Financial statements are prepared to help its users in making economic decisions. All such information which can be reasonably expected to affect decisions of the users of financial statements is material and this property of information is called materiality. Materiality is a key concept in accounting because it helps accountants and auditors in deciding which figures need separate reporting and what is the maximum amount above which errors or omissions should be avoided at all costs.
Deciding whether a piece of information is material or not requires considerable judgment. Information can be material either due to size of the amounts involved or due to the nature of the event.
Example: Materiality due to size
Maldives Plc’s total sales for the financial year 2012 amounts to $100 million and its total assets are $50 million. The company’s external auditors have found out that $3 million worth of sales shouldn’t be recognized in financial year 2012 because the risks and rewards inherent in the sales have not been transferred.
This amount of $3 million is material in the context of total assets of $50 million. The company should adjust its financial statements.
Examples: Nature of the event
- EW Casinos Corporation operates in a country which is about to enact a new legislation which would seriously impair the company's operations in future. Although there are no figures involved, the disclosure of the development is required in the financial statements for the period on account of materiality because the new legislation can potentially end the revenues and profits earned from the country.
- The remuneration paid to a company’s executives and directors is material due to qualitative reasons (even it is not material quantitatively). It is because the investors would like to make sure that the management is not overcompensating itself.
- The accounting policies are material and can’t be omitted because they help the users understand how the management arrived at the amounts presented in the financial statements.
Accounting frameworks and standards have avoided setting any quantitative guidance for materiality because materiality always depends on the nature of the amount (such as how reliability it is possible to calculate/estimate the amount) and on other related circumstances.
In practice accountants and auditors need some crude estimate as quantitative threshold of materiality. They estimate it either as some percentage of a net measure such as 0.5% of net income or as percentage of some gross measure such as 5% of total assets.
Some accounting and financial reporting standards do provide some quantitative guidance. For example, accounting standards on segment reporting treat segments with revenue or assets greater than 10% of total revenue/assets as reportable segments.
Written by Obaidullah Jan, ACA, CFA