proposal that provided the motivation for the study,

the research questions, and the deliverables. We requested the firms’ materiality guidance for

four research questions and we told the firms that the research would follow the process used by

Epps and Messier (2007) that examined the major firms’ guidance related to engagement quality

review. A copy of the Epps and Messier article was included with the email. Our proposal

indicated that we would sign a NDA and that the discussion of the guidance would not identify

individual firms. The proposal also set out the steps that would be followed. More specifically,

the firms agreed (1) to review our coding of the data for accuracy and completeness, (2) to

complete a short questionnaire that requested additional clarifying information about selected

issues,12 and (3) to review a draft of the paper before distribution. The Appendix contains a copy

of the questionnaire. The proposals were sent out in Fall 2011 with approval and completion of

the NDAs in Spring 2012. Firm guidance was received shortly thereafter. Coding by the authors

and review by the firms occurred in the Summer and Fall of 2012.

RESULTS

We first present the details of the data coding and then the results of the study are

discussed along the lines of each RQ.

Data Coding Procedures

The process for coding the firms’ guidance proceeded as follows. Each author reviewed

the relevant auditing standards and read a summary of prior research (Messier et al. 2005). The

coding of the data was relatively straightforward since most of the data points used for analysis

in the paper are simple to identify within the firms’ guidance. The first coder (one of the authors)

12
In our negotiations with one firm, it was agreed that they would verify our coding but not respond to the other
questions included in the questionnaire.

12

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started by reading one firm’s guidance and then creating tables similar to those included in the

paper. Each additional firm’s guidance was then read and the data added to the tables. Using the

tables created by the first coder, the second coder (the other author) read the firms’ guidance to

confirm the coding in the tables.13 Following our research procedures, each firm reviewed our

coding for accuracy and completeness. We tested the degree of accuracy of our coding with the

firms’ coding by running a “compare documents” in WORD. Thus, any addition, deletion or

change to a table was considered a difference in coding. The results show the following: For

Table 2, there were 3 deletions of our coding by the firms, 3 additions to our coding by the firms,

and 1 correction. For Table 3, there were 7 additions, 4 deletions, and 3 revisions for new

guidance. There were no changes to Table 4 and two corrections to Table 5. For Table 6, we

developed the list of qualitative factors from AS14, Appendix B. The firms made 16 additions

and 1 deletion. Most of the differences identified in Table 6 were due the fact that some firms

included qualitative factors from other standards or guidance (AU-C 450.A23; ISA 450.A16;

SAB No. 99) that closely match the factors in Table 6. Based on these procedures, we believe

that the data accurately represents the firms’ guidance.

RQ1: What Benchmarks do Firms Use for Determining Overall Materiality?

Table 2 presents the benchmarks used by the firms to determine overall materiality. For

public companies, seven firms use income before income taxes as the main benchmark. Firm 6

uses income after income taxes. One firm's guidance provides their rationale for this choice. "For

SEC engagements, the SEC staff often takes a very narrow view of materiality, depending on the

facts and circumstances. As such, the SEC staff would ordinarily base materiality on a pre-tax

income criterion, except in rare cases such as a breakeven situation in a given year." Another

13
Because of the NDAs we could not use independent coders.

13

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firm states "Users of the financial statements of listed entities or entities in regulated industries

often focus on operating results, particularly income. Therefore, absent other factors as described

below, pretax income from continuing operations (pretax income) is the appropriate basis for

determining PM for a listed entity or an entity in a regulated industry that is profitable."

The firms allow the use of alternative benchmarks for public companies in certain

situations. One firm provides the following examples that are typical of guidance for the other

firms:

• If the entity is normally profitable, but is experiencing a loss in the current period,
we consider whether other measures of results of operations, such as revenue or
gross margin, may be a more appropriate basis for overall materiality.
• If the entity operates at or near breakeven or fluctuates between net profits and net
losses from period to period, an operating measure other than pretax income would
be a better basis for determining overall materiality. In these situations, we may
consider revenues or gross margin, or some other operating measure (e.g., operating
income, EBITDA) as our measurement basis if it seems reasonable and there is
evidence that analysts or other users of the financial statements would focus on that
measure.
• In circumstances when the entity‘s operating results are so poor that liquidity or
solvency is a more critical concern, basing overall materiality on financial position
(e.g., equity) may be more appropriate.

