Accounting is a world that follows many rules. But amid all the “musts,” a bit of subjectivity is also permitted when it comes to deciding what is important or relevant enough to include in a company’s financial reports. This determination is based on a concept known as materiality, and it is guided by whether the exclusion of information will have a detrimental effect on “reasonable users” who are basing their decisions on these reports.
Materiality can be thought of as a filter applied to financial reporting, transactional accounting and auditing that considers whether information is relevant for readers. Significant pieces of information are considered material, though what is deemed significant to one business may be considered immaterial for another, based on a company’s size, industry and the nature of the information. Suffice to say, anyone who relies on accounting information to make business decisions, as well as those in charge of what to include and not include, must understand materiality and its implications.
What Is Materiality?
Materiality is a key accounting principle that determines whether a discrepancy, such as an omission or misstatement, would impact a reasonable user’s decision-making. If it would, the information is material. If the information is insignificant or irrelevant, it is said to be immaterial. Many types of interested parties — for example, potential investors, lenders and business partners, as well as internal business management — examine a company’s financial statements for decision-making purposes. They need to be able to trust that the information is accurate and presented fairly. But even audited financial statements can be less than perfect.
Both quantitative and qualitative factors are relevant when determining whether a discrepancy is important to a reader. Quantitative materiality refers to an item’s dollar amount, where a very small transaction might not make a difference to the readers of the information. Qualitative materiality considers the nature of an item, regardless of its amount, to determine whether it matters, such as a pending lawsuit. The Financial Accounting Standards Board (FASB) has issued several concept statements defining materiality, and other standards bodies have suggested certain quantitative “rules of thumb,” but, ultimately, materiality is a matter of judgment and circumstance.
Material vs. Immaterial Information
Material information is anything of importance that would affect an interested party’s decisions. If errors or omissions of information would cause a reasonable user to come to a different conclusion, then the information is said to be material. If it would not have an impact, it is considered immaterial. While the litmus test for determining materiality is subjective and not a formulaic threshold, as a practical matter, material information tends to be significant relative to a company’s size.
For example, purchasing $25,000 of equipment is likely a material event for a business with $500,000 in annual revenue. However, the same transaction might be considered immaterial for a $500 million business. However, the nature of a transaction can also influence whether it is material or immaterial. For example, the Securities and Exchange Commission (SEC), which regulates financial disclosures of public companies, suggests that certain items should be considered material even in insubstantial amounts. These include:
- Errors or misstatements that affect a company’s compliance with loan covenants, other contractual requirements or regulatory requirements.
- Errors or misstatements that flip a business’s net loss for a period into net income or vice versa.
- Errors or misstatements that artificially increase compensation for company management.
- Errors or misstatements that involve fraud or illegal transactions.
Key Takeaways
- Materiality is a GAAP principle that determines whether discrepancies in financial reporting, such as an omission or misstatement, would impact a reasonable user’s decision-making.
- Quantitative and qualitative characteristics can determine whether information is material.
- Businesses use materiality when setting accounting policies in order to help manage workload and focus.
Materiality Explained
Materiality is not only a consideration for accounting errors, omissions and misstatements, it is also a factor when setting accounting policies. A company may determine that it is expedient to apply different policies according to an item’s materiality. For example, a company could set a policy that all asset purchases under a certain threshold are expensed immediately, rather than capitalized and depreciated over time in accordance with GAAP. Such a policy would cause the company’s asset values to be understated and current period expenses to be overstated. But if the levels are immaterial to its overall financial statements — including its balance sheet, income statement and statement of cash flows — a company may prioritize the benefit of reducing the accounting workload over accuracy. Using materiality in this way is common but can become tricky, because too high a volume of immaterial items can become material in the aggregate.
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What Is the Materiality Concept?
The materiality concept recognizes that certain items are too small to make a difference in the overall financial picture. It is a “close enough” approach and is a delicate matter of judgment. The concept of materiality might be invoked during an account reconciliation, requiring larger items to be investigated and those below a certain threshold accepted as is. In other cases, a company may choose to ignore a GAAP rule because the underlying matter is immaterial to its business. (More on this later.)
