What is a Tolerable Misstatement?

A tolerable misstatement is the amount by which a financial statement line item can differ from its true amount without impacting the fair presentation of the entire financial statements. The concept is used by auditors when designing audit procedures to examine the financial statements of a client. The procedures chosen should be able to locate all instances in excess of a tolerable misstatement.

The tolerable misstatement that an auditor allows is a judgment call, based on the proportion of planning materiality for an audit. If the perceived risk level is high, the tolerable misstatement will be a smaller percentage of the planning materiality, such as 10-20%. Conversely, if the perceived risk level is low, the tolerable misstatement can be a much higher percentage of the planning materiality, such as 70-90%. The risk level will vary, depending on the auditor’s assessment regarding different classes of transactions or accounts.

The Impact of Fraud on Tolerable Misstatement

It is possible that there are tolerable misstatements in several financial statement line items. When combined, these misstatements in aggregate could result in a material misstatement of the financial statements. This is especially likely when management is engaged in financial statement fraud, so that a number of individually tolerable misstatements are all in the same direction, rather than offsetting each other. Conversely, it is less likely in the absence of fraud, where the various misstatements are more likely to be randomly positive or negative, and so will approximately cancel each other out.