Materiality is one of the essential accounting concepts and is designed to ensure all of the crucial information related to the business are presented in the financial statement. The purpose of materiality is to ensure that the financial statement user is provided with financial information that does not have any significant omissions/misstatements.
If there is any omission/misstatement, the users (investors, shareholders, suppliers, Government) may not be able to make an informed decision. Hence, materiality in accounting refers to the concept that no significant misstatement/omission in the financial record impacts the financial reporting.
All crucial facts about the business are presented in the best possible ways to help the financial statement user make a decision. In simple words, any misstatement that impacts the decision of the financial statement user is material and vice versa.
Explanation of materiality
Sometimes, the cost of correction may exceed the benefits to be obtained. In this scenario, the business is logical in ignoring an error and moving ahead. However, the business needs to ensure that ignorance of error does not have a material impact on the financial statement in any form.
For instance, in the million-dollar balance sheet, $10 inappropriately classified under prepaid expense does not seem to impact the final user of the financial statement. Instead, passing journal entries to make a correction seems to be counter-productive activity.
It’s important to note that the definition of materiality does not focus on quantitative aspects as there can be different materiality for different organizations based on their nature of business and size of total assets etc. It’s also important to note that materiality in accounting is about presenting accurate and crucial financial data to the users that help them in decision making.
Further, under IFRS, there is a more relaxed interpretation of the materiality concept. For instance, an accountant can disclose high-value items with other account balances as there are no specific criteria to disclose separate account balances. On the other hand, US GAAP and SEC require separate disclosure of the account balance in the balance sheet if its balance is 5% or more of the total assets.
Similarly, if an item in the income statement has sufficient potential to convert profit to loss and loss to profit is considered to be material irrespective of the amount. Hence, there is a connection between the size of the profit/loss and the size of the balance in the income statement when it comes to presentation.
Likewise, an item is not always material with its volume, but its impact and nature can impact determination materiality. Let’s discuss these aspects in some more detail.
Materiality by impact
Materiality by impact refers to the concept that even a trivial amount can be material if its impact is higher on the financial statement. For instance, if a trivial amount changes loss into profit, the amount is considered to be material due to its impact.
Material by nature
Some account balances are material in nature, irrespective of their size and volume. For instance, the balance of the related party transaction, director’s emoluments, and bank balances, etc.
Examples of materiality in accounting
Following are some examples of materiality.
- The company discovers that they omitted capitalization of the asset last year. However, an amount of asset is trivial and does not significantly impact the financial statement. So, the business can decide to ignore an error.
- The business decides to charge the purchase of a capital asset in the income statement. It’s because the value of an asset is below the capitalization threshold (trivial amount), and treatment does not materially impact the financial statement.
Application of materiality in accounting practice
The company’s management needs to make several decisions based on the materiality/significance of the account balance. Some of the instances are discussed below.
1- Capitalization threshold
The companies set capitalization thresholds to ensure only material items are capitalized, depreciated, and tracked. This helps the companies to utilize their resources on monitoring capital items with significant value.
As capitalization of the assets increases administrative tasks for the business. So, companies charge immaterial items of purchase (capital assets) in the income statement rather than capitalizing and increasing administrative efforts.
However, companies need to carefully decide the capitalization threshold to ensure charging the purchase of a capital asset in the income statement does not have a material impact on the financial statement.
2- Minor errors
The concept of materiality enables the company’s accounting function to ignore small errors that do not seem to have any impact on the financial record of the business. Suppose the financial controller finds some minor errors in the journal entries while closing books of account; these errors can be ignored as the amount is not material enough to impact the financial statements.
3- Adoption of accounting standard
In the US GAAP, if some specific amount is not material, the company may decide not to comply with the provisions of specific accounting standards. The company can ignore the adoption of certain accounting standards if the adoption does not have a material impact on the financial statement user.
However, the definition of materiality does not provide quantitative aspects regarding the materiality/immateriality of the account balance. Hence, the business needs to decide if an amount is material with professional judgment and professional skepticism.
Materiality is one of the essential concepts in accounting. It’s designed to guide an accountant on which line items should be merged and which line items should be separately disclosed.
Further, the concept of materiality helps to decide if certain omissions/misstatements should be corrected in the books of accounts. As a bottom line, there must not be any omission/misstatement in the financial statement.
The most common application of materiality in accounting is observed in capitalization, adoption of accounting standards, and deciding if corrections should be made in the books for some specific error.
The concept of materiality is equally important for auditors, their approach is to collect sufficient and appropriate audit evidence on all the material balances/events in the financial statement.
Frequently asked questions
What is the main purpose of materiality in accounting?
The main purpose of materiality in accounting is to provide guidance to an accountant for the preparation of a financial statement. The guidance is directed to include all the crucial information in the financial statement that impacts the decision of the user.
How is materiality calculated?
Calculation of the materiality is a complex task and requires the use of professional judgment. Usually, a significant balance is selected, and the percentage is applied to it. For instance, materiality is taken to be 0.5% to 1% of the total sales, 1% to 2% of the total assets, 1% to 2% of gross profit, and 5% to 10% of the net profit.
The nature of the business significantly matters in the selection for the balance to calculate materiality. For instance, it’s logical to calculate materiality on total sales in the service industry, materiality on total assets in manufacturing company, and likewise.
Why do auditors calculate materiality?
Calculation of materiality enables the auditor to set the sample size and plan resources required to complete the audit. Suppose materiality calculated for the business is higher. So, fewer transactions are expected to be in the sample, and less time and resources can be planned.
On the flip side, if materiality is higher, an auditor may have to perform audit procedures on more samples. Hence, more time and resources are needed. Although, sample size can also be reduced by obtaining assurance from TOC – Test Of Control and AP –Analytical Procedures.
What’s the difference between management materiality and auditor materiality?
The basic concept of materiality is the same for management and auditors. However, both have a different perspective of use. Management is concerned that all the material information that is crucial for the user’s decision-making should be presented appropriately.
While auditors believe that there should not be any material error in the financial statement that impairs the user’s decision, further, they have performed audit procedures and collected sufficient and appropriate audit evidence on all material balances.