Another emerging version of the materiality concept worth noting, though tangential to accounting, relates to environmental, social and governance (ESG) reporting. ESG materiality considers a company’s impact on the environment, society and the economy, especially regarding the sustainability of their activities. Several international regulations require companies to disclose their ESG activity as part of their corporate reporting, using materiality to prioritize activities that support a company’s ESG strategy. Like the materiality concept in accounting, ESG materiality is a way to focus on major, meaningful information that is significant to readers of the report.
Applications of the Materiality Concept
Materiality is always at the forefront of accountants’ minds as they work to ensure that any financial reporting conveys the most comprehensive and accurate picture to its readers. At the same time, it is generally accepted that there needs to be a level of efficiency and speed within the accounting process. Materiality can help ease that inherent tension and is commonly applied in the following ways:
Accounting standards
GAAP-compliant companies must try to reasonably apply all the GAAP accounting standards, especially those that are material to their businesses. However, in practice, some businesses ignore standards concerning immaterial parts of their business, because they bank on the assumption that the errors that arise from doing so are immaterial. For example, a small bakery may choose to ignore inventory standards for valuing finished goods and not include unsold bakery items that spoil quickly, because their value is immaterial. It’s important to note that public companies are more restricted in their ability to ignore standards, in accordance with SEC guidance.
Minor transactions
Minor transactions are often bypassed during the accounting close process if they are immaterial in amount and in nature. This is most often the case during interim fiscal periods and especially when an immaterial transaction would normally be captured in the next period. An example would be a single outstanding travel and expense report from one of 50 salespeople that was submitted after the accounting close and wasn’t properly accrued.
Capitalization limits
Capitalization limits are an everyday application of the materiality concept. In this case, a company sets a materiality threshold value for asset purchases. Amounts over the threshold are capitalized and amounts under it are immediately expensed. Capitalization and depreciation is a more accurate way to spread costs over the periods the assets serve, but it requires tracking the asset, establishing its useful life and regularly recording depreciation journal entries. Capitalization limits reduce the workload for items that are too small to make a material difference. For example, a construction company may set a capitalization limit of $20 because the aggregated cost of small tools is immaterial to the overall value of equipment.
Materiality and GAAP
Materiality is one of the 10 principles of GAAP. It acts as a quality control to the other nine interrelated principles. At its core, materiality requires all significant information to be included in financial reporting to ensure reporting usefulness. At the same time, the materiality concept helps businesses achieve the objective of providing complete, accurate financial information while managing the cost, effort and time needed to provide the information. In other words, materiality helps keep accounting processes from getting lost in the weeds of minutiae to instead focus on providing meaningful, reliable content.
Nevertheless, materiality is not an excuse for shoddy bookkeeping. When applying materiality or when errors and omissions are identified, it’s important to remember that the ultimate test of whether information is material is whether its absence or misstatement misleads a reasonable reader.
It’s noteworthy that the definition of materiality for GAAP differs slightly from the definition under International Financial Reporting Standards (IFRS). Whereas GAAP focuses on errors, omissions and misstatements, the IFRS version is a little broader by also including obscuring data, in addition to omitting or misstating.
Examples of Materiality
Most companies use varying forms of materiality, regardless of their size. Some common examples include:
Expensing vs. depreciating assets:
A company that uses a capitalization limit, as described above, fully expenses immaterial items when they’re purchased, rather than depreciating them over their useful lives. For example, a boutique fitness studio might choose to fully expense the $20 cost of five new yoga mats in a single period, rather than set them up as fixed assets and depreciate them over their two-year useful lives.
Losses compared to net income:
A business can use materiality to determine whether to report a loss on its income statement. In this case, materiality is based on the size of the loss relative to the amount of the business’s net income. For example, if a bakery’s refrigerator breaks down, causing $1,000 worth of butter, eggs and other ingredients to spoil, it may elect to leave this loss out of its financial statements because it is immaterial compared to the bakery’s $1 million of net income. However, if the bakery’s net income for the year is only $10,000, the loss would likely be a significant item on the income statement.