The arguments to deviate from the use of income before taxes are also relevant for non-

public companies. For non-public companies, in addition to income before (after) taxes, the firms

provide a number of potential benchmarks for overall materiality. For example, all of the firms

allow the use of total assets and total revenues. Seven firms allow the use of net assets or total

equity. Seven firms also allow the use of "normalized" earnings (i.e., income adjusted for

significant non-recurring items, average or income trends based on past results) for entities near

breakeven, with volatile earnings, or losses. Three firms allow the use of earnings before interest,

taxes, depreciation, and amortization (EBITDA) while one firm views this benchmark as not

appropriate and two firms caution against its use but indicate that it may be appropriate in some

14

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situations. Most of the concern raised by the firms in using EBITDA as a benchmark is that it is a

non-GAAP measure. With the exception of the use of EBITDA, there is a relatively high level of

consensus on the benchmarks used for determining overall materiality across the eight firms.

[Insert Table 2]

RQ2: What Percentages are Applied to the Benchmarks for Determining Overall

Materiality?

Table 3 presents the percentages used by the firms to determine overall materiality. For

public companies, six firms expect, suggest, or require the use of 5 percent of income before

taxes while one firm allows 5-10 percent. One firm's guidance states "In our experience it

appears the SEC Staff generally consider amounts over 5% of pre-tax income (loss) from

continuing operations to be material." Firm 6 provides the following guidance: “The percentage

applied to net income is facts and circumstances based, and no prescribe specific percentage is

applied to pre- or post-tax income for a public company.”

For total assets or total revenues, seven firms have ranges inside .25 to 2 percent. Firm 8

allows a wider range for the percentage applied to total revenues: .8 to 5 percent. Four of the six

firms that have net assets as a benchmark use percentages that are within 2 to 5 percent. Firm 3

allows the use of a percentage as high as 10 percent while Firm 4 uses a range of .5 to 1 percent.

For total equity, four firms use percentages that fit inside a 1 to 5 percent range. Firm 3 again

allows a broader range (up to 10 percent). Overall, the percentages applied by the firms’ to their

respective benchmarks are reasonably consistent across the firms.

[Insert Table 3]

RQ3: How do Firms Determine Tolerable Misstatement?

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 Table 4 presents the methods used by the firms to determine tolerable misstatement.

Seven firms use a percentage of overall materiality that fits in a 50 to 75 percent range and one

firm allows a range up to 90 percent. The firms generally provide specific guidance for

establishing tolerable misstatement for public companies. For example, one firm states "For

listed entities and entities in regulated industries, our starting point for setting tolerable

misstatement is 50% of overall materiality."

The firms also provide guidance that assists their auditors in determining the appropriate

percentage to use within the range. Some of the factors included in the firms’ guidance that

would cause the auditor to use a lower percentage for tolerable misstatement are:

• overall engagement risk is considered high (e.g., high-risk industries, unusually high
market pressures, first year and special purpose financial statements);
• fraud risks (e.g., tone at the top, internal or external pressures, ineffective governance
controls, incompetent accounting personnel, contentious with auditors, evasive
responses to audit inquiries);
• a history of identified misstatements in prior periods audits;
• high risk of misstatement within the account balance, class of transaction, or
disclosure;
• increased number of accounting issues that require significant judgment and/or more
estimates with high estimation uncertainty;
• identified misstatements during the course of the current year audit that indicate that
the remaining margin for possible undetected misstatements is insufficient;
• a deficient control environment;
• a history of material weaknesses, significant deficiencies and/or a high number of
deficiencies in internal control;
• high turnover of senior management or key financial reporting personnel; and
• the entity operates in a number of locations.

Overall, the eight firms follow a consistent approach to determining tolerable misstatement.

[Insert Table 4]

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RQ4: What Amounts are Used to Determine What is a Clearly Trivial Misstatement?

Table 5 presents the methods used by the firms to determine what is a clearly trivial

misstatement. Seven of the firms generally establish a clearly trivial misstatement to be 3 to 5

percent of overall materiality. Firm 6 provides a range of 5 to 8 percent. Two firms refer to the

history of misstatements as a factor to consider when setting the percentage within the range. Thus,

there is substantial agreement across firms for establishing what constitutes a clearly trivial

misstatement.

[Insert Table 5]

RQ5: How is Materiality Used to Evaluate Misstatements?

All of the eight firms’ guidance on the evaluation of misstatements closely parallels the

guidance provided in the PCAOB and ASB standards. First, the firms require that all

misstatements that are not trivial be posted to a summary of unadjusted misstatements. This

includes classification misstatements subject to a trivial limit.14 The firms' guidance also includes

statements that the auditor request that management correct all accumulated misstatements.

