Materiality Concept in Accounting

The materiality concept helps ensure that firms do not withhold critical information from investors, owners, lenders, and regulators.

What is the Materiality Concept?

The materiality concept is the principle in accounting and financial accounting and reporting that firms may disregard trivial matters, but they must disclose everything that is important to the report audience. Items that are important enough to matter are material items.

United States GAAP, for instance, states that items are material if "they could ... influence the economic decisions of [financial statement] users…". In other words, materiality errors can mislead decision makers.

Note that the materiality concept has meaning for any financial statement only concerning:

• The statement's intended audience.
• The statement's purpose for this audience.

When an independent auditor reviews a firm's financial statements, the best possible outcome is an auditor's opinion of Unqualified. This opinion affirms the auditor's judgment that the reports are accurate and conform to GAAP. And, this means the auditor finds no materiality issues.

Materiality Depends On the Purpose and the Audience

The first answer to that question is the following: "Materiality depends on the purpose of the financial report and its intended audience."

Consider, for instance, a firm's financial reports for the period just ended. Different versions of the statements can serve different audiences for different purposes.

Financial Statement Audience 1
Materiality in the Annual Report to Shareholders

The Annual Report to shareholders includes one version of the firm's statements. Here, the firm is legally responsible for publishing statements that serve two purposes.

• Firstly, statements must enable shareholders to make informed decisions when electing directors. The firm, therefore, must disclose information about individual candidates that could influence a voting decision. Information for this purpose could include, for instance, information about potential conflicts of interest or family ties with the firm's officers.
• Secondly, these statements enable shareholders and investors to evaluate the firm's recent financial results and prospects for future business. As a result, the materiality concept requires full disclosure on everything that could influence a decision to hold, buy, or sell shares of stock. Relevant information here could include, for example::
• Transparent interpretation of recent performance
  For this purpose, firms sometimes supplement GAAP-required metrics such as Net Income with particular income metrics such as EBITDA (Earnings before interest, taxes, depreciation, and Amortization)
• Analysis of the firm's competitive situation
• Disclosure of forthcoming lawsuits or government penalties

Financial Statement Audience 2
Materiality For Lenders and Bond Rating Agencies

Potential lenders and bond rating agencies are another report audience. This audience, of course, must judge the firm's creditworthiness. Here, the audience tries to answer questions such as these:

• Firstly, can the company service it's debt load if it takes on still more debt?
• Secondly, what is the firm's level of leverage?
• Thirdly, what are the firm's earnings prospects in its core line of business?

The audience must have enough detail to address such questions seriously. Here, the audience needs full disclosure on the firm's creditors, liabilities, and investments. They also need full disclosure on planned changes to the firm's business model and strategies. And, they must know which financial and business risks the firm faces.

Financial Statement Audience 3
Materiality For Potential Mergers and Acquisitions

Here, each potential partner must know the other business accurately and in detail. Each must know, in other words, the other party's:

• Business model. The business model reveals, for instance, which of the firm's products earn healthy margins and which do not.
• Cost structure. This structure describes the kinds and relative proportions of fixed and variable costs that a firm incurs.
• Capital and financial structures. These structures define the firm's level of leverage. The structures show how the firm's creditors and owners share business risks and rewards.
• Organization and governance structures.
• Marketing strategy and selling model.

All potential partners need this information, in advance. Everyone must know what each adds to partnership production, marketing, selling, and general management. And, they must plan together how to eliminate redundancies and overly costly operations. And, each must know the risks and liabilities that the others bring to the partnership. Only with full knowledge in these areas can they make an informed decision on going forward joining together.

What Constitutes Materiality Abuse?

Abuses of the materiality concept in accounting can have serious legal consequences. Nevertheless, GAAP and FASB have resisted stating precisely an error size that qualifies as materiality abuse. In reviewing specific cases, however, auditors and courts use several "rules of thumb."

• On the Income statement, errors of 5% or more of before-tax Profit, or 0.5% of sales revenues, are more likely seen as "large enough to matter."
• On a Balance sheet, a questionable entry more than 0.3 to 0.5% of total assets, or more than 1% of total equity, is likely to be viewed suspiciously.

Abuse of the Materiality Concept

Those judging materiality must also consider other factors besides error magnitude. This requirement is no doubt one reason that regulators resist setting size criteria for materiality abuse. They also take into account two other factors:

• Firstly, Motivation and Intent Behind the Error.
   
  An abuse judgment is more likely if auditors or a court can prove intent to do any of the following:
  • Keep stock prices artificially high. 
  • Inflate reported earnings.
  • Understate the actual value of the asset base.
  • Inappropriately influence merger or acquisition decisions.
• Secondly, the Likely Effect on User Perceptions and Judgment.
  
  Consider for instance an Income statement placement error. Suppose there are significant "Manufacturing indirect labor expenses" for this period. Suppose also these are wrongly placed under "Direct manufacturing labor." That error probably does not qualify as materiality abuse. Regarding materiality, it is likely a harmless error because both kinds of expense contribute to cost of goods sold (COGS). As a result, the critical information for decision-makers—gross profits—is the same regardless of which COGS category has the indirect labor expense.
  
  However, suppose instead that the same indirect labor expenses appear wrongly below the gross profit line instead of above it. This kind of mistake may qualify as fraud. This mistake is harmful because the misstatement does inappropriately improve gross profits.