What is the Materiality Concept?
In any financial accounting statements, there are some transactions that are too small to be recognized and such transactions might not have any impact on the analysis of the financial statement by an external observer; removal of such irrelevant information to keep the financial statement crisp and consolidated is called as the concept of materiality.
The materiality concept refers to a situation where the financial information of a company is considered to be material from the point of view of the preparation of the financial statements if it has the potential to alter the view or opinion of a reasonable person. In short, all that financial information that is likely to influence a knowledgeable person’s judgment should be captured in the preparation of the financial statements of the company. The materiality concept in accounting is also known as materiality constraint.
The concept of materiality in accounting is very subjective, relative to size and importance. Financial information might be of material importance to one company but stand immaterial to another company. This aspect of the materiality concept is more noticeable when the comparison between companies that vary in terms of their size i.e., a large company vis-à-vis a small company. A similar cost may be considered to be the large and material expense for a small company, but the same may be small and immaterial for a large company because of their large size and revenue.
As such, it can be said that the main objective of the materiality concept in accounting is to assess whether the financial information under consideration makes any significant impact on the opinion of the financial statement users. If the information is not material, then the company does not need to worry about including it in their financial statements. The financial statement users mentioned here can be auditors, shareholders, investors, etc.
In general, the thumb rule for the materiality of financial information is stated as,
- On the Income statement, a variation of more than 5% of before-tax Profit or more than 0.5% of sales revenue may be seen as “large enough to matter.”
- On the Balance sheet, a variation in the entry of more than 0.5% of total assets or more than 1% of total equity may be viewed as “large enough to matter.”
Materiality Concept as per GAAP and FASB
Materiality Concept as per GAAP
For GAAP (Generally Accepted Accounting Principles) the primary rule for deciding on materiality is-
“Items are material if they could individually or collectively influence the economic decisions of users, taken from financial statements.”
Materiality Concept as per FASB
On the other hand, for FASB (Financial Accounting Standards Board) the primary rule for deciding on materiality is-
The magnitude of an omission or misstatement of accounting information that, in the light of surrounding circumstances, makes it probable that the judgment of a reasonable person relying on the information would have been changed or influenced by the omission or misstatement.”
Examples of Materiality Concept in Accounting
Let’s understand the Materiality concept in accounting with the help of a simple example to understand it better.
Let us take the example of a large company that had a building located in the hurricane zone during the recent natural calamity. The hurricane has destroyed the company building, and after a gruesome legal battle with the insurance provider, the company has reported an extraordinary loss of $30,000. Determine the materiality of the event based on the below-given conditions:
- For company A which is large and generates a net income of $40,000,000
- For company B which is very small and generates a net income of $90,000
a) Now, let us calculate the materiality for company A by dividing the loss of $30,000 by the net income of the company i.e. $30,000 / $4,000,000 * 100% = 0.08%
By using the above-given data, we will calculate the Materiality of Company A
The materiality of Company A =0.08%
According to the materiality concept, this loss of $30,000 is immaterial for company A because the average financial statement user would not be concerned with something that is only 0.08% of the total net income.
b) Again, let us calculate the materiality for company B by dividing the loss by the net income of the company i.e., $30,000 / $90,000 * 100% = 33.34%
Now, we will calculate the Materiality of Company B
The materiality of Company B = 33.33%
According to the materiality concept, this loss of $30,000 is material for company B because the average financial statement user would be concerned and might opt out of the business given that the loss constitutes around 33.33% of the total net income.
The above example emphasizes the difference in the size of the two companies and the variation in the behavior of their financial statement users.
Relevance and Uses of the Materiality Concept in Accounting
It is to be understood that materiality is a subjective concept that guides a company to identify and disclose only those transactions which are sufficiently large compared to the operations of the company such that it would concern the users of the financial statements of the company. The materiality concept says that a company is obligated to account for such substantial amounts in a way that complies with the financial accounting principles. However, materiality is measured in terms of dollar amount, and the consequence is a misstatement if the accounting principles are not followed.
Consequently, each company should develop the ability to determine which items are material relative to its operations and then engage enough employee cost to ensure adherence to accounting principles for those items. The company’s characteristics, the prevailing economic and political environment, and the role of the reviewer of the financial statements may each impact the materiality judgments. However, if the cost of adherence to the accounting principles seems to exceed the foreseen benefit of doing it, then a company might do away with the principles.
Abuse of Materiality concept in Accounting
Any practice of abuse of the materiality concept in accounting can result in serious legal consequences. However, both GAAP and FASB have been reluctant to state any precise range for error size that may qualify as a materiality abuse. In most of the cases, the auditors and the courts take the help of “rules of thumb” to review cases associated with materiality abuse. Nevertheless, the reviewers who judge such materiality abuse cases must also take into consideration some other factors besides error magnitude. Two such factors can be the motivation and intent behind the error and the likely effect on user perception and judgment.
This has been a guide to Materiality Concept and its definition. Here we discuss the materiality concept as per GAAP and FASB with a simple Example. You can learn more about from the following articles –