Second, in accordance with SAB No. 108 (SEC 2006), all misstatements for public

companies are evaluated using the dual method (Nelson et al. 2005). Under the dual method if a

misstatement is material under either the rollover and iron curtain methods it should be adjusted.

For non-public companies, three firms allow the use of all three methods (iron curtain, rollover

and dual), four firms use the rollover method, and one firm uses only the dual method. The more

flexible guidance for non-public companies may reflect lower expected auditor litigation risk

associated with non-public companies (Katz 2009, Badertscher et al. 2014).

Third, all the firms’ guidance discuss the offsetting of misstatements in accordance with

14
Based on discussions with partners from some of the major firms, it is our understanding that the PCAOB is now
requiring the use of the same materiality measures for classification misstatements as misstatements that affect
income.

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existing standards. For example, most firms include statements that are consistent with the

following firm’s guidance:

• Before considering the aggregate effect of identified uncorrected misstatements, we

shall consider each misstatement separately to evaluate whether, in considering the
effect of the individual misstatement on the financial statements taken as a whole, it
is appropriate to offset misstatements.
• If an individual misstatement is judged to be material, it is unlikely that it can be
offset by other misstatements. For example, if revenue has been materially
overstated, the financial statements as a whole will be materially misstated, even if
the effect of the misstatement on earnings is completely offset by an equivalent
overstatement of expenses.
• It may be appropriate to offset misstatements within the same account; however, the
risk that further undetected misstatements may exist is considered before concluding
that offsetting even immaterial misstatements is appropriate.

Fourth, all firms require that uncorrected misstatements not only be evaluated

quantitatively, but that qualitative factors also be considered. For example, one firm states "The

circumstances surrounding certain uncorrected misstatements may cause us to conclude that they

are material, individually or when considered together with other identified misstatements, even

if they are of a lower level than overall or performance materiality, or materiality for particular

classes of transactions, account balances or disclosures. Obtaining the views and expectations of

the client's Audit Committee and management may be helpful in gaining or corroborating an

understanding of user needs such as those illustrated below." The factors shown in Table 6 are

taken from AS14, Appendix B. Some of the firms also reference factors included in SAB No. 99

(SEC 1999) and AU-C 450.A23. So while some firms (especially Firms 5 and 7) do not

specifically reference all of the factors shown in Table 6, their inclusion of factors from SAB No.

99 and AU-C 450.A23 in their firms’ guidance sufficiently covers relevant qualitative factors.

[Insert Table 6]

Finally, all firms provide guidance that requires the auditor to consider the possibility of

undetected misstatements when evaluating whether uncorrected misstatements are material,

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individually or in combination, with other misstatements. Thus, firms have to give consideration

to possible undetected misstatements as the level of uncorrected misstatements approaches

“materiality.” Four firms provide specific quantitative guidance on how to handle such situations.

One firm uses an allowance equal to 80% of the materiality limit as a reserve for possible

undetected misstatements for SEC clients. For non-SEC clients, the firm states that an allowance

should be reserved for possible undetected misstatements based on engagement risk and provides

three ranges: 20, 40, and 60% related to risk. If waived adjustments exceed the limit,

consultation is required. The other three firms use tolerable misstatement. For example, one firm

states, "As the aggregate of the uncorrected misstatements approaches (or exceeds) established

tolerable misstatement, audit risk and the risk of undetected uncorrected misstatements

increases." Two firms seem to use overall materiality, but allow for judgment. The other two

firms are not so specific and also appear to allow the use of judgment. For example, one firm

states, “the audit team also considers the possibility that other misstatements exist. In practice, it

will frequently be clear that the unrecorded misstatements together with the possible existence of

further misstatements are not material from either a quantitative or a qualitative perspective.

There will be situations where unrecorded misstatements are approaching amounts that we would

consider material or have exceeded such amounts. In these situations, the audit team should

consider performing additional audit procedures.” For example, if tolerable misstatement is set

$2 million and uncorrected misstatements approach or exceed that amount, the auditor would

consider the need to perform additional work.

RQ6: How is Materiality Determined and Applied on Group Audits?

