Materiality concept of accounting

The materiality concept of accounting states that all material items must be properly reported in financial statements. An item is considered material if its inclusion or omission significantly impacts the decision of the users of financial statements. Items that have very little or no impact on a user’s decision are termed immaterial or insignificant. Such items may be handled in the most convenient and easiest manner. In short, we can say that if an item does not make a difference, it need not be disclosed.

The materiality concept also allows accountants to ignore other accounting principles or concepts if an action does not have a significant impact on the financial statements of the entity. For example, a company may charge its telephone bill to expense in the period in which the bill is paid rather than in the period in which the telephone service is used. This treatment is a violation of the matching principle of accounting. However, accounting for telephone or other utility bills on a cash basis is very convenient because the monthly cost of the service used is not known until the utility bill is received by the company. Under this cash basis approach, the telephone bill charged to expense in the current month actually belongs to the previous month, but the error in financial statements resulting from this action is likely to be immaterial.

What constitutes materiality?

The materiality of an amount is a matter of professional judgment. Several factors are considered to decide whether a particular item is material or immaterial. Some important factors are discussed below:

Size of the organization:

The concept of materiality refers to the importance of a specific item in relation to other items on financial statements and largely depends on the size of the organization. For example, an expenditure of $500 may be material in relation to other financial statement items of a small business but immaterial to the financial statement items of a large corporation like Sony, Samsung, Northern Tools, and General Electric. There is no rule of thumb available to determine the materiality of an amount. However, most accountants consider an amount immaterial if it is less than 2 or 3 percent of net income.

Cumulative effect:

For assessing the materiality of an item, accountants not only take into account the individual amounts but also the cumulative effect of all immaterial amounts. For example, each of the fifteen items may be immaterial when considered individually, but the combined effect of those fifteen items may be material when seen together.

Nature of the item:

The materiality concept is valid and applicable for the dollar amount as well as for the nature of the item or event under consideration. Suppose, for example, that some managers are involved in stealing money from the company’s business. This fact would be considered important even if the amount stolen is very small in relation to other items on the relevant financial statement.