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In an ideal world, accounting data would always be perfectly accurate and the concept of materiality would be, well, immaterial. However, manual accounting processes and disjointed accounting systems create environments where errors, omissions and inconsistent application of accounting standards become more likely. A solution like NetSuite Cloud Accounting Software increases accounting accuracy by eliminating duplicated and miscalculated information, which improves the quality of information in a company’s financial reports and, therefore, their usefulness. In addition, NetSuite helps to ensure consistent application of accounting rules, improving compliance. At the same time, companies can set materiality rules and risk ratings per account within the accounting software, which streamlines accounting processes like account reconciliations and variance analysis, making them more efficient and faster. It also strengthens the control environment by identifying anomalies and issuing alerts in real-time.
Materiality boils down to a judgment of whether an omission or misstatement of quantitative and qualitative information in financial statements would impact a reasonable user’s decision-making. It can be thought of as a “close enough” approach that tolerates certain items that are too small to make a difference in the overall financial picture. Materiality is a matter of efficiency and expediency that helps businesses manage the objective of providing complete, accurate financial information within the cost, effort and time parameters needed to produce that information.
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Materiality FAQs
How do you measure materiality?
Materiality is a relative measure. It is considered in the context of a business’s size, typically using total assets and net income as guidelines. However, there is no set formula for determining materiality.
Why do we need materiality?
Materiality helps businesses manage the objective of providing complete, accurate financial information within the amount of cost, effort and time needed to produce the information. It is a way to keep accounting processes from getting bogged down by minutiae and instead focus on providing meaningful financial information. When applying materiality, it’s important to remember that the ultimate test of whether something is material is whether its omission or misstatement could mislead a reasonable user.
What is the difference between planning materiality and performance materiality?
Planning materiality is an audit term that refers to the tolerable aggregate value of errors and misstatements that would still allow financial statements to be materially accurate and earn a positive audit opinion. Even an unqualified, or “clean,” audit opinion asserts only that the financial statements are free of material misstatements, not that they are 100% accurate. Performance materiality is a smaller dollar value than the planning materiality that auditors use at a detailed level. The gap between planning and performance materiality is a risk cushion intended to compensate for undetected errors, sampling risk and uncorrected findings. The performance materiality is the “working” value used to determine statistical samples and tests at an account level.
How is materiality defined?
Materiality is a concept that determines whether the omission or misstatement of information in a financial report would impact a reasonable user’s decision-making. If information is significant, it is material. If the information is insignificant or irrelevant, it is said to be immaterial. Materiality is both quantitative and qualitative. The definition of materiality under the Generally Accepted Accounting Principles differs slightly from the definition under International Financial Reporting Standards (IFRS). The IFRS version is a little broader in that it includes obscuring data, in addition to omitting or misstating it.
What are the 3 types of materiality?
In general, materiality is both quantitative and qualitative. There are three types of materiality that are specific to audits: planning materiality, performance materiality and specific materiality. Planning materiality refers to the tolerable aggregate value of errors and misstatements that would still allow financial statements to be materially accurate and earn a positive audit opinion. Performance materiality is a smaller dollar value than the planning materiality that auditors use at a detailed level. Specific materiality is a particular threshold set for a certain account or category of accounts. For example, a related party transaction might be audited using a specific (often lower) materiality threshold because of the sensitivity of those transactions.
What is an example of materiality?
A common example of materiality is when a business chooses to expense small assets instead of capitalizing and depreciating them. Typically, a company sets a capitalization limit and expenses immaterial items when purchased. For example, an insurance agency with $1 million annual net profit might choose to fully expense a newly purchased $200 fax machine in a single period, rather than set it up as fixed asset and depreciate it over its estimated three-year useful life.
What does materiality mean in auditing?
Audits do not verify that the financial statements are perfectly accurate. Instead, an unqualified, or “clean,” audit opinion asserts only that the financial statements are free of material misstatements. Materiality means that the financial statements are useful and do not contain or omit any information that would cause a reasonable user to be misled. Auditors use several versions of materiality during their work.
