So where does this materiality come into play? Well you have to establish materiality at the overall financial statement level, then you need to determine materiality at the account balance level, and you need to evaluate materiality of misstatements that you find in the course of your audit. So establish, determine, evaluate. Again establish, that's when you're saying, what's material for the financial statements taken as a whole. Determine, now you're looking at individual account balances in the balance sheet, or the income statement. And then this helps you guide the audit to know what size of misstatements you're looking for. This is always less than overall materiality. How much less? Well, sometimes textbooks don't tell you too much, but now we know from this research and then you evaluate audit results. We found this misstatement, are we going to require management to adjust this misstatement on grounds of this material, or not? That's what we're talking about there. And clearly, once you get misstatements that in isolation or in aggregate error in excess of overall, or planning materiality, they have to adjust. If you have a misstatement that is less than overall or planning materiality, but larger than tolerable misstatement or performance materiality, you should get management to adjust that. Although firms sometimes differ on that. It really comes down to a professional judgment call about whether something that clearly is material at an account balance level is still material at the level of the financial statements taken as a whole. Let me give you an example. If the account you're talking about is revenue, that is one of the most critical accounts on the financial statements. It's very, very difficult. In fact, I would almost say in impracticable for an account called revenue to be materially misstated at the account balance level, and for that not to matter, for the financial statements taken as a whole. But if it was maintenance expense, or some obscure long-term asset, then you could be in a situation when something would be material for an account balance does not rise to being material in the audit professional judgment for the financial statements taken as a whole. So again, you're evaluating whether misstatements of lesser amounts than established materiality would influence the judgment of a reasonable investor. This takes some stepping into the shoes of an investor if you're the auditor, and that's not always easy. In fact, that actually is pretty difficult. One reason it's difficult is that it's not really possible for the auditor to be an investor literally of that company they're auditing, because that would violate independence standards. Tolerable misstatement is the amount, or amounts, that you're trying to reduce to an appropriately low level that the total uncorrected found and undetected misstatements would result in a material misstatement of the financial statements. To reiterate, in this study, 7 of the largest 8 firms, and remember, there are big 4 firms and then we're looking at the next largest 4s as well, use 50 to 75% of overall materiality which, in turn, is often going to be 5% of net income before taxes, or if it's a loss firm, 1% of revenues, 2% of revenues, something like that. One firm allows up to a range of 90%. So, what are the qualitative factors, I alluded to some of these, that firms use to... You know they have this range 50 to 75% and where do they fall in that 50 to 75%? That's where the qualitative factors come into the role at the planning stage. If the overall engagement risk is considered high, I alluded to that earlier, like if a company is planning to sell all of it or spin off a significant part of it's operations, see that gives management a real incentive to look really good to really window dress the financial statements that pushes the risk of the audit higher. If you're worried about the tone at the top or management's integrity, which would relate to the overall engagement risk, but also to fraud risk. Now fraud risk, you would also bring in, we'll talk a little bit more about that later, but when you think of fraud risk you really look at your management's incentive to commit fraud, manager's opportunities to commit fraud, and how can they reconcile and rationalize that in their own mind. It's really not being so bad after all. The other thing you look at is if this is a continuing engagement, whether there is a history of repeat audit adjustments. Sometimes, the first place you want to look as an auditor in the second year or third year in audit is in those troubling spots from last year. There's a couple of reasons. One is that companies sometimes don't take the audit too seriously, and if in fact they do not, in the sense that the same exact errors and misstatements are arising, that gives you second order worries about the tone at the top at that company. That would cause you to shift away from 75% of overall materiality to 50% or closer to, there too, in your planning of the audit. Now, one thing to keep in mind is that not all audits are created equal, right? In other words, because what is material differs across companies. So, even though the word in English is the same, material misstatement, we now know from this lesson that materiality could be very different from one audit to the next. It's for that reason that I applaud the UK, and I would hope that this becomes much more widespread in the United States, that the auditor's opinion right there in black and white for users will express for the users what was overall work planning materiality and what was tolerable misstatement, i.e. performance materiality for that engagement. I think you're going to get a lot more use out of the audits, if that's the case.
