United States GAAP, for instance, states that items are material if "they could ... influence the economic decisions of [financial statement] users…". In other words, materiality errors can mislead decision-makers.
Note that the materiality concept has meaning for any financial statement only concerning:
- The statement's intended audience.
- The statement's purpose for this audience.
When an independent auditor reviews a firm's financial statements, the best possible outcome is an auditor's opinion of Unqualified. This opinion affirms the auditor's judgment that the reports are accurate and conform to GAAP. And, this means the auditor finds no materiality issues.
Explaining Materiality Concept in its Context
This article further describes and illustrates the materiality concept in the context of related concepts such as:
- The definition of material
- Materiality errors in accounting
- Motivation and intent in materiality
- Materiality rules of thumb
- Subjectivity in materiality
- Abuse of the materiality concept
The materiality concept concerns omissions, errors, and misleading statements in accounting reports. The central question is this: Do they matter? Or, in other words: Are they material?
Materiality Depends On the Purpose and the Audience
The first answer to that question is the following: "Materiality depends on the purpose of the financial report and its intended audience."
Consider, for instance, a firm's financial reports for the period just ended. Different versions of the statements can serve different audiences for different purposes.
The Annual Report to shareholders includes one version of the firm's statements. Here, the firm is legally responsible for publishing statements that serve two purposes.
- Firstly, statements must enable shareholders to make informed decisions when electing directors. The firm, therefore, must disclose information about individual candidates that could influence a voting decision. Information for this purpose could include, for instance, information about potential conflicts of interest or family ties with the firm's officers.
- Secondly, these statements enable shareholders and investors to evaluate the firm's recent financial results and prospects for future business. As a result, the materiality concept requires full disclosure on everything that could influence a decision to hold, buy, or sell shares of stock. Relevant information here could include, for example::
- Transparent interpretation of recent performance
For this purpose, firms sometimes supplement GAAP-required metrics such as Net Income with particular income metrics such as EBITDA (Earnings before interest, taxes, depreciation, and Amortization)
- Analysis of the firm's competitive situation
- Disclosure of forthcoming lawsuits or government penalties
- Transparent interpretation of recent performance
Potential lenders and bond rating agencies are another report audience. This audience, of course, must judge the firm's creditworthiness. Here, the audience tries to answer questions such as these:
- Firstly, can the company service it's debt load if it takes on still more debt?
- Secondly, what is the firm's level of leverage?
- Thirdly, what are the firm's earnings prospects in its core line of business?
The audience must have enough detail to address such questions seriously. Here, the audience needs full disclosure on the firm's creditors, liabilities, and investments. They also need full disclosure on planned changes to the firm's business model and strategies. And, they must know which financial and business risks the firm faces.
With mergers and acquisitions, each potential partner must know the other 's business accurately and in detail. Each must know, in other words, the other party's:
- Business model: The business model reveals, for instance, which of the firm's products earn healthy margins and which do not.
- Cost structure: This structure describes the kinds and relative proportions of fixed and variable costs that a firm incurs.
- Capital and financial structures: These structures define the firm's level of leverage. The structures show how the firm's creditors and owners share business risks and rewards.
- Organization and governance structures.
- Marketing strategy and selling model.
All potential partners need this information, in advance. Everyone must know what each adds to partnership production, marketing, selling, and general management. They must plan together how to eliminate redundancies and overly costly operations, and each must know the risks and liabilities that the others bring to the partnership. Only with full knowledge in these areas can they make an informed decision on going forward joining together.
The definition of material refers to a particular audience and to the kinds of decisions this audience must make.
In the United States, the primary rule for deciding materiality appears in GAAP (Generally Accepted Accounting Principles):
"Items are material if they could individually or collectively influence the economic decisions of users, taken from financial statements."
The GAAP definition is consistent with a more formal statement from the board responsible for GAAP, the United States Financial Accounting Standards Board (FASB). For FASB, 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
The materiality concept is an established accounting convention, recognized universally. Another such principle is the historical cost convention by which firms:
- Record transactions at the prevailing price at the time of acquisition.
- Value assets at original cost.
Note that historical costs are usually easy to find and agree. As a result, historical values come with very little uncertainty. However, materiality judgments can be less objective and more uncertain. Here, the question is whether or not specific information could influence a particular decision. Conclusions about materiality, therefore, may include a subjective element. And this inevitably means that different people can reach different conclusions.
Not surprisingly, materiality judgments can differ among the following:
- The Board of Directors.
- Corporate officers.
- Senior managers.
- Potential business partners.
- Potential investors.
Differences are especially likely when these groups have different interests, different motivations, and different objectives.
Abuses of the materiality concept in accounting can have serious legal consequences. Nevertheless, GAAP and FASB have resisted stating precisely an error size that qualifies as materiality abuse. In reviewing specific cases, however, auditors and courts use several "rules of thumb."
- On the Income statement, errors of 5% or more of before-tax Profit, or 0.5% of sales revenues, are more likely seen as "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 likely to be viewed suspiciously.
Abuse of the Materiality Concept
Those judging materiality must also consider other factors besides error magnitude. This requirement is no doubt one reason that regulators resist setting size criteria for materiality abuse. They also take into account two other factors:
- First, Motivation and Intent Behind the Error.
An abuse judgment is more likely if auditors or a court can prove intent to do any of the following:
- Keep stock prices artificially high.
- Inflate reported earnings.
- Understate the actual value of the asset base.
- Inappropriately influence merger or acquisition decisions.
- Second, the Likely Effect on User Perceptions and Judgment.
Consider for instance an Income statement placement error. Suppose there are significant "Manufacturing indirect labor expenses" for this period. Suppose also these are wrongly placed under "Direct manufacturing labor." That error probably does not qualify as materiality abuse. Regarding materiality, it is likely a harmless error because both kinds of expense contribute to cost of goods sold (COGS). As a result, the critical information for decision-makers—gross profits—is the same regardless of which COGS category has the indirect labor expense.
However, suppose instead that the same indirect labor expenses appear wrongly below the gross profit line instead of above it. This kind of mistake may qualify as fraud. This mistake is harmful because the misstatement does inappropriately improve gross profits.