The concept of materiality helps an accountant decide which account balances should be disclosed separately and which of the account balances should be merged. The concept of materiality is straightforward, which states all the balances/information that impacts the decision of the financial statements user should be separately presented/disclosed in the financial statements.
The concept of materiality is based on qualitative aspects and requires the use of professional judgment. There is no defined rule that some specific balance will impact the financial statement while it’s about the management’s judgment.
Sometimes, even the balance of $50 can be material, and sometimes $50,000 may not be material. So, it’s about the related size of the entire business that helps to determine if some specific balance is material or not.
It’s also important to note that account balance can be material in three ways,
- Material by amount balance – some higher amount of the account balance.
- Materiality by impact – Inclusion/exclusion of the account balance converts the loss to profit or profit to the loss.
- Material by nature – Some of the account balances like related party transactions, the Directors’ fee, and inter-company transactions are material by nature.
Further, under IFRS, the concept of materiality is more flexible and subject to interpretation. However, US GAAP provides specific criteria for the account balances to the material. For instance, if some account balance exceeds 5% of the total assets, it should be separately disclosed in the financial statement.
Likewise, if accounting transactions in the profit and loss with the ability to convert profit to loss/loss to profit should be separately disclosed.
Following are some examples to illustrate how the concept of materiality is used in accounting.
1-Capitalization of the assets in the balance sheet
Capitalization is done for the assets that are used in more than one accounting period. However, some of the assets are used for more than one accounting period and qualify for the definition of capital assets and are still charged as an expense in the income statement because the amount is so trivial that there is no impact on the financial statement if we charge in a single accounting period or capitalize and depreciate over its useful life. So, to avoid the burden of administrative effort, the companies prefer to expense an asset in a single accounting period. Hence, the concept of materiality helps us to decide if an asset should be charged as an expense in a single accounting period or capitalized to be depreciated over its useful life.
2-Adoption of accounting standard
US GAAP allows bypassing the requirement of the accounting standard if the appropriate balance is not material and it does not impact the decision of financial statement users.
Sometimes, the management of the company discovers errors in the accounting record. However, these errors are so trivial that they do not impact the user of the financial statement. So, the company’s management can decide to ignore a mistake because the cost of correction is more than the benefit to be obtained from the correction of the error.