Materiality concept in accounting. Definition. Uses

Materiality concept

If you're looking for a resource on the materiality concept, you've come to the right place.

The definition of materiality is one of the most important concepts in accounting. By understanding what qualifies as a material item, accountants can make more informed decisions about financial statements.

This article will provide you with all the information you need to understand materiality and how it affects your accounting decisions. After reading this article, you'll be able to apply this concept in your own work and produce accurate financial statements.

We have also put our faculty video to explain the concept. Do scroll below to watch or read our article on the materiality concept in accounting!

Definition of materiality

An item is regarded as material if its omission or misstatement is likely to change the perception or understanding of the users of that information.

On the other hand, an error that is too trivial to affect anyone's understanding of the accounts is considered immaterial. 

Materiality is simply a measure of how important that information is to users.

For example, consider if the bank balance of a large entity is misstated by $1 in the statement of financial position. This item is immaterial and may not be regarded as a material misstatement that would impact the financial information on the balance sheet.

However, suppose the bank balance was misstated by $100,000. In that case, this is more likely to be regarded as a material misstatement as it significantly impacts the financial statements.

Watch our faculty's video explanation of the concept of materiality

How is materiality concept relevant in accounting

In accounting, the materiality concept is relevant in two situations:

• when considering whether an item should be disclosed in the financial statements and
• when making decisions about classifying an item as an expense or an investment. 

The purpose of the materiality concept is to ensure that financial statements are accurate and provide meaningful information to users. 

Generally, items must meet a certain threshold before they are considered material and affect the financial statements.

 Accountants consider quantitative and qualitative factors in determining if an item is material. 

• Quantitative factors: measure net income, revenue, profit, total assets, and cash flows. Usually, a 1% threshold is applied to determine quantitative materiality.
• Qualitative factors – related party transactions, unusual transactions, geography, and broader economic uncertainty.

Relation with other accounting principles

Relevance:  Information is relevant if:

• it can influence the economic decisions of users, and
• is provided in time to influence those decisions. 

Materiality has a direct impact on the relevance of information.

Free from error

The accounting information must be free from error within the bounds of materiality. A material error or an omission can cause the financial statements to be false or misleading.

Examples of uses in materiality concept in accounting standards under IFRS

IAS 1 requires disclosure of line items in the financial statements based on materiality.

IAS 8:  Change in accounting estimate. The materiality of the changes is also relevant. The nature and amount of a change in accounting estimate that has a material effect in the current period should be disclosed. This fact should also be disclosed if it is impossible to quantify the amount.

IAS 24: Even if the amounts are immaterial. A company must disclose any transactions with the directors or relatives. 

Impairment of assets: IAS 36: Every entity needs to assess for indicators of impairment of assets at every reporting period. The concept of materiality applies, and only material impairment needs to be identified.

Example with calculation

An example of the materiality concept in accounting would be a company deciding whether to disclose a specific transaction or event in its financial statements.

Example 1

For example, let's say that a company has a one-time gain of $10,000 from the sale of a piece of equipment. The company must determine whether this gain is material, or significant enough, to be disclosed in its financial statements. If the gain is not material, it may not need to be disclosed at all. On the other hand, if the gain is material, it must be disclosed in the financial statements and may require additional disclosures or explanations.

The materiality of an item or transaction is typically determined by considering its size in relation to the overall financial statements. For example, a gain of $10,000 may be considered material for a small company with total assets of $100,000, but it may not be considered material for a large company with total assets of $1 billion. In general, the larger the company, the more material an item or transaction must be to be considered significant enough to be disclosed in the financial statements.

Example 2

A company has a lease agreement for office space that will last for the next 5 years. The company must decide whether the lease should be classified as an operating lease or a capital lease. If the lease is classified as a capital lease, it must be recorded on the company's balance sheet as a long-term asset and a corresponding liability. However, if the lease is classified as an operating lease, it does not need to be recorded on the balance sheet and can instead be expensed on the income statement as an operating expense.

In this case, the materiality of the lease classification is determined by considering the size of the lease payments in relation to the company's overall financial statements. If the lease payments are significant in relation to the company's assets and income, the lease should be classified as a capital lease. However, if the lease payments are not material, it can be classified as an operating lease and expensed on the income statement.

In general, the materiality concept in accounting is used to ensure that financial statements accurately and fairly represent the financial position and performance of a company. It helps to ensure that important items and transactions are disclosed in the financial statements, while less significant items and transactions are not given undue emphasis.

Academic research articles on concept of materiality 

1. An Empirical Investigation of the Concept of Materiality in Accounting
   • This paper discusses the implicit role of materiality in every accounting decision, defining it as the relative, quantitative importance of financial information to a user in the context of decision-making. The study highlights that while definitions exist, they must be more operational, emphasizing the challenge of identifying materiality in practice..
2. A Genealogy of Accounting Materiality
   • This paper explores the historical dimensions of materiality, identifying it as a concept shaped by power dynamics and multiple roles, including moral responsibility and risk management. It argues that materiality is malleable and can be reinvented to meet changing priorities and challenges in accounting.
   • (Bolt, 2016).
3. Discussion of an Empirical Investigation of the Concept of Materiality in Accounting
   • This discussion critiques the approach of linking materiality judgments to the sophistication of financial statement users, arguing that materiality should be consistent regardless of the user group. It emphasizes focusing on the objectives of financial statements rather than user capabilities.
4. An Examination of the Perceptions of Auditors and Chief Financial Officers of the Proposed Statement of Financial Accounting Concept Definition of Materiality
   • This study examines the perceptions of auditors and CFOs regarding a proposed new definition of materiality based on the US Supreme Court's definition. It finds that both groups have negative perceptions of the new definition and suggests that materiality should be evaluated from the user's perspective.
   • (Du et al., 2019).
5. Applying the Materiality Concept: The Case of Abnormal Items
   • This research investigates how materiality was applied in the disclosure of abnormal items in Australian financial reports. It finds that a significant portion of disclosed abnormal items were immaterial, thus potentially misleading users..
6. An Economic Modeling Approach for the Determination of Materiality in Auditing
   • The paper proposes an economically based model for determining materiality that minimizes the economic consequences of audit decisions. It examines materiality sensitivity to prior information and costs associated with audit decisions.
   • (Crosby et al., 1987).
7. Materiality as a Sustainability Accounting Concept: Three Definitional Streams and Critiques
   • This study reviews different streams of definitions of materiality in sustainability accounting, highlighting the concept's complexity and varied interpretations and suggesting a more versatile, forward-looking understanding of materiality.
   • (Zhou, 2017).
8. The Impact of Materiality: Accounting's Best Kept Secret
   • This review highlights the context in which materiality is relevant, compares definitions from legal, accounting, and stock exchange sources, and discusses methods for calculating quantitative thresholds. It calls for future research to address gaps in understanding materiality.

Closing comments: 

The materiality principle is a key consideration in financial accounting. The materiality principle holds that financial statements should be prepared and presented so that they fairly represent the economic substance of transactions and events