Materiality Principle in Accounting: Definition | Explanation | Example

Overview

Materiality Principle or materiality concept is the accounting principle that concern about the relevance of information, and the size and nature of transactions that report in the financial statements.

The main objective of the materiality principle is to provide guidance for the accountant to prepare the entity’s financial statements.

And the most important thing is to make sure that information using by shareholders and investors is sufficient enough for them in making the correct decision.

The information, size, and nature of transactions are considered material if the omission or error of it could potentially lead to the decision of users of financial information.

The materiality concept is not only used by the accountant as the basis to prepare the entity’s financial statements but also used by auditors to assess the correctness of financial statements’ disclosure and use in their audit testing.

Normally, the auditor determines what is the performance materiality and what is the tolerable error for their testing.

There are some differences from one accounting standard to another accounting standard. For example, in IFRS, information is material if the omission could lead to misleading in decision making.

And the filter of materiality hand to management for decision making. IFRS is a kind of principle base accounting standard. Therefore, many shareholders and investors find it difficult in dealing with materiality.

In US GAAP, for example, items should be separately disclosed in the financial statements if they have value over 5% of total assets. This is also the same the security and exchange in the US and it is used to apply to the items in the balance sheet.

But, for items in income statements, items that could affect the net income from positive to negative are also considered as material items even they are small.

Basically, materiality applies in US GAAP sound easy and helpful for shareholders and investors that IFRS. Because in US GAAP if the transaction meets the requirement, then the accountant must be complying with it.

But in IFRS, the accountant still could disclose the transactions with others even the value is high enough to disclose alone. If they could interpret that it will not misleading.

In general, in the materiality principle, the size, information, and nature of the transaction are considering as materiality is different from one entity to another entity. The difference is mainly because of the size of the entity.

Conclusion:

The materiality Principle is not only protected the shareholder’s and investors’ interest but also help to account for preparing its Financial Statements.

Base on this principle, the account could know what is material and what is immaterial. They also know what should be separately disclosed and what should be included with other transactions.

In case you want to discover more about the accounting principle, this book is recommended for you: Accounting Principles
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Written by Sinra

Full Disclosure Principle: Definition | Example | Checklist

Definition:

Full Disclosure Principle is the accounting principle that requires an entity to disclose all necessary information in its financial statements and other related signification.

This is to ensure that the users of financial information are not misled by the lack of information. The idea behind the Full Disclosure Principle is that management might try not to disclose any information that could impair the entity’s financial statements as well as its reputation as a whole.

In doing so, the financial statements still look good and healthy so that all of the stakeholders still happy about the company.

full-disclosure-principle

Full Disclosure Principle requires the entity to disclose both, Financial Related Information and No Financial Information Related to the company.

This kind of non-financial information including major changed in the business, contracts, related parties transactions, and any other significant information.

Example of Full Disclosure:

The entity might lose large contracts with its customers to its competitor. And the subsequent loss of contract could turn the entity into bankruptcy. In such a case, management probably doesn’t want outsiders, especially investors to know the real situation of an entity.

And base on the Full Disclosure Principle, the entity is required to disclose such a situation in its financial statements.

Another example is related to the full disclosure of contingency. It can be contingent assets or contingent liabilities. For example, the company is facing the lawsuit as the result of disposing poison material into the water and it going to be a large penalty.

Based on the Full Disclosure Principle, the entity required to fully disclose this information in its Financial Statements. Once the users of Financial Statements noted this information, they will understand what are the current contingent liabilities of the entity.

Related: Best know Accounting Principle

But, how do we know if the entity complies with the Full Disclosure Principle?

Well, basically, to ensure that whether the entity complies with the Full Disclosure Principle or not, the entity should go to the standard that they are following. Remember, Full Disclosure is just the principle to help entity especially accountant in prepare and present financial statements.

In practice, you are highly recommended to see the specific requirement of each accounting standard. For example, in IFRS, each standard has the requirement of disclosing accounting transactions or even that entity deal with and do so US GAAP.

Different accounting standard has different requirement of disclosure. IFRS is the kind of principle base and the requirement still based on the judgment of the practitioner. However, US GAAP is the role base where the disclosures are the must.

