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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
2
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.
3
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.
4
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 should
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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.
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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.
9
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 team
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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):

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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.
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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.
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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,
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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.
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• 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
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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;
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• 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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Gibbins, M., S. A. McCracken, and S. E. Salterio. 2007. The chief financial officer’s perspective
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Gibbins, M., S. A. McCracken, and S. E. Salterio. 2010. The auditor’s strategy selection for
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Glover, S. M., D. F. Prawitt, J. T. Liljegren, and W. F. Messier, Jr. 2008. Component materiality
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Hatfield, R., C. Agoglia, and M. Sanchez. 2008. Client Characteristics and the Negotiation
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29
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

30
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.




31
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.


32
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)


33
TABLE 2
Quantitative benchmarks used for establishing overall materiality

FIRM
Quantitative Benchmarks 1

2 3 4 5 6 7 8
Income (Loss) before income taxes
a
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.
34
TABLE 3
Percentages used for setting quantitative benchmarks

FIRM
Quantitative Benchmarks 1
a
2 3 4 5 6 7 8
Income (Loss) before income taxes 5.0 – 6.0
b
5 – 10
b
3 – 10
b
5 – 10
b
5 – 10
b
3 – 10
b
5 – 10
d
Income (Loss) after income taxes 20
c

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.


35

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.


36
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.



37
Table 6
Qualitative factors included in evaluation of misstatements

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

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.