What is materiality in accounting? (Definition and examples)
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In accounting, not all financial transactions are equal. Larger financial figures tend to be more significant, or material, for a company's finances than small ones. The concept of materiality refers to the impact a particular financial figure has on a company's accounts, and whether its omission or a mistake in its calculation has a material impact on the outcome of the financial statements. In this article we look at the concept of materiality in accounting, providing a definition, explaining how it's assessed and offering some examples of materiality and immateriality.
What is materiality in accounting?
Materiality in accounting refers to the relative size of an amount, and the impact it makes on the financial statements. In the accounting process, accountants deem relatively large sums of money to be material. This means they have a significant impact on the company's finances. Accountants tend to deem relatively small sums as immaterial. This means they don't have a significant impact on the company's finances. Accountants typically use their professional judgement in defining whether a sum is material or not.
Another way of defining materiality refers to the impact an omission or mistake in the company's finances might make on the individual reviewing them. If the omission or mistake is likely to mislead the individual or alter their actions, then accountants define the omission or mistake as material. If the omission isn't likely to have altered the actions of the individual, then accountants consider it to be immaterial.
Uses of materiality
Accountants apply the concept of materiality in several ways during the accounting process. Materiality can help to improve the efficiency of the accounting activities of a company, with accountants sometimes using the concept of materiality to bypass or ignore certain accounting standards. Here are several situations where accountants might decide to apply an assessment of materiality in their work:
When applying accounting standards
One use of materiality is in the process of applying accounting standards. If accountants deem a transaction or financial sum to be immaterial to the company's financial statements and accounts, they may be able to avoid the process of applying accounting standards to it. This can speed up the accounting process and increase the accountant's efficiency.
For minor transactions
Accountants may sometimes deem minor transactions to be immaterial. This may happen when a financial controller is attempting to close the books for a particular accounting period. Accountants can choose to omit minor transactions from the final calculations if they would have an immaterial impact on the overall financial statements.
Accountants may classify small expenditures as expenses if they're considered immaterial to the outcomes of the financial statements. If accountants deem these expenditures to be material, they would include them in the financial statements and apply capitalisation and depreciation over time, which could have an impact on the final financial statements. A material expenditure that requires accountants to apply capitalisation and depreciation provides an accountant with more work, as the expenditure requires tracking over time. Deeming it immaterial and classifying it as an expense saves the accountant time and creates efficiencies in the accounting activities.
How to assess materiality
There's no standardised, universally accepted method for calculating or assessing materiality. The decision to apply the concept of materiality depends largely on the professional judgement of the accountant creating the financial statements. One important point for accountants to consider is that materiality is relative to the size of the company. There's no single threshold for materiality. It's all dependent on the size of the company and the size of the sum, relative to the company. There are though, some principles that accountants can apply when determining whether a transaction can be either material or immaterial. These are as follows:
1. Determine a benchmark
Accountants can choose from several accounting figures as the benchmark for assessing materiality. This benchmark acts as the baseline against which accountants measure transactions to decide whether they're material or immaterial. The benchmark could be the company's gross revenue, gross profit, operating income, net profit, total assets or shareholder's equity. Operating income from continuing operations tends to be the most frequently used benchmark for commercial, profit-making companies, though this may change if the company made a loss, or only made a small profit.
Related: How to become a chartered accountant
2. Decide the percentage threshold
After determining the benchmark, the accountant goes on to select a threshold of that benchmark, which determines whether a transaction is material or immaterial. These thresholds may be a fixed percentage or a range that the sum falls into, for accountants to class it as immaterial. A fixed percentage is a 'single-rule method', while a range of percentages is a 'variable-size rule method'.
Under a single-rule method, a transaction may be immaterial if, for example, it costs less than 1% of the company's total revenue or 5% of its pre-tax income. Under the variable-size rule method, you may have a sliding scale of percentages, depending on the size of the company. For example, the threshold may be 5% of gross profit if the company's profit is less than £20,000, 2% if the profit is £20,000 to £100,000, and 1% if the profit is more than £100,000.
3. Document the judgements for the benchmark and threshold
After deciding the benchmark for assessing materiality, and the threshold for judging each transaction, it's important for accountants to document these judgements along with a justification for each. This creates a record of the decisions that a financial controller or auditor can refer to if required.
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4. Apply the calculation to your transactions
Once the benchmark and threshold are finalised, the accountant can apply them to their transactions. The accountant may identify transactions that might qualify as immaterial, and each transaction can be assessed for whether it's material or immaterial. This can help the accountant to understand which transactions can be excluded from the financial records.
Examples of materiality
There are numerous situations where accountants could use materiality to speed up and create efficiencies in the accounting process. For each instance, it's essential that the accountant uses their professional judgement and applies consistent principles to justify their decisions, including recording any rules they've set. This ensures accountants can support any instances where they've deemed a transaction as immaterial with evidence of their professional process and decision-making. Some examples of materiality in accounting are as follows:
A company spends £100 on a new office chair. The accountant classifies the £100 expenditure as a business expense for the year the company purchases it in, rather than recording it as an asset. If the accountant classed the purchase as an asset, they would report it on the financial statements and record depreciation of the asset on each year of the financial statements. For example, this could be a depreciation of 10% (or £10), every year for 10 years.
Materiality allows accountants to expense the whole cost of the chair in a single accounting year. This is a valid use of materiality because classifying the purchase as an expense wouldn't be likely to mislead any investor, creditor or auditor. The application of materiality could vary according to the value of the purchase, relative to the size of the company.
A company discovers an accounting error in financial statements that they've already completed and filed. Amending the error would require accountants to reopen the financial statements, redact the error and amend their calculations. In this case, it's only worthwhile for the accountant to reopen the financial statements if an observer or reviewer of the accounts could consider the error to have misled them, or led to them making an incorrect judgement or decision.
If an observer does consider that the error has misled them, it would be material, and an auditor may ask the accountant to reopen the books and amend the error. Otherwise, if it's considered that the error or omission doesn't result in misleading information, accountants could write it off as immaterial.
An accountant is waiting to receive several invoices for products or services before closing the books on an accounting period. In this case, the accountant may decide to estimate the sums included in the invoices and include the estimated or projected figure in the financial statements, so they can close the books.
When the accountant receives the final invoices, the sum may be different to the estimated amount that they included in the financial records. The accountant can review the figures, and decide whether the difference between the estimated amount and the actual amount is significant or not. If the difference is relatively small, then the accountant may decide to consider it immaterial, and amending the financial statements won't be necessary. If the difference is more significant, then it might be a material difference, and the accountant may reopen the financial records, make amends and resubmit the accounts.
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