If your Financial Statements us IFRS, IAS 1 Presentation of Financial Statement should be applied. Here is the general disclosure that the financial statements of an entity are required to have.

Full Disclosure Principle Check List:

  • Full Financial Statements. Generally, Statement of Financial Position, Income Statements, Statement of Change in Equity, Statements of Cash Flow and Noted to Financial Statements
  • Significant Accounting Policies: State the basis and accounting policies of each significant accounting policies. For example, Revenue Recognition, Depreciation, Asset Measurement and Recognition…etc
  • Accounting Standard use to prepare financial statements. For example, IFRS, US GAAP or other local GAAP.
  • Nature of business
  • The significant event happens in the business
  • Going Concern Assumption
  • Changes in accounting estimates

Full Disclosure Principle simply mean disclose all information that requires by an accounting standard, and the best way to check this is going to the specific standard.

Related book: Accounting Principles
This book is punished by three co-authors and by Jerry J. Weygandt,  Paul D. Kimmel, and Donald E. Kieso (Author) and written review by 176 customers.

By Sinra

Consistency Principle (Definition and Example)

Definition:

Consistency principle is the accounting principle that requires an entity to apply the same accounting methods, policies, and standards for preparing and reporting its financial statements.

The main objective of the consistency principle is to avoid any intention from management using an inconsistency approach to manipulate the financial information to ensure their financial statements look healthy.

And sometime, management could use the inconstancy principle on the same accounting transactions or accounting even in their financial records. It is the hug risk to the user of financial statements if they are not fairly present.

IFRS also requires the entity to apply the same accounting policies in reporting its financial statements. In case there is any change in accounting policies and estimates, IAS 8 should be used.

In addition, this concept, consistency principle, also quite important for users of financial statements, investors, and shareholders.

As long as the financial statements are consistently use accounting policies and principles, the financial statements will be more accurate and reliable.

The correctness of decision making highly depends on the accuracy of financial information.

Why is the accounting principle inconsistency?

There are many cases that caused the entity to apply inconsistency accounting principles or policies. For example, there is a requirement to change accounting policies by the standard setter.

There is a requirement from the regulator of those jurisdictions and also the requirement from the entity itself.

All of these things cause the entity to apply the inconsistency principle. And the solution is the find the guideline on how to deal with it.

Different accounting standards probably use different guidelines. For example, if the financial statements use IFRS. The Consistency Principle that you should follow is IAS 8.

Example of the consistency principle:

For example,

Company A’s Financial Statements report base on IFRS. Its accounting policies for depreciation is using a straight-line basis. In 2014 and 2015, it uses a straight line.

But, the company subsequently wants to change its accounting policies from a straight line to a declining balance.

In this case, the entity should apply with IAS 8 whether it is the retrospective or prospective change. All of the change requires full disclosure in the financial statements and how the change affected. This is how we apply the Consistency Principle.

Sometimes, management’s performance is based on Net Sales or Net Profit and the way how management not complying the Consistency Principle in their Financial Statements also based on this.

For example, if the performance is base on Net Sales, management might not recognize revenues by using the same accounting policies.

And if management performance is base on Net Profit, management might play around with operating expenses to ensure that net profit looks favorable. For example, through depreciation, accrual and other expenses.

If you have any comments related to the Consistency Principle, please drop it here or create a new topic in our forum.

Written by Sinra

Conservatism Principle: Definition | Example | Explanation

Definition:

Conservatism principle is the accounting principle that concern about the reliability of Financial Statements of an entity. The conservatism principle provides guidance to accountants on how to records and recognizes the uncertainty outcome of revenues, expenses, assets, and liabilities in financial statements.

This principle also intends to ensure that the users who use financial statements receive enough and reliable information as they should be.

Under the conservatism principle, assets and revenue could be recorded or recognize unless it is clear that the entity could measure those transactions reliably. In addition, the expenses and liabilities are records at the highest value where assets and revenues are records at the lowest value.

This principle could help to minimize the entity to overstate the revenue and assets and understate the liabilities and expenses in its financial statements.

