Introduction to Materiality Concept
The materiality concept is a concept of accounting where the transaction or item that has significant effect on the business financial position i.e., having a major impact on the profitability and existence of the business are needed to be reported in the financial statements of the business so that the users of the financial information or the business investors can know about the occurrence of that business transaction.
The materiality concept is to be followed by each business organization as it states that all the material business transaction should come into the knowledge of investors before making any business decision. Material items are those items whose non-consideration may mislead the investors about the profitability of the business. The transaction or item that has little or low effect on the decision of the investors are not needed to be disclosed.
The impact of the transaction depends upon the size of the business and the amount of transaction. The same transaction can be significant for one business and meaningless for the other. For a large business, a cost can be immaterial but the same cost can be significant for small business. The items disclosed should be in such a manner that is understandable by the users that include investors, auditors, shareholders, lenders, etc. of the business.
The thumb rule related to the judgment of materiality of the financial statements is as follows:
- If an omission or error in the Balance sheet item is greater than or equal to 0.5% of total assets of the business or greater than or equal to1% of total equity then such omission or error is material.
- If an omission or error in the Income statement is greater than or equal to 0.5% of profit before taxes of the business or greater than or equal to 0.5% of total sales revenue then such omission or error is material.
Examples of Materiality Concept
Examples are given below:
- Suppose there is a company named ABC incorporation which deals with mobile phones. The company has an inventory worth $10,000. One day due to some technical issues in the company fire broke out which resulted in the loss of inventory amounted to $100. The insurance claim received by the company for such inventory was $80. So, the overall loss was of $20. Now at the end of the financial year, the company booked a profit of $200. Now the loss of $20 is significant as it is around 10% of the net income. So this item has to be shown separately in the books of accounts of the company
Now if in the above example the net income of the company would be $30,000 then the same amount of $20 would be insignificant as it has a very low impact on the profitability of the business. Therefore separate disclosure of such transaction is not required.
- Now a company that has the business of manufacturing of cameras purchased machinery worth $50,000. The annual revenue of the business is around $200,000. This purchase of machinery of $50,000 is a significant item as the purchase amount is 25% of the total revenue amount. Therefore, separate disclosure of such purchase of machinery is required to be disclosed.
But the repairs in the building years later worth $200 is not required to be disclosed separately because that amount doesn’t have any impact on the financial decision of the business.
Abuse of Materiality Concept
The abuse of materiality concept is the unnecessary disadvantage taken by the companies to show more strong financial positions of the business that it actually is or sometimes the companies hide the information give excuses later on that the amount was very insignificant that’s why they had not disclosed the required transaction. The abuse of materiality concept can cause a business to have intense legal consequences that are based on the intention behind the error and the impact that such error can have on the investor’s judgment. The auditors, as well as the law courts, consider ‘rules of thumb’ to analyze the cases that are related to the abuse of materiality concept.
Why is it Important?
The main reason and importance of the materiality concept are to keep a check that companies do not hide crucial information from the investors, lenders, and other regulators of the business. It develops faith for the business among the users. The materiality is also important for the auditors as it is the responsibility of auditors to see whether the financial statements are free from material misstatements or not.
Advantages and Disadvantages of Materiality Concept
Below are the advantages and disadvantages:
The advantages are as follows:
- The concept of materiality helps the users to know about the important business transactions. Since the investors’ and shareholders’ money is invested in the business so they have the right to know the significant matters so that they remain ensured that their money is in safe hands.
- The materiality concept provides the context for establishing auditors’ judgment. The auditors are required to publish the report stating the true and fair picture of the financial statement of the business. So with the help of material information, it will be easier for an auditor to frame an unbiased opinion.
- It reduces the need of recording every business transaction since only the material ones require full disclosures.
The disadvantages are as follows:
- There can be errors in judgment. Since the item can be material for a person and can be immaterial for another so forming judgments can be difficult.
- Sometimes there is a need to hire professional for deciding whether the transaction is material and immaterial and that can be expensive for the small business.
- The disclosures of material transactions are sometimes cumbersome and time-consuming.
Thus, the concept of materiality is the principle that requires a business to disclose every material transaction in the books of accounts of the entity. The item is material an immaterial is purely based on the judgment of management which is based on the cost and nature of the transaction. The transaction can be financial or non-financial but has a significant impact on the decision making of the users. There are also legal consequences if the business fails to follow the materiality concept.
This is a guide to Materiality Concept. Here we also discuss the introduction to materiality concept along with examples, advantages and disadvantages. You may also have a look at the following articles to learn more –
- What are Accounting Principles?
- Generally Accepted Accounting Principles
- Conservatism Principle of Accounting
- Accounting Transaction