Importance of Materiality in Accounting
Financial information is a useful measure of a company's performance. Financial statements inform interested parties of a company's overall worth, the value of the company's assets and liabilities, and the significance of the company's day-to-day transactions. Users of financial information assume companies comply with accounting principles when creating financial statements. Based on prevailing accounting conventions, this is true as long as the cost of applying an accounting principle does not exceed the benefit of doing so. For example, the materiality concept enables a company to depart from financial accounting principles if a transaction is of insufficient size to be of concern to financial statement users.
The manner in which a company accounts for a transaction can have a material effect on the usefulness of financial statements to the documents’ readers. Information is material if its misstatement or omission might influence the judgment of anyone who relies on the data provided in financial statements. The company's operations, the nature of the item and its monetary size each influence the materiality of information.
If a transaction's dollar amount is sufficiently small or its nature is relatively inconsequential to the company's primary business operations, a company may consider the information immaterial. In this case, a company can forgo the accounting method suggested by accounting principles and, instead, use a less-costly or more expedient method to account for the transaction. One company's threshold for materiality may differ from that of another company, and the threshold may also vary over time.
If the cost of adhering to accounting principles exceeds the benefit of doing so, a company can depart from the principles. For example, the matching principle recognizes that an asset’s useful life may extend beyond a current accounting period. Therefore, this principle requires a company to report asset costs in the balance sheet during a current accounting period and subsequently expense these costs during the asset’s useful life. However, the cost of an asset, such as a stapler, may be immaterial. In addition, the labor cost to capitalize the stapler's purchase price and expense it over multiple periods is probably higher than the cost of the stapler. Therefore, the company can elect to expense the cost in the current period. This approach does result in the misstatement of income in the current and future periods based on the stapler’s useful life. However, the misstatement is immaterial in terms of its impact to any decisions based of the company’s financial statements.
Materiality is a subjective concept that enables a company to measure and disclose only those transactions that are of a sufficiently large dollar amount to be of concern to the users of a particular company's financial statements. A company must account for these substantive amounts in a way that complies with financial accounting principles. However, materiality – the significance of an item – is measured in terms of the item's dollar amount and the nature of the misstatement that results if accounting principles aren't followed. Therefore, each company has the ability to determine what items are material in the context of its operations and justify the labor cost of adhering to accounting principles when accounting for the items. The company's characteristics, the prevailing political and economic environment, and the role of the person who reviews the financial statements may each affect materiality judgments.