For example, without using this concept, the accountant could manipulate the accounting records where those transactions are not reliable.

Then, the financial statements result unreliable. Subsequently, there is an effect on the users of Financial Statements.

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In real life, smart CFO and CEO might play some tricks on how to ensure that Financial Statements of the company look healthy while the reality doesn’t.

Over recognition of revenues and assets, and negligently relay to recognize liabilities are the basic place to start.

Example of Conservatism Principle:

For example, the entity should recognize the liabilities that claim to the employee for the legal case even the entity not sure if they are failing. And the recognition should be at the highest value.

But, the entity should recognize assets for legal claims from an employee unless there is a clear statement from the court.

And if assets are recognized, it should be at the lowest value. In this case, it is helping users of FS to understand all types of liabilities and expenses that probably happen to the entity. And, it assures that the revenues recorded are realistic.

Conservatism principle assumes the entity could possibly try to overstate assets and revenues, and understate expenses and liabilities.

For recognition revenue, conservatism principle, the entity could recognize the revenue if the revenue transaction could not measure reliably and the outcome of those transactions are unpredictable.

Conclusion:

This concept seems difficult, but it is quite straight forward. Here is the summary of principle:

  • Assets and Revenue are recognized at the lowest value and unless we can measure it is reliably
  • Expenses and Liabilities as soon as possible when there is uncertainty

In case, you found Conservatism Principle difficult. I give you one statement and hope it helps.

The same to in real life, you recognize bad news first, and for goods news, wait until it come true.

Feel free to leave a comment here.

Written by Sinra

Business Entity Concept or Principle: Definition | Example | Explanation

The business entity concept or business entity principle considers the owner of an entity has different legal liabilities from the entity’s obligations.

Under this concept, the entity must records all transactions separately from that transaction that belongs to its owner. If it is recording, the substance of the transactions or balance should clearly be defined.

For example, the owner of an entity withdraws money from the entity for use in personnel matters. In such a situation, the accounting record must clearly state these transactions in the entity’s financial statements.

Income that personally earns by the owner should also record separately from the income that generates by the entity.

From the accounting point of view, using a business entity concept, owner assets, liabilities, income and expenses as well as equity are considered separately from his/her entity. For example, if the owner of the entity borrows money from the bank.

The debt belongs to the owner, not the entity. And, if the entity borrows money or purchase goods on credit, then the debt is belonging to the entity. Not the owner.

Tax Responsibilities:

There are many reasons why financial statements should be prepared base on the Business Entity Concept. From the tax perspective, the owner and entity have different tax rights and responsibilities.

The entity is not responsible for paying the tax instead of its owner, and the owner is also not bear any responsibilities for its entity.

Well, sometimes it also depends on the type of entity that it is registered in. Partnership, limited liabilities, or else. But, in general, the owner and entities have different tax liabilities.

Because of these different liabilities, accounting information must be separately recorded, taxes are separately submitted.

They have different legal responsibilities. The owner owns the bank if they borrow, not the entity. If the money is not paid back, bank sue owner, not entity

Legal Responsibilities:

When the company liquidates, creditors, bankers, and other parties could have the right to enforce the company to pay the debt. But they can’t enforce the owner to pay the debt on behalf of the entity.

Again, this also depends on the type of regal entity that the company register in and how it is interpreted according to the local law.

In general, the owner and entity have different legal liabilities and having separate records of assets and liabilities are required by most of the local law as well as accounting standard.

The benefit is when there are legal or financial problems with both the entity or its owner.

Importance:

The business entity concept is one of the account principles that are really important to the stakeholders and the key users of financial statements.

For example, by taking this principle into account when analyzing and recording financial statements, the users could assure that the information contains in the statements was related only to the business. They are not mixed up with the owners of the company.

Or if the transactions between owners and the entity have occurred, then the treatments were transparently taken between owner and entity.

It is also really important for banks and other lenders when the entity submits the financial statements to the banks or lenders as part of the loan’s requirement and the bank/lender could use the information to assess the entity’s financial position and performance confidently.

Banks/lenders could assure that financial information is only related to the entity’s business.

