Definition of Materiality
Materiality is one of the most important concepts in accounting. It is simply a measure of the impact of any financial misstatement on the decision-making ability of the given user. In this regard, it is important to note the fact that materiality is not a single ballpark figure.
In fact, it is a subjective estimate that varies from organization to organization depending on the volume of transactions that a given organization deals with.
It is important to consider materiality, primarily because of the fact that it can directly impact the decision-making ability of the end-user. Therefore, this threshold needs to be kept in mind, by both, the accountants, as well as auditors.
Materiality in accounting can be broadly categorized into two different categories of financial transactions:
- Material Misstatement: This refers to transactions that are significantly misstated such that they can influence the decision-making capability of the end user of the financial statements.
- Immaterial (or non-material misstatement): This refers to the transactions that are not significantly misstated, and hence, they are not in a position to impact the decision-making ability of the final user of the financial statements.
Explanation of Materiality
Materiality, as mentioned earlier is a subjective measure of transactions to determine if they can potentially impact the financial statements or not. But the question is, why does materiality tend to be so important from the perspective of the organization, and overall stakeholders?
In a lot of instances, accountants tend to brush aside some important transactions, under the umbrella of materiality. In this regard, it is important to consider the fact that this tends to falsify financial statements since the financial position of the company tends to be exaggerated if materiality-related metrics are not duly met.
Therefore, extra care and precaution are supposed to be factored in when making decisions regarding materiality, since it can have detrimental repercussions on the accuracy of the financial statements, if not recorded.
On the flip side, there is also a need to ensure that immaterial transactions are actually pointed out, and duly left behind in a normal course of the business. During the general functioning of businesses, there are a plethora of transactions that need to be accounted for by businesses.
Doing all these transactions in a single manner is not only extremely time-consuming but also counter-productive. It marginally reduces the efficiency of the accounting process in place.
Therefore, there is a need for accountants (as well as auditors) to subjectively, and accurately gauge materiality in the organization. There are several different factors that need to be considered when considering materiality and defining materiality-related thresholds. These factors are as follows:
- Size and volume of transactions: For some companies, a Capital Expenditure of $1,000 might not be significant. However, for other companies with a smaller transaction, this amount might be classified as material.
- Industry Averages and Trends: For some industries and lines of work, capitalization costs tend to be highly important. Examples include oil and gas companies, as well as telecommunication companies. For other manufacturing concerns, capital costs might not be very significant. Therefore, industry standards present a proper stencil in order to ensure that best possible results are obtained in order to gauge the respective thresholds.
- Past History and consistency: Across years of operations, materiality threshold is unlikely to change in a company. It is important to consider the fact that materiality is supposed to stay consistent from year to year. If a company regards one particular transaction (or type of transaction) as material one year, they cannot randomly classify it as immaterial in the next year.
Materiality Concept in Accounting – Fundamental Uses
Materiality Concept is used in accounting on a number of grounds, specifically the following instances:
- Application of accounting standards: Accounting standards need to be catered in when it comes to application of accounting standards. Materiality should be factored in at all points of financial statement creation, because it can directly impact the overall outlook of the financial statement.
- Minor or insignificant transactions: For transactions that are not very significant, and that do not really have a substantial impact, accountants can choose to ignore those transactions, only if they are certain that leaving them out will have no impact on the financial statements.
- Capitalization Limits: A company that has concurrent expenses pertaining to Non-Current Assets, that are insignificant in nature, does not necessarily need to capitalize them on a regular basis. In fact, they can continue to expense them in the Income Statement, since the impact on the financial statements is going to be negligible.
The main premise and rationality of materiality in accounting tend to be directed towards ensuring that accounting standards and other protocols are ignored only to an extent where they do not impersonate the financial statements, or make them fabricated.
If ignoring accounting standards for the purpose of materiality tends to increase the efficiency of the accounting process, then those standards can be overlooked.
It must be reinstated that there is no line that separates materiality from immateriality. It is fairly subjective, and there are no stringent rules as to what classifies as material or immaterial from the perspective of the organization.
Hence, this is something that depends from business to business, as well as the propensity of the given transaction to impact the financial statement as a whole.
Examples of Materiality
Materiality and its application are highly contextual based on a number of grounds. However, here are a few examples of materiality, and how they come into play during the normal course of business.
- The accountant and Mayfair Co. was internally auditing the financial statements. During the audit process, they came across an error in the financial statement. Fixing that error would reduce the net profit by $300. Currently, the Profit declared on the Income Statement was $250,000. The accountant chose not to correct this error, because it would have required introspective application, and changing this transaction was unlikely to impact the decision-making ability of the end-user of financial statements.
- After the financial statements were issued, the accountant of Teddy Inc. found out that he had not recorded sales returns equivalent to $9,000. The total revenue declared on the balance sheet was equivalent to $21,000. He then retracted the financial statements, and then corrected it so that the financial statements represent true and fair view of the financial statements. Regardless of the fact that the net impact of this transaction was zero (since inventory was added back, and declared as ending inventory), yet it was important to remedy this error in the financial statements since it changed the position of Current Assets, as well as Revenue earned by the company over the year.
In the examples given above, both, instances of material misstatement, as well as immaterial misstatement are illustrated.
As far as Mayfair Co. is concerned, the transaction was immaterial for them, and hence, the accountant chose to ignore this transaction altogether. On the other hand, as far as Teddy Inc. is concerned, the accountant chose to fix the financial statements, since the misstatement was regarded as material keeping in mind the organizational context in this aspect.
This implies that materiality differs from organization to organization, depending on the transaction involved, and the overall ability of the transaction to influence the decision of the respective stakeholder.