Our reading of the eight firms’ guidance for group audits indicates that it is consistent

with the guidance provided in AU-C 600. The following provides an example of the steps

included in the firms' guidance:

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The Group Engagement Team determines:

• Overall materiality for the group. This is determined following the guidance provided
in the discussion of RQ1 and 2.
• Tolerable misstatement for the group. This is determined following the guidance
provided in the discussion of RQ3.
• Component materiality, component tolerable misstatement. Component materiality is
overall materiality for the component being audited as part of the group as is
component tolerable misstatement. The group auditor may determine different levels
of materiality for different components. The aggregate of component materiality may
exceed the overall materiality for the group.
• Clearly trivial to the group. This is the threshold above which misstatements cannot
be regarded as clearly trivial to the group financial statements and is generally 3 to
5% of overall materiality for the group.
• Component subject to statutory audit. If a component is subject to audit by statute or
regulation, and the component audit is used for the group audit, the group
engagement team will determine overall materiality and tolerable misstatement for
the component. This may be delegated to the component auditor subject to the group
audit team requirements.

Two firms (Firms 1 and 6) use a methodology similar to the approach suggested by Glover et al.

(2008) to establish a maximum aggregate amount for component materiality. 15 The firms

calculate an aggregate component materiality (i.e., the maximum amount that the sum of the

individual component materiality amounts may exceed group overall materiality) by using

benchmark multiples, determined based on the number of significant components. Group overall

materiality is multiplied by the benchmark multiplier to determine aggregate component

materiality. Firm 2 has an optional framework that also uses multiples of overall materiality

based on the number of components, but places an upper limit on group overall materiality for

the group audit. The other firms do not provide specific guidance to establish a maximum

aggregate amount for component materiality.

Questionnaire Responses

When we confirmed our coding of the firms’ guidance, we also asked each firm to have a

15
See Stewart and Kinney (2013) for an alternative approach for setting group materiality benchmarks.

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partner respond to selected questions about materiality issues. Seven firms provided responses to

the questionnaire (cf., footnote 12). Six of the seven partners were male, and the respondents had,

on average, 15 years in their current position and 28 years of overall audit experience. All

respondents had a bachelor’s degree and three also had a master’s degree.

The first question asked if there were any situations or circumstances where a benchmark

not shown in the firm’s guidance would be used to set overall materiality. Four of the seven

partners indicate “no” to this question. One partner stated that there are likely some situations

where another benchmark might be more appropriate, but such “situations would be rare and

require consultation.” Another partner indicated that in some circumstances, cash flows might be

an appropriate benchmark and another indicated a not-for-profit benchmark (not included in our

framework).

The second question asked whether there were any situations where a percentage lower

than 50% or higher than 75% might be used to determine tolerable misstatement for an account

or disclosure. The partner from Firm 1’s response includes the exception noted in Table 4 where,

for public companies, tolerable misstatement is set at 20% of materiality for the valuation

assertion when significant estimates are involved. Four partners indicated that there are situations

where a lower tolerable misstatement might be used (e.g., related party transactions, accounts

with identified fraud risks, non-routine transactions, and if significant prior period misstatements

reverse in the current period). Two partners provided answers that indicated examples where the

percentage used might exceed 75 percent. One example was a situation where very little

sampling is anticipated in the audit approach (such as companies that do not have significant

accounts receivable, fixed assets, or inventory). However, technical partner approval would be

required if tolerable misstatement exceeds 75% of materiality.

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 The third question asked, “Auditors are encountering more accounts (e.g., the allowance

for doubtful accounts or inventory obsolescence) that contain estimates. Please indicate the

percentage of the evidence supporting the auditor’s test of the reasonableness of the client’s

estimate that is normally developed by each member of the audit team. Assume that this is a

listed company” while the fourth question asked “Suppose a misstatement greater than tolerable

misstatement occurred in an estimate (e.g., the allowance for doubtful accounts or inventory

obsolescence). In percentage terms, which member of the audit team would be responsible for

initially presenting the evidence supporting the auditor’s test of the reasonableness of the client’s

estimate and the proposed adjustment to the client? Assume that this is a listed company.” One

partner responded that “each instance is unique” and another partner stated, “there are too many

variables to answer such a question” for both questions. While some partners provided ranges for

each team level, a number of the partners qualified their responses with comments such as: “This

is a vast guess. I am assuming you mean for a complex difficult estimate” or “This is my rough

estimate but such could vary widely from engagement to engagement and based on the type of

estimate (e.g., allowance for doubtful accounts vs. a required deferred tax valuation allowance).