Sinra

13 Top Accounting Principles ( Books, Definition, and Examples)

Definition:

Accounting principles are the principle, concept, basic, guidance, as well as the rule that use by the accountant to prepare the financial statements of an entity. They are also used by the standard-setting body to develop accounting standards and frameworks.

You may find out some of the accounting principles have been set out in the qualitative and quantitative characterization of information in IFRS.

Most of the accounting principles are also set in the accounting standard and well as frameworks. Even those accounting standards (local GAAP) vary from one country to another, but the principles that set out in the standards are in the same fashion.

For example, GAAP or IFRS is different in many areas but the principles that use in those standards are very much the same.

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Even the accounting principles in one financial reporting standard to another is not much different, most investors still not get comfort when the investments are moved to the country where different accounting standards are required.

Yet, in the near future, IFRS will replace the local GAAP and be the world accepted accounting standard. In this article, we will explain the detail of most of the accounting principles that use to prepare financial statements:

List of accounting principles:

1) Accrual Principle:

Accrual accounting concept has required the revenues and expenses to be recorded and recognized in the entity’s financial statements when they are incurred rather than when cash is paid or received.

This principle helps the users of financial statements to get the financial information that really reflected in the current financial status or the economic situation of the entity.

The recognition is not only related to the cash flow like a cash basis where the revenues are recorded and recognized in the financial statements only when the cash is collected from the customers for the services or products that entity sells to them.

And the expenses are recordings and recognized in the financial statements when the cash is an outflow from the entity.

For example, based on accrual accounting principle, sales revenues from selling of cloths are recognized where the right and obligation are transferred from seller to buyer even the seller does not receive the payments from buyer.

Records and recognize the sales based on the accrual basis, the users could see all of the sales that entity make during the period for both credit sales and cash sales. It provides a complete picture of sales during the period.

Another example related to accrued expenses is that the maintenance expenses are recognizing at the time that services consume by entity rather than at the time that the entity paid to suppliers.

This recognition will bring the complete picture to the users of financial statements about how much the maintenance expenses incurred during the period rather than just showing how much the payments are made for maintenance expenses during the period as per cash basis.

2) Conservatism principle:

Conservatism principle concern about the reliability of Financial Statements of an entity for the benefit of users especially in the areas of overstating the revenue and assets as well as understating the liabilities and expenses.

This accounting principle requires the entity to record and recognize the liabilities and expenses in the financial statements as soon as possible when there is uncertainty about the outcome.

And the entity should not recognize assets or revenue in the financial statements if the outcome is not certain. If it does, the revenues might be overstated and lead users to make the wrong economic decision.

For example, the entity should recognize the expenses immediately in the financial statements if there is the probability that an entity might lose the lawsuit to its customers.

This is to ensure that the liabilities are recognized in the financial statements and it is actually reflecting the current financial situation of the entity that it probably makes a loss.

If these expenses are material to financial statement and they are not recording, then the potential investors who make their decision make their decision based on the financial statements that off these expenses could potentially make loses.

The entity might come to the situation where it is probably of winning the lawsuit. In this case, and base on this principle, the entity should not recognize the possible revenue from this lawsuit.

In addition, the entity might also come to the situation where inventories or fixed assets that entity just purchased last month could be purchase now by spending less money.

In this case, the entity should consider writing off the portion that different into expenses so that assets could be present at the realizable value.

3) Consistency principle:

Consistency Principle is the accounting principle that requires the entity to apply the same accounting method, policies, and standard for reporting its financial statements.

There are many benefits for the stakeholders of financial statements when the consistency principle is correctly and strictly applied.

For example, if different accounting policies or methods are used to measure and recognize the revenues then there will a significant different revenue amount present in the income statement while there could be slightly differenced if the same accounting policies or methods of measurement and recognition are used.

For example, depreciation rate and methods should be applying consistently from one accounting period to period to the same fixed assets. If there is any change in accounting policies, the appropriate standard should be applying.

Normally, if your financial statements are prepared and present by accounting IFRS, then IAS 8 change in accounting policies, is the standard that you should look for.

This standard guides you on how to deal with such a case that you want to change the accounting policies or accounting estimate.

