Electronic copy available at: http://ssrn.com/abstract=2274845

MATERIALITY GUIDANCE OF THE MAJOR AUDITING FIRMS

Aasmund Eilifsen Professor

Norwegian School of Economics (NHH) aasmund.eilifsen@nhh.no

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) bill.messier@unlv.edu

November 2013

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 PwC (Norway) during 2012.

Electronic copy available at: http://ssrn.com/abstract=2274845

MATERIALITY GUIDANCE OF THE MAJOR AUDITING FIRMS

Abstract

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

Knowledge of how materiality guidance is integrated into a firm’s methodology is important for

accounting and auditing researchers. 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 offer insights into implementation of standards that provides valuable information for

future archival and behavioral research.

Keywords: Materiality, Tolerable misstatement, Misstatements, Group audits JEL: M40, M41, M42

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MATERIALITY GUIDANCE OF THE MAJOR AUDITING FIRMS

1. Introduction

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

major 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, recent research into auditors’ materiality judgments has

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examined 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, Salterio and Webb 2001;

Gibbins, McCracken and Salterio 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 examines the proprietary materiality guidance of eight of the largest

U.S. auditing firms in order to provide information for researchers that may assist in designing

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

possible answers to the concerns raised by these researchers.

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

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

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

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

valuable information for researchers in how the concept of materiality is applied by the major

auditing firms.

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.

2. 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 new standards related to materiality. Table 1 presents a list of the auditing

standards that are relevant to this study.2 These standards prescribe a more comprehensive

framework for materiality judgments than the prior standards but do not provide specific

authoritative guidance on the calculation of materiality and how misstatements are to be

evaluated in relation to materiality levels. Thus, audit firm policies are an important source for

how materiality standards are applied by audit firms. To our knowledge, there is no available

recent information on how the major auditing firms have integrated materiality guidance into

their firm methodologies. Martinov and Roebuck (1998) was the last published research that 2 It is our understanding that the Canadian Institute Chartered Accountants (CICA) issues auditing standards that are identical to the standards issued by the IAASB. 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. 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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examined the major firms’ policies on materiality and we suspect that their work is outdated.3

[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), and (3)

evaluate audit results (see Messier et al. 2014, 84-89).4 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

3 See Holstrum and Messier (1982), Leslie (1985) and Messier et al. (2005) for reviews of materiality research. 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.

5

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).

6

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.

7

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).

8

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 group (or

multi-location) audit is an important issue (Messier et al. 2005; Messier 2010). The ASB has a

separate standard for group audits (AU-C 600) and how this process should occur.

The group engagement team9 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

different components.

Research questions

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

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

9 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

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.

3. Method

Firm participants

Eight of the largest U.S. auditing firms agreed to participate in the study.10 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.

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 the

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

10 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. These are eight of the nine largest firms in the U.S. based on revenues (The Platt Consulting Group 2011) and all firms are subject to an annual PCAOB inspection. The numbers used for the firms throughout the paper do not correspond to the order listed in this footnote.

11

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 all firms would remain anonymous. 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,11 and (3) to review a draft of

the paper before distribution. The Appendix contains a copy of the questionnaire.

4. 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)

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.12 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, 11 In our negotiation with one firm, it was agreed that they would verify our coding but not respond to the other questions included in the questionnaire. 12 Because of the NDAs we could not use independent coders.

12

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 these 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

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.

13

• 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.

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. Five

firms allow the use of "normalized earnings" (income adjusted for significant non-recurring

items, entities near breakeven, 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 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 tax

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

14

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?

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;

15

• 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]

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. 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.13 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

13 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.

16

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. 2013).

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

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

17

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,

individually or in combination, with other misstatements. Four firms provide specific

quantitative guidance. 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

18

procedures.”

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:

The Group Engagement Team determines:

• Overall materiality for the group. • Tolerable misstatement for the group. • Component materiality (different levels may be established for different components)

and component tolerable misstatement (50-75% of component materiality) and materiality for particular classes of transactions, account balances or disclosures at a component.

• Threshold above which misstatements cannot be regarded as clearly trivial to the group financial statements. Generally in the range 3 to 5% of overall materiality for the group.