Here, I have assumed a “normal” estimate related to the allowance for doubtful accounts or

inventory obsolescence reserve and assumed the staff (not the senior) was assigned the area.”

Given the responses to the two questions, it appears that the scenarios that we posed suggest that

each estimate situation is very fact specific.

The last question posed the following scenario: “Suppose a misstatement greater than

tolerable misstatement occurred in an estimate (e.g., the allowance for doubtful accounts or

inventory obsolescence) and was detected prior to year-end. Under normal circumstances, would

this misstatement be brought to the attention of the client immediately or held until all

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misstatements have been identified? Assume that this is a listed company.” All seven responding

partners indicated that the detected misstatement would be brought to the attention of

management immediately.

SUMMARY, IMPLICATIONS, AND CONCLUDING COMMENTS

Summary of the Results

Research questions 1 – 4 deal with the basic application of materiality on an audit for

planning purposes. Overall, the results indicate a significant amount of agreement between the

firms on the benchmarks (e.g., income before taxes, total assets or revenues, and total equity) and

percentages applied to those benchmarks when establishing overall materiality (RQ1 and RQ2).

Similarly, there is substantial agreement on how to determine tolerable misstatement (RQ3) with

most firms using a 50 to 75 percent range. Finally, there is also agreement on what constitutes a

clearly trivial misstatement: 3 to 5 percent of overall materiality (RQ4). Research question 5

addresses the use of materiality in evaluating detected and undetected misstatements. The results

show that the firms require the following. First, all misstatements that are not clearly trivial

should be posted to a summary of unadjusted misstatements and management is requested to

correct all accumulated misstatements. Second, all misstatements for public companies are

evaluated using the dual method and there is some variability in how to handle such

misstatements for nonpublic companies. Third, all the firms provide guidance for offsetting

detected misstatements. Fourth, qualitative factors are to be considered in determining the

materiality of uncorrected misstatements. Fifth, there are differences in the firms’ guidance when

evaluating uncorrected misstatements and considering the possibility of additional undetected

misstatements. Finally, material misstatements (one greater than tolerable misstatement) detected

during the audit should be brought to management's attention immediately. Research question 6

examines how the eight firms handle materiality on group audits. The results show that the firms’

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guidance closely follows existing auditing standards.

Implications for Research and Education

As noted earlier, much of the published research related to materiality was conducted

prior to the implementation of the risk assessment and materiality auditing standards by the

major public accounting firms. We believe that our data provides a strong roadmap for choosing

appropriate materiality benchmarks and thresholds, and information about the evaluation of

detected misstatements. The information provided by this study can be helpful to future archival

research that directly involves materiality; studies where materiality plays a role as a test or

control variable, or in explaining research findings. Similarly, behavioral researchers interested

in materiality judgments can use these results for designing case information and setting up

levels for testing various benchmarks.

In addition to the implications for research, the information provided in this paper can be

used to inform auditing students. Providing students with the information included in this paper

should help them better understand the concept of materiality and how it is applied in real

settings.

Future Research

There are a number of areas for future research suggested by our work. One area of

research concerns whether the benchmarks and percentages used by the firms map to user needs.

For example, the Financial Reporting Council (FRC) recently required disclosure of overall

materiality in the auditor’s report. Does this type of disclosure affect users’ decisions? Would

users benefit from additional disclosure of how the auditor applied the concept of materiality,

including the specific thresholds of tolerable and clearly trivial misstatement? Does materiality

disclosure affect user groups (e.g., investors versus creditors) differently?

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 Second, our results show that there is considerable agreement among the firms in how

they determine tolerable misstatement – generally a 50 – 75 percent range is used. No research

that we are aware of examines the effectiveness of such an allocation scheme. This is an essential

question. Allocation amounts set too high expose users to unacceptable risk that aggregate

undetected and uncorrected misstatement materially misstates the financial statements, while

amounts set too low entail excessive audit cost. For example, how do internal controls affect the

achieved assurance level of auditors’ practiced or alternative tolerable misstatement allocation

schemes and at which audit cost?

Third, our results show that there are differences in how firms handle the materiality of

detected misstatements and how they consider the possibility of undetected misstatements.

Examining the how auditors handle the possibility of undetected misstatements given the

existence of uncorrected misstatements is an important area for future research. For example,

how do auditors’ handle the imprecision inherent in fair value estimates when they consider the

possibility of undetected misstatements? How does the auditors’ reserve for undetected

misstatements relate to engagement risk? What benchmark is used when evaluating an

uncorrected misstatement; overall materiality, tolerable misstatement, or some other threshold?