Another example is that your entity is current using FIFO to value your inventories and this method should be used to value your inventories not only in this period but also in the next period. This is also assumed your entity should FIFO was used to value previous inventories.

4) Cost Principle or Historical Cost Principle:

The concept of historical cost principle is that the assets should be recorded base on the price at the time they are purchased.

And the liabilities should be recorded based on the values that expected to pay at the original value rather than market value or inflation-adjusted value.

The historical cost principle is also called the cost principle. To avoid incorrect recognition and measurement, it is recommended that the accountant should follow the accounting standards that they are using to prepare the financial statements.

For example, you are using IFRS to prepare your financial statements, then you should go to each standard under IFRS that is applicable for the items you are dealing with. For example, the recognition of PPE is initially measured at costs and subsequently, the entity could use costs module or revaluation module to measure.

However, some financial assets and financial liabilities are not applicable to use this principle. The cost principle is a benefit to accountant and other related stakeholders who use the financial statements since the financial transactions are records at the identify costs and verifiable evidence. For example, the costs of fixed assets could be verified with the suppliers’ purchase invoices.

5) Economic Entity Principle:

Business Entity Concept or Business Entity Principle considers the owner of an entity has different legal liabilities. Under this concept, the entity must record all transactions separately from its owner or owners and other business.

This means that the transactions that record in the entity accounts are only those transactions that belong to the entity.

Any financial transactions, assets, liabilities, and equities that belong to owner, owners or other entity should not include in entity accounts.

Example, Sinra shop sell the cake in Bangkok, Thailand. Sinra takes two take-ups for his wife’s birthday. In this case, we need to identify who is the owner and what is the entity. And what transactions happening between Sinra and the entity.

So, Sinra is the owner and Sinra Shop is the entity. Sinra withdraws the cases for this wife. Therefore, by using the business entity concept, the accounting records for the shop is recording decreasing for stoke and increasing owner withdrawal. Or maybe treat as sell to normal customers.

This principle could help to minimize conflict between owners in case there are many owners of the entity. And it also prevents the owner to avoid tax obligation to the government.

It also benefits to owners or shareholders to assess the performance of each entity separately and well as to assess the financial position of the entity.

6) Full Disclosure Principle:

Full Disclosure Principle requires the entity to disclose all necessary information in its financial statements. The main idea behind this principle is that the users of financial statements of entity might depend on the financial information disclosed in the financial statements to make their decision.

Therefore, it is important to make sure that all the information that they should know are available to them.

This is why this principle is introduced to ensure that information that should be disclosed in the entity’s financial statements as per the requirement of accounting standards or frameworks had been disclosed.

In practice, you might follow each accounting standard whether the situation that happens in your entity should be disclosed or not as per standard.

The information to be disclosed is only the financial information but also non-financial information such as new law and regulation that come into effect soon and the entity’s business might get hurt from that law and regulation. The subsequent adversely affect the revenues or the going concern of the entity.

For example, the government of the country where the entity run its business just amount that numbers of the tax rate will increase and it will come to effect next year. Entity’s business and specifically profits will get hurt.

Going concern of entity is questionable. This case, based on full disclosure principle, this revision and how it is affected the entity should be fully disclosed in the entity’s financial statements.

7) Going Concern Principle:

Going concern is the concept that assumes entity will remain the business in the foreseeable period which is normally twelve months from the operating date. If the financial statements are prepared based on the going concern basis.

In others words, the entity does not face going concern problem, then the users of financial statements could their reliance on entity’s financial information that they are valued by considering the entity could survive in the period of twelve months.

There are many factors that indicate entity might face going concern problem. Or entity might stop it business in the period of twelve months from the reporting date of financial statements.

For examples, the entity’s main services or products are no longer need in the markets and sales dramatically drop also most to zero. This situation indicates that an entity probably liquidates its assets to support its operation in the period of less than twelve months.

And, we could say that it will go into solvency in a period of fewer than twelve months. In this case, the financial statements should not prepare by using the going concern problem. For example, there is no accrual of expenses recognize in both balance sheet and income statement. Prepayments should not also recognize.

