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.

Examples of Tolerable Misstatements

Here are several examples of tolerable misstatements:

Inventory valuation. In a retail company, the total inventory balance is $5 million. The auditor sets the tolerable misstatement for inventory at $50,000 (1% of total inventory). If a discrepancy of $45,000 is identified, it falls within the tolerable misstatement and might not require a correction.
Revenue recognition. For a company with annual revenue of $10 million, the tolerable misstatement for revenue could be set at $100,000 (1%). If there is a $90,000 misstatement in revenue due to a minor error in revenue recognition timing, it may be deemed tolerable.
Accounts receivable. A company has accounts receivable totaling $2 million, and the tolerable misstatement for this account is set at $20,000. An audit uncovers a $15,000 misstatement in the calculation of allowance for doubtful accounts. Since it is within the tolerable threshold, it might not need adjustment.
Depreciation expense. In a manufacturing company, the annual depreciation expense is $500,000. The auditor determines that a tolerable misstatement for depreciation is $10,000 (2%). If a $9,000 misstatement is found in the depreciation calculation, it falls below the threshold and could be considered tolerable.
Fixed assets. A company reports $15 million in fixed assets. The auditor sets the tolerable misstatement for fixed assets at $75,000 (0.5%). If a $70,000 discrepancy is found, perhaps due to an asset's useful life estimate, it might be within tolerable limits.

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.