Fourth, there is ambiguity in how to handle detected “offsetting” misstatements. For

example, how do auditors handle the correction of offsetting misstatements within one account

or across different accounts?

Fifth, given the significance of group audits, how effective is the current standard and

firm guidance in addressing the application of materiality to such audits. Steward and Kinney

(2013) provides a model for determining component materiality amounts. The model gives a

conceptual basis on how to meet the group audit assurance objective while minimizing component

audit cost. How does this model compare to the current firm guidance of determining component

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materiality?

Lastly, one major limitation of our work and an area for future research is that while we

have identified what the eight firms' guidance indicates should be done on an audit, we provide

no evidence on what is done on actual audits. This would require direct access to the firms’

working papers. In summary, our work provides a number of important avenues for future

research.

Concluding Comments
Materiality is a key concept both for auditors, managers, and users of financial statements.

The auditor’s determination of materiality is a matter of professional judgment and is affected by

the auditor’s perception of the financial information needs of users of the financial statements

(AU-C 320.04). Audit standard setters have recently issued standards related to materiality.

Firms translate such auditing standards into their methodologies. We argue that auditing

researchers and educators can benefit from knowledge about how firms apply materiality

concepts and standards. We hope that this paper will stimulate further research on issues related

to materiality.

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 APPENDIX
CODING QUESTIONNAIRE

Dear Participant:

Thank you for agreeing to participate in the second part of our materiality study. In the first part
of the study, my colleague and I were provided with your firm’s materiality guidance related to
the following research questions:

RQ1: How do firms set planning and tolerable misstatement (considered similar to
performance materiality)?
RQ2: How do firms allocate materiality to financial statement components?
RQ3: How do firms allocate materiality to components in multi-location or group audits?
RQ4: How is materiality applied when evaluating detected misstatements?

We read all of the materials provided and “coded” them to address each question. In the
Appendix, we have attached 7 tables that contain our coding of your firm’s materiality guidance
as it relates to these RQs.

The second part of the project requests that a partner from the firm review our coding for
completeness and accuracy, and complete a short questionnaire. The intent is to insure that we
have not made any errors in coding your firm’s guidance. You will note that we have included
only the data from your firm in the tables at this time. The questionnaire contains 3 parts. Part I
requests some demographic data. Part II asks if our coding is correct and, if not, what should we
change. Part III contains some supplementary questions based on our reading of the guidance.

We will prepare a draft of a paper that will report the results for all firms for review by the
participating firms. In reporting the results of this questionnaire, all firms and participants will
remain anonymous. If possible, we hope that the questionnaire can be completed within 2 weeks.
When you have completed the questionnaire, please return by email to me at

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 Materiality Guidance Questionnaire

PART I – DEMOGRAPHIC INFORMATION

Please provide the following information:

Name

Firm

Email Address

Phone

Position

Years in that Position

Total Years of Professional Auditing Experience

Age

Gender: Male

Female

Highest Level of Education Completed:

Bachelor’s

Master’s

Other

PART II – CONFIRMATION OF THE FIRM’S MATERIALITY GUIDANCE

Please review the researchers’ coding of your firm’s materiality guidance and answer the following
question:

Yes No
Do you agree with the researchers’ coding of your firm’s guidance on the enclosed table?
If not, please indicate where your firm’s guidance would support any changes.

You can make changes directly to the tables using the track changes function.

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PART III – SUPPLEMENTAL DISCUSSION QUESTIONS

Please respond to the following questions:

Discussion Question Response

1. Are you aware of any situations or circumstances

where a benchmark not shown in the firm’s
guidance would be used to set planning
materiality? If so, please describe the benchmark
and circumstances surrounding its use.
2. Typically firms use 50 – 75% of planning
materiality to establish tolerable misstatement. Are
there situations where a percentage lower than 50%
or higher than 75% might be applied to an account
or disclosure? If so, please provide an example?
3. Auditors are encountering more accounts (e.g., the Staff
allowance for doubtful accounts or inventory Senior in charge
obsolescence) that contain estimates. Manager
Partner
Please indicate the percentage of the evidence
100%
supporting the auditor’s test of the reasonableness
of the client’s estimate that is normally developed
by each member of the audit team. Assume that
this is a listed company.
4. Suppose a misstatement greater than tolerable Senior in charge
misstatement occurred in an estimate (e.g., the Manager
allowance for doubtful accounts or inventory Partner
obsolescence). 100%

In percentage terms, which member of the audit

team would be responsible for initially presenting
the evidence supporting the auditor’s test of the
reasonableness of the client’s estimate and the
proposed adjustment to the client? Assume that this
is a listed company.
5. Suppose a misstatement greater than tolerable
misstatement occurred in an estimate (e.g., the
allowance for doubtful accounts or inventory
obsolescence) and was detected prior to year-end.
Under normal circumstances, would this
misstatement be brought to the attention of the
client immediately or held until all misstatements
have been identified? Assume that this is a listed
company.

