Main purpose of financial accounting is to prepare and present the financial statements of an entity which are used by various internal and external stakeholders for decision-making purposes. Keeping this core objective of accounting in mind, materiality principle is accepted and followed all over the world. Materiality principle requires that financial statements should not be materially misstated which means that financial statement should not omit or misstate any such information which can influence the economic decisions of the users of the financial statements.
Any such information whose omission or misstatement can have an influence on the economic decisions of the users is considered as material. Materiality principle guides the accountants to set a materiality threshold, so that there are no errors or omissions above this materiality threshold. In practical situations, sometimes the cost of following an accounting principle is more than its benefit in terms of being beneficial to the users of the financial statements. For instance, a company is working on a project which has two components. One is the delivery of certain machinery and the second is its installation. Installation component is just 10% of the total contract value. At the reporting date, the company has delivered the machinery and recorded revenue related to that part. However, installation is in process and the company is not able to ascertain the percentage of completion which is required for calculating revenue related to installation services as per matching principle. Only due to this issue, the company is not able to finalize its financial statements and can miss the local regulator’s stipulated deadline for issuance of financial statements. The accounting team of the company has evaluated the effect of omission of installation revenue and concluded that it is not likely to effect the decisions of the users as the amount is very insignificant in the context of overall financial statements. IS THIS RIGHT? Yes! In such cases, materiality principle allows us to override any other principle, as long as the information omitted or misstated is not material.
We have discussed the materiality principle and what is material information, but practically, determining materiality is a tricky business and involves considerable amount of professional judgement. Accounting standards have also not issued any quantitative guidance on setting materiality, as it is not just the amount, the nature of an item is also critical and information can be material either due to its magnitude or its nature. Generally, accountants and auditors use certain gross or net benchmarks and percentages to determine materiality levels depending upon the nature of business. For instance, a profit oriented manufacturing business can use revenue (gross measure) or net profit (net measure) as a benchmark and apply percentages such as 2% or 5% respectively to workout materiality.
Let’s take a look at some examples of material information which will clarify how information can be material due its magnitude or its nature.
Examples – material by magnitude
A company manufactures and installs a special machinery package for its customers in the field of metallurgy. During an accounting year, the company has recorded sales revenue of $100,000; however, it has not recorded installation revenue as the installation is still in process. Let’s evaluate the following cases:
- As per percentage of completion method, installation revenue to be recorded is only $1,800, which is even less than 2% of total sales revenue, so it can be regarded as immaterial.
- As per percentage of completion method, installation revenue to be recorded is $15,000. Now this is quite a significant amount in the context of overall sales revenue. It should considered as material to the users and must be recorded and reported in the financial statements.
Examples – material by nature
- A company is involved in conducting aviation training courses and has a special license to operate in country XYZ. During the year, there are some discussions at the senate level and there are possibilities that a new legislation will be made cancelling all such licenses of aviation training academies as the country is aiming to provide these training courses at government institutes. Now, this information does not involve any amounts, but it is directly related to the going concern assumption of the company and is a material information which must be reported to the users of the financial statements.
- Transactions and balances with related parties are often considered as material by nature and are required to be disclosed in the financial statements, even if the amounts are not material by magnitude.
- Accounting policies and areas involving significant estimates are also considered material by nature as this information is critical for the understanding of the users of the financial statements.