Materiality Concept

Some transactions are too small to be recognized in any financial accounting statement. Such transactions might not impact the analysis of the financial statement by an external observer; the removal of such irrelevant information to keep the financial statement crisp and consolidated is called the materiality concept accounting.

It is to be understood that materiality is a subjective concept that guides a company to identify and disclose only those transactions that are sufficiently large compared to the company's operations such that it would concern the users of the company's financial statements. Therefore, they are always cross-checked with respect to GAAP or FASB guidelines.

The materiality concept refers to a situation where the financial information of a company is considered 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 company's financial statements. The materiality concept in accounting is also known as materiality constraint.

The materiality concept accounting is 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 comparing companies that vary in size, i.e., a large company vis-à-vis a small company. A similar cost may be considered a large and material expense for a small company, but the same may be small and immaterial for a large company because of its large size and revenue.

The financial statement users mentioned here can be auditors, shareholders, investors, etc. 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, the company does not need to worry about including it in financial statements.

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.”

Let us understand the materiality concept accounting in accordance with Generally Accepted Accounting Principles (GAAP) and the Financial Accounting Standards Board (FASB) through the detailed explanation below.

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.”

Now that we understand the basics and its relevance with GAAP and FASB of materiality concept audit, let us apply the theoretical knowledge to practical application through the examples below.

Example #1

Let us take the example of a large company with 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:

• Company A which is large and generates a net income of $40,000,000
• 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. 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.

Example #2

In March 2022, the SEC presented their climate disclosure proposal. This proposal sparked a series of debates if the regulatory body has the authority to ask corporations to disclose their carbon footprints.

The foremost question people raised was related to its applicability to making financial decisions. However, experts gave a different perspective; they brought in double materiality, which the European regulators popularized for double-checking parameters relating to Environment, Social, and Governance issues.

The materiality concept accounting 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 financial statements reviewer may 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.

Any abuse of the materiality concept in accounting can result in serious legal consequences. In most cases, the auditors and the courts take the help of "rules of thumb" to review cases associated with materiality abuse.

However, both GAAP and FASB have been reluctant to state any precise range for error size that may qualify as materiality abuse. Nevertheless, the reviewers who judge such materiality abuse cases must also consider 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.

Let us understand the importance of materiality concept audit through the points below.

• Materiality is a fundamental concept in finance that helps individuals, businesses, and investors make informed decisions. It ensures that only significant financial information is disclosed, preventing information overload.
• Materiality guides financial reporting by requiring companies to focus on disclosing information that has a substantial impact on their financial statements. This, in turn, enhances transparency and trust in financial markets.
• Materiality is a cornerstone of accounting standards and regulations. It assists companies in complying with reporting requirements, preventing unnecessary reporting of immaterial details.
• Investors rely on financial statements to assess the health and performance of companies. Materiality ensures that financial reports provide a clear picture of a company's financial position, fostering investor confidence.
• For businesses, the concept of materiality helps in allocating resources efficiently. It allows companies to prioritize and address significant financial issues promptly while avoiding unnecessary administrative burdens.
• Material misstatements in financial reporting can have legal consequences. Understanding materiality is crucial for avoiding legal issues related to financial fraud or misrepresentation.

Like any other concept or phenomenon, the materiality concept accounting also has two sides of the coin. Let us discuss both of them through the advantages and disadvantages below.

Advantages

• Materiality ensures that financial reporting concentrates on the most relevant and impactful information, making financial statements more concise and informative.
• It helps users of financial information, including investors and analysts, in making well-informed decisions by filtering out immaterial data that may distract from key insights.
• By reducing the reporting burden of including insignificant details, materiality concept saves companies time and resources in preparing financial statements and disclosures.
• It aligns with accounting standards and regulatory requirements, promoting compliance and consistency in financial reporting.
• Materiality aids in presenting a clearer picture of a company's financial health, increasing transparency and accountability.

Disadvantages

• Determining what is material can be subjective, leading to potential discrepancies and disagreements, especially in cases with borderline significance.
• Strict adherence to materiality may result in the omission of seemingly minor but cumulatively significant information, potentially impacting stakeholders' decisions.
• Companies may exploit materiality to downplay certain negative aspects, potentially misleading stakeholders.
• Different stakeholders may interpret materiality differently, leading to varying expectations about the level of disclosure.
• Misjudging materiality could lead to legal repercussions, as regulators and shareholders may challenge companies for not disclosing what they consider material.

This has been a guide to Materiality Concept and its definition. Here we explain the concept as per GAAP and FASB, examples, importance, and advantages. You can learn more about it from the following articles –

• Audit Materiality
• Prudence Concept in Accounting
• What is Conservatism Principle of Accounting?
• Matching Principle of Accounting