Exercise-5: Identification of material and immaterial items

Learning objective:
This exercise illustrates how to determine the materiality of financial statement items.

Given below are three independent transactions related to the materiality of financial statement items:

1. Alpha Corporation has a policy to expense all capital equipment that costs under $15,000 on the basis that it is immaterial. The company has been practicing this policy for a number of years.
2. Master Company has reported a positive trend in earnings for the last five years. To ensure another positive earnings year, the company has reduced the allowance for bad debts. The impact of this change is equal to only 2% of the net income.
3. Marshal Company’s income for the current year is $8 million. It has an extraordinary gain of $1.5 million on the sale of an old plant asset and a loss of $1.7 million on the sale of an equity investment. Since the net effect is considered immaterial, the company has decided to net the gain and loss for reporting purpose.

Required: Describe whether or not the above transactions would be classified as material.

Solution

For initial assessment of materiality, a general rule of thumb among companies and auditors is that anything below 5% of net income is considered immaterial. However, companies must also consider many other factors in this regard. For example, a company must not fail to record amounts in order to preserve a positive earnings trend, convert a loss to profit or a profit to loss, meet consensus analysts’ earnings numbers, increase management compensation, or hide an illegal transaction like a bribe. In other words, companies must consider both quantitative and qualitative factors when determining the materiality of financial statement items.

1. Expensing capital items that cost below a certain amount is not considered a violation of the materiality concept. Alpha’s treatment is acceptable because it has followed the same practice year after year.
2. Since the change in allowance for bad debts is intended to create a positive trend in earnings, it would be considered material.
3. The gain on sale of plant assets and the loss on sale of investments must be considered separately and not netted. Therefore, both items are material.