Materiality concept of accounting

The materiality concept of accounting stats that all material items must be properly reported in financial statements. An item is considered material if its inclusion or omission significantly impacts the decision of the users of financial statements. The items that have very little or no impact on a user’s decision are termed as immaterial or insignificant items. Such items may be handled in most convenient and easiest manner. In short, we can say that if an item does not make a difference, it need not be disclosed.

The materiality concept also permits accountants to ignore another accounting principle or concept if such action does not have an important effect on financial statements of the entity. For example, a company may charge its telephone bill to expense in the period in which it is paid rather than in the period in which the telephone service is used. This treatment is a violation of matching principle of accounting. However, the accounting for telephone or other utility bills on cash basis is very convenient because the monthly cost is not known until the utility bill is received. Under this cash basis approach, the telephone bill charged to expense actually belongs to prior month but the error in financial statements resulting from this action is likely to be immaterial.

What constitutes materiality?

Materiality of an amount is a matter of professional judgment. Several factors are considered to decide whether a particular item is material or immaterial. Some important factors are discussed below:

Size of the organization:

The concept of materiality refers to the importance of a specific item in relation to other items on financial statements and largely depends on the size of the organization. For example, an expenditure of $500 may be material in relation to other financial statement items of a small business but immaterial to the financial statement items of a large corporation like Sony, Samsung, Northern Tools and General Electric. There is no rule of thumb available to determine the materiality of an amount. However, most of the accountants consider an amount immaterial if it is less than 2 or 3 percent of net income.

Cumulative effect:

For assessing materiality of an item, accountants not only take into account the individual amounts but also the cumulative effect of all immaterial amounts. For example, each of fifteen items may be immaterial when considered by itself. However, the combined effect of those fifteen items may be material when seen together.

Nature of the item:

Materiality concept is valid and applicable for the dollar amount as well as for the nature of the item or event under consideration. Suppose, for example, some managers are involved in stealing money from the company’ business. This fact would be considered important even if the amount stolen is very small in relation to other items on the relevant financial statement.