Question

When would the accounting principle of Materiality be applied in a company's financial statements or notes? Please give an example of its application.

Answer 1

As per the various Standards & Frameworks, such as GAAP, IFRS, the key focus area is to make information in financial statements more relevant and less confusing.

Materiality is defined as, An Information is material if omitting, misstating or concealing it could reasonably be expected to influence decisions that the primary users of general purpose financial statements make on the basis of those financial statements, which provide financial information about a reporting entity. In simpler terms, All such information that can be reasonably expected to affect decisions of the users of financial statements is material and this property of information is called Materiality.

Materiality in accounting, the concept of materiality is applied by the management to decide what information should be included in, excluded from, or aggregated with other information in, the financial statements. The concept is also applied by the management to decide how information should be presented in the financial statements to ensure the financial statements are clear and understandable. Therefore, the accounting principle of Materiality is applied in Accounting at the time of preparation of the financial statements. The materiality principle of accounting guides about recognition of a transaction. It means that transaction which is of insignificance importance should not be recorded. A transaction may be recorded keeping in view its relevance and significant importance. While matching concept and accrual concept requires an accountant to accurately calculate the exact cost to be charged to the income statement for any particular period, the materiality principle of accounting states that this should be done only to the extent that it is material. Unnecessary details should be avoided as the cost of going into such details is often greater than the benefit of the exercise.

Materiality in auditing, the purpose of an audit is to enhance the degree of confidence of intended users in the financial statements. The auditor expresses an opinion on whether the financial statements are prepared, in all material respects, in accordance with an applicable financial reporting framework. The concept of materiality is applied by the auditor both in planning and performing the audit, and in evaluating the effect of identified misstatements on the audit and of uncorrected misstatements, if any, on the financial statements and in forming the opinion in the auditor’s report.

Example of Materiality Concept of Accounting, a file/folder is bought for $ 5, the useful life for it is five years or even more. But it would be a tedious, time-consuming, and generally inconvenient to consider a file/folder costing $ 5 as a fixed asset and depreciate it over five years using the straight-line method. It would be much easier to declare the entire cost of $ 5 as an expense for the year in which the file/folder is bought. It would not materially misstate the profit or affect the user's decisions over the financial statement for that year (or the remaining four years). This example is related to the size of the transaction. It would be difficult to set a limit as to what is material, as that would differ from organization to organization. For large organizations, an expense of $ 100 may be too small to capitalize while a small shop owner might consider assets costing $100 large enough to be treated as an asset rather than an expense. Entities should have internal rules about such materiality limits. Once such rules or limits are set, they should be consistently applied.