The entity should conduct going concern assessment annually to see if it is in the going concern problems. The assessment should not only focus on financial factors but also non-financial factors that might affect the entity to shut down its business.

8) Matching principle:

Matching Principle is the accounting principle that uses to records and recognizes expenses and revenues in the financial statements.

This principle wants to make sure that the incomes and expenses in the income statement really reflected in the period that they actually incurred.

When this principle is correctly applied, net income is truly and fairly present in the income statement. It is not the result of overstatement or understatement of revenues or expenses.

For example, when the entity sells goods to its customers, the entity will generate revenues and at the same time, the entity also has to spend its finish goods to its customers.

In this case, sales revenues are recognized in the income statement and the cost of goods sold is also recognized in the same period. Revenues are matched with cost of goods sold in the income statement.

If either revenue or costs of goods sold are deferred to the next period because of whatever reason, then net income will not arrive as it should be. Then the users’ decision could when wrong if it is depending on this information.

The entity might come into the situation where customers pay for the goods they have not received. In this case, the entity could not recognize the payments that they received from customers as revenue. This is because goods are not delivered to customers yet.

The entity should recognize the payment received from customers as unearned revenues under liabilities accounts.

Subsequently, the entity delivers the goods to customers then the entity could move from unearned revenues to revenues in the income statement. At the same time, the costs of goods sold are also recognized.

9) Materiality principle:

Materiality Principle or materiality concept is the accounting principle that concern about the relevance of information, and the size and nature of transactions that report in the financial statements.

Based on this concept, financial information is material if its omission and addition could be misleading the users’ decision. The same size and nature of financial information might material to one entity’s financial statements but might not material to another.

For example, the wrong recognition of revenues amount USD 50k of ABC is not material if we compare to its total revenues USD 500,000K. However, 50K is material to financial statements of DEF and especially it could be misleading to the users’ decision if it is over or under recognize when the total revenues are just USD 100K.

This principle is not only used by the accountant to prepare the financial statements as the basis to decide the financial transaction and event that is material to financial statements, but it is also used by the auditor as to calculate the tolerable error, performance materiality as well as planning materiality.

These materiality use as the matrix or tools for auditors to decide if unadjusted transactions or amounts are material to financial statements. This unadjusted transactions or amounts is part of auditors’ evident to support their opinions.

10) Monetary unit principle:

Monetary Unit Assumption is the accounting principle that concern about the valuation of transactions and event that entity records in its financial statements. In monetary unit assumption, transactions or even could records in the Financial Statements only if they could measure in the monetary.

There are many transactions that occur in and by entity every day. Not all of those transactions are recording in the financial statements. For example, sales staff got accident and the entity pay for the costs of accident and hospital.

The entity could record these costs in the income statement but the entity could not record the costs that sales staff’s performance becomes low as the result of an accident.

Entity’s financial transactions and events use a monetary unit to records in the financial statements due to many reasons. Some of those including:

  • Simple and easy to use. Money is very simple to use and easy to understand therefore it is easy to use to records business transactions. It is easy to understand by users.
  • Universally recognized and communicated. Money is generally and globally used in a normal business transaction.
  • The monetary unit that is used to records the financial statements should be stable like USD currency. The currency that is not stable is not applicable for use as a unit to record financial statements.
  • The entity uses a monetary unit to record financial transactions and events The value of assets that record in the financial statements is changed due to inflation.

11) Reliability principle:

Reliability Principle is the accounting principle that concern about the reliability of financial information that presents in the financial statements of an entity. This accounting concept is quite an importance for the users of financial information. If the information is not reliable, then the decision making will be unlikely correct.

12) Revenue Recognition Principle:

There are many principles that use to recognize revenue in the Financial Statements. For example, Accrual Basis or Cash Basis. In accrual accounting Principle, Revenue should be recognized when risks and rewards are transferred.

Here is the detail of Revenue Recognition Principle

13) Time period principle:

Time Period Principle or Periodicity Principle, Financial Statements of an entity could be prepared in an artificial period of time. They are no need to be prepared based on the regulatory requirement.

Here is the detail of the Time Period Principle or Periodicity Principle

Written by Sinra