The materiality concept, also called the materiality constraint, states that financial information is material to the financial statements if it would change the opinion or view of a reasonable person. In other words, all important financial information that would sway the opinion of a financial statement user should be included in the financial statements.
The concept of materiality is relative in size and importance. Some financial information might be material to one company but might be immaterial to another. This is somewhat obvious when you think about a small company verses a large company. A large and material expense to a small company might be small an immaterial to a large company because of their size and revenue. The main question that the materiality concept addresses is does the financial information make a difference to financial statement users. If not, the company doesn’t have to worry about including it in their financial statements because it is immaterial.
Most of the time financial information materiality is judged on qualitative and quantitative characteristics. Professionals are often left up to their experience and good judgment to understand what is material and what isn’t.
Examples
– A large company has a building in the hurricane zone during Hurricane Sandy. The company building is destroyed and after a lengthy battle with the insurance company, the company reports an extra ordinary loss of $10,000. The company has net income of $10,000,000. The materiality concept states that this loss is immaterial because the average financial statement user would not be concerned with something that is only .1% of net income.
– Assume the same example above except the company is a smaller company with only $50,000 of net income. Now the loss is 20% of net income. This is a substantial loss for the company. Investors and creditors would be concerned about a loss this big. To the smaller company, this $10,000 would be considered material.
– A small company bookkeeper doesn’t do a very good job of keeping track of expenses. Most random expenses get recorded in the miscellaneous expense account. At the end of the year the miscellaneous expense account has a total of $1424.25 in it. The total net income of the company is $36,940. The miscellaneous account is immaterial to the overall financial picture of the company and there is no need to reclassify the expenses in it.
