Updated July 20, 2023
Introduction to Materiality Concept
The materiality concept is a concept of accounting where the transaction or item that has a significant effect on the business’s financial position, i.e., having a major impact on the profitability and existence of the business, needs 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.
Explanation
Each business organization should follow the materiality concept, which states that all material business transactions should be disclosed to investors before making any business decision. Material items are those whose non-consideration may mislead the investors about the business’s profitability. The transaction or item that has little or no effect on the investors’ decision must not be disclosed.
The impact of the transaction depends upon the business’s size and amount. The same transaction can be significant for one business and meaningless for the other. A cost that may be immaterial for a large business could be significant for a small business. The items disclosed should be in such a manner that is understandable by the users, including investors, auditors, shareholders, lenders, etc., of the business.
The thumb rule related to the judgment of the materiality of the financial statements is as follows:
- Suppose an omission or error in the Balance sheet item is greater than or equal to 0.5% of the total assets of the business or greater than or equal to 1% of total equity. In that case, 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
- Suppose there is a company named ABC Incorporation that 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 of $100. The insurance claim received by the company for such inventory was $80. So, the overall loss was $20. At the end of the financial year, the company booked a profit of $200. 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 company’s books of accounts.
Now if, in the above example, the company’s net income is $30,000, then the same amount of $20 would be insignificant as it has a very low impact on the business’s profitability. Therefore separate disclosure of such transactions is not required. - Now a company that has the business of manufacturing 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. Therefore, it is necessary to separately disclose such machinery purchases. The business doesn’t need to disclose the repairs in the building worth $200 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 the more strong financial position of the business than it is, or sometimes the companies hide the information and give excuses later on that the amount was very insignificant that’s why they had not disclosed the required transaction. The abuse of the materiality concept can cause a business to have intense legal consequences based on the intention behind the error and the impact such an error can have on the investor’s judgment. The auditors and the law courts consider ‘rules of thumb’ to analyze cases 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 investors, lenders, and other business regulators. It develops faith in the business among the users. The materiality is also important for the auditors as they are responsible for seeing whether the financial statements are free from material misstatements.
Advantages and Disadvantages of Materiality Concept
Below are the advantages and disadvantages:
Advantages
- The concept of materiality helps the users to know about important business transactions. The business invests the investors’ and shareholders’ money, so the investors and shareholders have the right to know the significant matters and ensure that their money is in safe hands.
- The materiality concept provides the context for establishing auditors’ judgment. The auditors must publish a report stating the true and fair picture of the business’s financial statement. So with the help of material information, it will be easier for an auditor to frame an unbiased opinion.
- It reduces the need to record every business transaction since only the material ones require full disclosures.
Disadvantages
- There can be errors in judgment. Forming judgments can be difficult since the item can be material for one person and immaterial for another.
- Sometimes there is a need to hire a professional to decide whether the transaction is material and immaterial, which can be expensive for the small business.
- The disclosures of material transactions are sometimes cumbersome and time-consuming.
Conclusion
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, and 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 significantly impact users’ decision-making. There are also legal consequences if the business fails to follow the materiality concept.
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