• If a component is subject to audit by statute or regulation, and the group engagement uses that audit 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.

Following this approach, overall materiality and tolerable misstatement for the group would be

determined as discussed under RQs 1 – 3. However, if the component is subject to a statutory

audit, lower amounts may be set for the component overall materiality and tolerable

misstatement. 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.14

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

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

19

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. Overall component materiality is determined with reference to overall group

materiality and individual component factors such as risks of material misstatement associated

with each component. Trivial misstatements would normally be set at a percentage of overall

materiality (see RQ 4).

Questionnaire responses

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

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

the questionnaire (cf., footnote 11). 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

20

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.

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

21

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

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.

5. Summary, implications for research, 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

22

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’

guidance closely follows existing auditing standards.

Implications for research

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

prior to the implementation of the recent materiality auditing standards by the major auditing

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.

Acito et al. (2009), Keune and Johnstone (2009, 2012), and Plumlee and Yohn (2010,

2013) are good examples of archival studies that examine important accounting and auditing

issues (e.g., restatements and compliance with SEC Staff Accounting Bulletins). These studies

include some measure of materiality for testing and evaluating results. For example, Keune and

23

Johnstone (2012, 1655), in testing their quantitative materiality model, “omit observations with

current-year losses and small profits that are less than 1 percent of total assets.” Based on our

research, they might have conducted additional analyses that included the omitted observations

because the auditing firms in our study provide for alternative benchmarks for such situations

(i.e., total revenues and total assets).

Behavioral researchers examining the materiality judgments of auditors, managers, or

users should find our data helpful. For example, the growing literature on auditor-client

negotiation offers a good example of how our findings can inform future research.15 Important

issues for future negotiation research based on our results include the following. First, clearly

provide the participants with the amount for overall materiality, tolerable misstatement, and

clearly trivial misstatement.16 This information is available to the auditor on an audit and it

makes the relevant benchmarks salient for evaluating the materiality of the identified

misstatement(s) used in the study. Our data on what constitutes a tolerable misstatement and a

clearly trivial misstatement could be used to reexamine research that has used immaterial or

insignificant misstatements (e.g., Hatfield et al. 2010; Ng and Tan 2003). Second, future

negotiation research should focus on judgmental or projected misstatement for experimental

purposes. Our results suggest that auditors should request that factual (known or objective)

misstatements be corrected unless they are trivial.17 A number of prior studies examined

concessions involving multiple misstatements that were either inconsequential (Sanchez et al. 15 Brown and Wright (2008) and Hatfield et al. (2010) provide reviews of this literature. 16 Many of the prior negotiation studies provided one or both of these benchmarks. We believe that providing both overall materiality and tolerable misstatement is important because current auditing standards are unclear on which one should be used for comparison purposes when evaluating detected misstatements. 17 Note that the prior auditing standard (AU 312.45) required “The auditor should request management to record the adjustment needed to correct all known misstatements, including the effect of prior period misstatement (see paragraph .53), other than those that the auditor believes are trivial.” As we reported, AU-C 450 requires that the auditor request management to correct identified misstatements regardless of type (factual, judgmental, and projected) that are not trivial. However, using judgmental or projected misstatements allows for some degree of uncertainty in the negotiation process (see Cannon and Bedard 2013).

24

2007; Hatfield et al. 2008) or factual (Hatfield et al. 2010). Third, it is clear that auditors should

consider qualitative factors (i.e., AS 14, Appendix B; AU-C 450.A23). Continuation of the

current recent research stream that examines qualitative factors (e.g., Libby et al. 2006; Libby

and Brown 2013) should offer interesting areas for future research. Finally, recent work by Kida

et al. (2012) examined whether a sequential or simultaneous approach to presenting detected

misstatements is more effective. Our research indicates that when a detected misstatement is

material, it is normally brought immediately to the attention of the client. This implies a

sequential process for handling material misstatements. Future research should recognize this

fact when designing negotiation experiments.

In addition to the prior discussion, we have identified two materiality issues that need

further research. First, our results show that there is a high agreement among the firm in how

they determine tolerable misstatement – the firms use a 50 – 75 percent range. However, we are

not aware of any research that indicates the efficacy of this approach. Second, our results show

that there are differences in how the firms handle the consideration of possible undetected

misstatements. Again, we are not aware of any research that has examined this issue. We suggest

that both of these issues be the subject of future research.