Thank you for completing the questionnaire.

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 TABLE 1
Relevant Materiality Auditing Standards

PCAOB:

AS11 - Consideration of Materiality in Planning and Performing an Audit

AS14 - Evaluating Audit Results

ASB:

AU-C 320 - Materiality in Planning and Performing an Audit

AU-C 450 - Evaluation of Misstatements Identified During the Audit
AU-C 600 - Special Considerations—Audits of Group Financial Statements (Including the Work of
Component Auditors)

IAASB:

ISA 320 - Materiality in Planning and Performing an Audit

ISA 450 - Evaluation of Misstatements Identified During the Audit
ISA 600 - Special Considerations—Audits of Group Financial Statements (Including the Work of
Component Auditors)

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 TABLE 2
Quantitative benchmarks used for establishing overall materiality

FIRM
Quantitative Benchmarks 1 2 3 4 5 6 7 8
Income (Loss) before income taxesa X* X* X* X* X* X X*
Income (Loss) after income taxes X*
Total assets X* X* X* X X* X* X X*
Total revenues X* X* X* X X* X* X X*
Net assets X* X* X* X X* X X*
EBITDA X* X ** X* ** **
Gross profit/gross margin X* X X*
“Normalized” earnings: Income adjusted for X X X X X X X
significant non-recurring items, average or
income trends based on past results.
Operating income X
Current assets X
Net working capital X
Total equity X* X X* X X* X* X*
Cash flow from operations X X*
Total expenses X* X* X

Note:
a
We use this term throughout the paper to identify the “income before taxes” benchmark. Some firms use more specific benchmarks such as
“income before taxes from continuing operations.” For public companies, income before taxes is normally the required benchmark. Generally, if
another benchmark is used, the engagement team documents and, for some firms, justifies its use.

* Indicates benchmarks that are suggested to be used under normal circumstances.

** Firm states that non-GAAP measures or alternative performance measures such as EBITDA are not appropriate, are only used in conjunction
with other measures, or cautions against the use of this measure except in very restrictive circumstances.

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 TABLE 3
Percentages Used for Setting Quantitative Benchmarks

FIRM
Quantitative Benchmarks 1a 2 3 4 5 6 7 8
Income (Loss) before income taxes 5.0 – 6.0b 5 – 10b 3 – 10 b 5 – 10 b 5 – 10b 3 – 10b 5 – 10d
Income (Loss) after income taxes 20c
Total assets .5 – 1.5 1–2 .5 – 2 .5 – 1 .25 – .5 1 1–2 1–2
Total revenue .5 – 1.5 1–2 .5 – 2 .5 – 1 .5 – 1 1 .5 – 1 .8 – 5
Net assets 3.0 – 4.0 3 – 10 .5 – 1 5 2–5 3
EBITDA 2.5 – 3.0 2.5 – 3.5 2–5 3–5
Gross margin 1–2
Total equity 3 – 10 1–2 1–5 5 3
Cash flow from operations 3–5
Total expenses .5 – 2

Notes:
a
Percentages are applied inversely to increments of the benchmark. For example, for income before taxes, 6% is applied to the first $5 million,
5.75% to the next $10 million, 5.50% to the next $15 million, 5.25% to the next $20 million, and 5% to the balance.
b
Firm expects, suggests, or requires 5% for U.S. listed entities and entities in regulated industries.
c
The percentage applied to net income is facts and circumstances based, and no prescribe specific % is applied to pre- or post-tax income for a
public company.
d
Firm typically applies 5 – 10% for public companies.

