The Meaning of the Materiality Concept
Encyclopedia of Business Terms and Methods, ISBN 978-1-929500-10-9 Revised 2013-12-03.
The materiality concept is the principle in accounting that trivial matters are to be disregarded, and all important matters are to be disclosed. Items that are large enough to matter are material items. Materiality refers especially to:
- The level of detail appropriate for different financial reports.
- The importance of errors such as:
- Reporting expenses, revenues, liabilities, equities, or assets in inappropriate accounts, or reporting them for incorrect reporting periods.
- Omitting or failing to report important financial data.
The materiality concept is an established, recognized accounting convention. Another such convention is the historical cost convention, by which transactions are recorded at the price prevailing when the transaction is made, and assets are valued at original cost. Comparing the two conventions, however, historical costs are usually ascertained and agreed rather objectively, with little uncertainty, whereas applying the materiality concept may call for more subjective judgment. Moreover, the subjective judgments of senior management, accountants, auditors, boards of directors, stockholders, and potential business partners, can differ, especially when competing interests are involved.
Why is the concept important and necessary in financial accounting? Note that some of the reasons explained below also show that materiality is necessary and inevitable in business case analysis, as well.
What is material? What is not material?
The materiality concept addresses omissions and misstatements in accounting reports and in business case analysis. The central question is: Do they matter?
Some omissions are inevitable and desirable in both cases.
- An income statement, for instance, is meant to help stockholders, management, and boards of directors make judgments about investing, managing, and evaluating management performance. A statement with too much detail could obscure the "larger picture," could be difficult to prepare, and difficult to read and use. An income statement with too much detail could also risk revealing sensitive information that should remain confidential.
- Similarly, a business case analysis is a tool for decision support and planning. Non material details are can be simply distracting and pointless.
On the other hand, omission or misstatement of material items would work against the purpose in either case.
In the United States, the predominant approach to deciding what is material and what is not, is the view written in the GAAP (Generally Accepted Accounting principles) that items are material if they could individually or collectively influence the economic decisions of users, taken on the basis of financial statements.
This definition is consistent with a more formal statement from the board responsible for GAAP, the United States Financial Accounting Standards Board (FASB). Here, materiality refers to ... "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.1
Judging the judgment:
What constitutes abuse of the materiality concept?
Abuses of the concept are more likely to have serious legal consequences in accounting, than in business case analysis.
For accountants, GAAP and FASB have resisted putting precise quantitative value on the size of misstatement or omission that qualifies as an error in materiality. Nevertheless, in reaching judgment on specific cases, auditors and courts have utilized several "rules of thumb."
- On an income statement, an omission or error greater than 5% of Profit (before tax), or greater than 0.5% of sales revenues is more likely to be considered "large enough to matter."
- On a balance sheet, a questionable entry more than 0.3 to 0.5% of total assets or more than 1% of total equity, is more likely to be viewed suspiciously.
The final judgment on a suspected materiality abuse, however, will also consider factors besides the magnitude of the error. Auditors and courts will also consider
- Motivation and intent behind the error
If the intent is to keep stock prices artificially high, inflate reported earnings, or inappropriately influence merger / acquisition decisions, for instance, an abuse judgment is more likely.
- The likely effect on user perceptions and judgment.
An accounting statement error with large "Indirect manufacturing labor expenses and overhead expenses" misclassified as "Direct manufacturing labor" might not be seen as materiality abuse, since both kinds of expense contribute to cost of goods sold and the gross profit / gross margin result is the same regardless of which category has the labor in question.
A statement with the same large expenses misclassified below the gross profit line under Operating Expenses instead of above the gross profit line, would more likely be seen as fraudulent because the misstatement does inappropriately improve gross profits.
1. Financial Accounting Standards Board, Statement of Financial Accounting Concepts No. 2, Qualitative Characteristics of Accounting Information.