Materiality principle
| Materiality principle |
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Materiality Principle is a principle used mostly in accounting to define the relevance of information and features of transactions, which are recorded as per financial statements.It also states that company can invade another rule used in accounting if the amount as per transaction is not big enough to cause an error in financial statement[1].
Usability
Main use of applying Materiality Principle is easing financial statements preparation by guiding an accountant. This leads to providing Investors and Shareholders with information needed to make a decision and ascertain that the information we deliver is comprehensive.
The idea of Materiality Principle is that if transaction or the amount are immaterial across the business, it should not be considered the same as material transaction and amount.
Aim of the principle is not only to protect the investors and shareholders interest, but it is facilitation for accountants while preparing Financial Statements. Except knowing what is material and what is not, elements that should be separately disclosed and those included in other transactions are indicated[2].
Conception
If dropping or error of information can cause making a different or new decision, then the size and details of transaction are considered as Material. Accountants are obliged to follow rules accepted in accounting unless it makes no difference if a specific rule is not followed and when proceeding as per the principle would be overly hard or expensive.
If the Materiality Principle is followed and other accounting rule is skipped, there will be no prominent change in net income of the company and financial statements should stay intact. Additionally, by following the principle by our accountants, auditors can easily measure propriety of financial statements[3].
Immateriality and Materiality
Immaterial case would be an expensive piece of furniture, its useful life is 5 years and it has been bought for the office. Different accounting principles would treat the purchase in various ways.
- As per Matching Principle, the cost would be recorded as an asset and amortised over the 5 years,
- As per Materiality Principle, the cost of furniture can be reported as lump-sum in a year-end financial statement, without amortising the purchase.
In that case we can follow the Materiality Principle as shareholders, investors and creditors will not be misinformed.
Materiality depends on the size of business, workstream, stocks and much more. It does not only involve monetary value of a purchase or features of the object of transaction, but also many different factors must be taken into account[4].
Examples of Materiality principle
- In financial statements, the Materiality Principle requires that any amount or transaction that is sufficiently large to have a significant impact on the overall financial position of the company be reported. For example, a company may consider a transaction of $500,000 to be material and thus would report it in their financial statements.
- In auditing, the Materiality Principle is used to assess whether certain errors or misstatements are significant enough to be reported in the audit report. For example, if an auditor discovers a misstatement of $100,000, this could be considered material and thus would be reported in the audit report.
- On tax returns, the Materiality Principle is used to determine whether certain discrepancies or errors are significant enough to report to the relevant tax authorities. For example, if a taxpayer makes a mistake in their return that results in an overpayment of $10,000, this could be considered material and thus would be reported to the tax authorities.
Advantages of Materiality principle
Materiality Principle serves as an important tool in financial accounting and reporting, providing many advantages in making decisions, such as:
- It helps to accurately record and report transactions, thus providing reliable financial statements.
- It assists in determining the relevance of transactions and information, thus providing an effective way to determine the significance of transactions.
- It helps to reduce the workload and costs associated with reporting transactions that are not material.
- It assists in preventing errors in financial statements that could be caused by transactions that are not material.
- It helps to ensure consistency in accounting practices, thus providing a standard for recording transactions.
Limitations of Materiality principle
The Materiality Principle is an important concept in accounting, but it has some limitations. These limitations are:
- It is hard to establish an exact threshold of materiality. Every situation is unique, and a financial statement user must decide whether a particular transaction is material or not.
- The principle only takes into account monetary value of a transaction and does not consider other factors such as the impact on reputation.
- The principle does not always recognize the importance of qualitative information such as customer relations or product safety.
- The principle does not consider the potential for a transaction to be misstated due to fraud.
- It does not consider the potential for future transactions to be affected by a particular transaction.
- It does not consider the potential for legal ramifications resulting from a particular transaction.
Overall, the Materiality Principle is an important concept in accounting, but it has some limitations that should be taken into account when making decisions.
The Materiality Principle is just one of the approaches used in accounting. It can be complemented by the following:
- The Matching Principle - This principle states that all expenses must be matched with the related revenues, in order to accurately reflect the financial performance of a business.
- The Principle of Full Disclosure - This principle requires an entity to disclose all relevant information related to financial statements, such as information on significant transactions and other events that could affect the financial statements.
- The Cost Principle - This principle states that assets should be recorded at their original cost and that the cost should be adjusted for inflation and other factors.
- The Conservatism Principle - This principle states that when there is uncertainty about the amount of an asset or liability, it should be recorded at the lower amount, in order to avoid overestimating income.
In summary, the Materiality Principle is an important approach in accounting, but it is just one of several approaches that should be considered when preparing financial statements. Other approaches such as the Matching Principle, the Principle of Full Disclosure, the Cost Principle, and the Conservatism Principle should also be taken into account.
Footnotes
References
- Chewning G., Pany K., Wheeler S., (1989). Auditor Reporting Decisions Involving Accounting Principle Changes: Some Evidence on Materiality Thresholds, "Journal of Accounting Research". v. 27, no. 1, 78-96.
- Eccles R., Krzus M., Rogers J., Serafeim G., (2012). The Need for Sector‐Specific Materiality and Sustainability Reporting Standards, "Journal of Applied Corporate Finance". v. 24, i. 2, 65-71.
- Hsu C., Lee W., Chao W., (2013). Materiality analysis model in sustainability reporting: a case study at Lite-On Technology Corporation, "Journal of Cleaner Production". V. 57, 142-151.
- Mio C., Fasan M., (2014). The determinants of materiality disclosure in integrated corporate reporting, "Università Ca' Foscari Venezia, Departament of Management". 8-17.
Author: Anna Zalewska