One major limitation of our work 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.

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 new standards related to materiality.

25

Audit firms translate such auditing standards into their methodologies. We argue that auditing

researchers 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.

26

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pricing in the U.S. Working paper, University of Texas. Brody, R. G., D. J. Lowe, and K. Pany. 2003. Could $51 million be immaterial when Enron

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(1): 91-109. Cannon, N., and J. C. Bedard. 2013. Evidence from auditors about auditing fair value

measurements. Working paper, Bentley University. Epps, K., and W. F. Messier, Jr. 2007. Engagement quality reviews: A comparison of audit firm

practices. Auditing: A Journal of Practice & Theory 26 (2): 167-181. Gibbins, M., S. Salterio, and A. Webb. 2001. Evidence about auditor-client management

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Gibbins, M., S. A. McCracken, and S. E. Salterio. 2005. Negotiations over accounting issues: the

congruency of audit partner and chief financial officer recalls. Auditing: A Journal of Practice & Theory 24: 171–193.

Gibbins, M., S. A. McCracken, and S. E. Salterio. 2007. The chief financial officer’s perspective

on auditor-client negotiations. Contemporary Accounting Research 24: 387–424. Gibbins, M., S. A. McCracken, and S. E. Salterio. 2010. The auditor’s strategy selection for

negotiation with management: flexibility of the initial accounting position and nature of the relationship. Accounting, Organizations and Society 35: 579–595.

Glover, S. M., D. F. Prawitt, J. T. Liljegren, and W. F. Messier, Jr. 2008. Component materiality

for group audits. Journal of Accountancy (December): 42-46. Hatfield, R., C. Agoglia, and M. Sanchez. 2008. Client Characteristics and the Negotiation

Tactics of Auditors: Implications for Financial Reporting. Journal of Accounting Research 46 (5): 1183-1207.

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Hatfield, R., R. Houston, C Stefaniak, and S. Usrey. 2010. The effect of magnitude of audit difference and prior client concessions on negotiations of proposed adjustments. The Accounting Review 85 (5): 1647-1668.

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Keune, M. B., and K. M. Johnstone. 2012. Materiality judgments and the resolution of detected

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Kida, T., S. Perrault, and M. D. Piercey. 2012. The relative effectiveness of simultaneous versus

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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 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.

Staff Senior in charge Manager Partner 100%

4. 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.

Senior in charge Manager Partner 100%

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 significant non-recurring items, entities near breakeven, volatile earnings, or losses

X X X X X

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 Notes: 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, especially trends in profitability.

X X X X X X X X

2. A misstatement that changes a loss into income or vice versa

X X X X X X X X

3. The effect of the misstatement on segment information.

X X X X X X X X

4. The potential effect of the misstatement on the company's compliance with loan covenants, other contractual agreements, and regulatory provisions.

X X X X X X X X

5. The existence of statutory or regulatory reporting requirements that affect materiality thresholds.

X X X X X X X

6. A misstatement that has the effect of increasing management's compensation, for example, by satisfying the requirements for the award of bonuses or other forms of incentive compensation.

X X X X X X X X

7. The sensitivity of the circumstances surrounding the misstatement, for example, the implications of misstatements involving fraud and possible illegal acts, violations of contractual provisions, and conflicts of interest.

X X X X X X X X

8. The significance of the financial statement element 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.

X X X X X

9. The effects of misclassifications, for example, misclassification between operating and non-operating income or recurring and non-recurring income items.

X X X X X X

10. The significance of the misstatement or disclosures 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.

X X X X X X X

11. The definitive character of the misstatement, for 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.

X X X X X X

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12. The motivation of management with respect to the 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.

X X X X X X

13. The existence of offsetting effects of individually significant but different misstatements.

X X X X X X

14. The likelihood that a misstatement that is currently immaterial may have a material effect in future periods because of a cumulative effect, for example, that builds over several periods.

X X X X X X X X

15. The cost of making the correction. If management has 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.

X X X X X X

16. The risk that possible additional undetected misstatements would affect the auditor's evaluation.

X X X X X X

* 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.