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 TABLE 4
Guidance for Establishing Tolerable Misstatement

Firm Guidance

1 • Tolerable misstatement can be set at 70-90% of overall materiality depending on overall

audit risk. For public companies, tolerable misstatement is set at 20% of materiality for the
valuation assertion when significant estimates are involved.
2 • Tolerable misstatement can be set at 50-75% of overall materiality. Factors are provided
for choosing the percentage for tolerable misstatement.
3 • Tolerable misstatement cannot exceed 75% of overall materiality. Factors are provided for
decreasing tolerable misstatement.
4 • Tolerable misstatement set at 60 to 75% of overall materiality. Positive and negative
factors are provided for determining an appropriate percentage.
5 • Calculate tolerable misstatement at either 50% or 75% of overall materiality depending on
whether the company is listed or not. Generally tolerable misstatement is set at 50% for
listed companies and 75% for non-listed companies. Firm guidance allows deviations
from these benchmark percentages under certain conditions.
6 • Generally 75% of overall materiality but may vary.

7 • Generally 50 – 75%. Conditions are provided for moving along the range.

8 • Overall materiality minus an estimate of the amount of unanticipated uncorrected

misstatements. Not to exceed 70% of overall materiality for SEC listed entities.

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 TABLE 5
Guidance on Establishing Clearly Trivial Misstatements

Firm Guidance
1 • Generally 3% of overall materiality.
2 • Generally 5% of overall materiality but should generally not exceed 10% of overall
materiality. Posting of amounts less than 5% may be appropriate under certain
circumstances.
3 • Generally it is 3 – 5% of overall materiality.
4 • 3% to 5% of overall materiality.
5 • Set at 5% of overall materiality.
6 • Generally 5 – 8% of overall materiality.
7 • Set at 5% of overall materiality.
8 • Set at 5% of overall materiality.

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 TABLE 6
Qualitative Factors Included in Evaluation of Misstatements

FIRM

Qualitative Factors* 1a 2 3b 4 5a,b 6 7a,b 8a

1. The potential effect of the misstatement on trends, X X X X X X X X

especially trends in profitability.
2. A misstatement that changes a loss into income or X X X X X X X X
vice versa
3. The effect of the misstatement on segment X X X X X X X X
information.
4. The potential effect of the misstatement on the X X X X X X X X
company's compliance with loan covenants, other
contractual agreements, and regulatory provisions.
5. The existence of statutory or regulatory reporting X X X X X X X
requirements that affect materiality thresholds.
6. A misstatement that has the effect of increasing X X X X X X X X
management's compensation, for example, by
satisfying the requirements for the award of bonuses
or other forms of incentive compensation.
7. The sensitivity of the circumstances surrounding the X X X X X X X X
misstatement, for example, the implications of
misstatements involving fraud and possible illegal
acts, violations of contractual provisions, and
conflicts of interest.
8. The significance of the financial statement element X X X X X
affected by the misstatement, for example, a
misstatement affecting recurring earnings as
contrasted to one involving a non-recurring charge or
credit, such as an extraordinary item.
9. The effects of misclassifications, for example, X X X X X X
misclassification between operating and non-
operating income or recurring and non-recurring
income items.
10. The significance of the misstatement or disclosures X X X X X X X
relative to known user needs for example:
a. The significance of earnings and earnings per
share to public company investors.
b. The magnifying effects of a misstatement on the
calculation of purchase price in a transfer of
interests (buy/sell agreement).
c. The effect of misstatements of earnings when
contrasted with expectations.
11. The definitive character of the misstatement, for X X X X X X
example, the precision of an error that is objectively
determinable as contrasted with a misstatement that
unavoidably involves a degree of subjectivity through
estimation, allocation, or uncertainty.

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12. The motivation of management with respect to the X X X X X X
misstatement, for example, (i) an indication of a
possible pattern of bias by management when
developing and accumulating accounting estimates or
(ii) a misstatement precipitated by management's
continued unwillingness to correct weaknesses in the
financial reporting process.
13. The existence of offsetting effects of individually X X X X X X
significant but different misstatements.
14. The likelihood that a misstatement that is currently X X X X X X X X
immaterial may have a material effect in future
periods because of a cumulative effect, for example,
that builds over several periods.
15. The cost of making the correction. If management has X X X X X X
developed a system to calculate an amount that
represents an immaterial misstatement, not correcting
such a difference may reflect a possible bias or
motivation on the part of management.
16. The risk that possible additional undetected X X X X X X
misstatements would affect the auditor's evaluation.

* Source: PCAOB, AS14, Appendix B.

Notes:
a
Makes reference to the qualitative factors included in SAB No. 99 in the firm’s guidance.
b
References the qualitative factors in AU-C 450.A23 / ISA 450.A16.

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