How are materiality (and immateriality) related to the proper presentation of financial statements

The concept of materiality refers to the relative significance of an amount, activity, or item to informative disclosure and a proper presentation of financial positions and the results of operations. Materiality has qualitative aspects; both the nature of the item and its relative size enter its evaluation.

An accounting misstatement is said to be material if knowledge of the misstatement will affect the decisions of the average informed reader of the financial statements. Financial statements are misleading if they omit a material fact or include so many immaterial matters as to be confusing. In the examination, the auditor concentrates efforts in proportion to degrees of materiality and relative risk and disregards immaterial items.

The relevant criteria for assessing materiality will depend upon the circumstances and the nature of the item and will vary greatly among companies. For example, an error in current assets or current liabilities will be more important for a company with a flow of funds problem than for one with adequate working capital.

The effect upon net income (or earnings per share) is the most commonly used measure of materiality. This reflects the prime importance attached to net income by investors and other users of the statements. The effects upon assets and equities are also important as are misstatements of individual accounts and subtotals included in the financial statements. The auditor will note the effects of misstatements on key ratios such as gross profit, the current ratio, or the debt/equity ratio and will consider such special circumstances as the effects on debt agreement covenants and the legality of dividend payments.

There are no rigid standards or guidelines for assessing materiality. The lower bound of materiality has been variously estimated at 5% to 20% of net income, but the determination will vary based upon the individual case and might not fall within these limits. Certain items, such as a questionable loan to a company officer, may be considered material even when minor amounts are involved. In contrast a large misclassification among expense accounts may not be deemed material if there is no misstatement of net income.

In accounting, materiality refers to the impact of an omission or misstatement of information in a company's financial statements on the user of those statements. If it is probable that users of the financial statements would have altered their actions if the information had not been omitted or misstated, then the item is considered to be material. If users would not have altered their actions, then the omission or misstatement is said to be immaterial.

The materiality concept is used frequently in accounting, especially in the following instances:

• Application of accounting standards. A company need not apply the requirements of an accounting standard if such inaction is immaterial to the financial statements.

• Minor transactions. A controller who is closing the books for an accounting period can ignore minor journal entries if doing so will have an immaterial impact on the financial statements.

• Capitalization limit. A company can charge expenditures to expense that would normally be capitalized and depreciated over time, because the expenditures are too small to be worth the tracking effort, and capitalization would have an immaterial impact on the financial statements.

Thus, materiality allows a company to ignore selected accounting standards, while also improving the efficiency of accounting activities.

The dividing line between materiality and immateriality has never been precisely defined; there are no guidelines in the accounting standards. However, a lengthy discussion of the concept has been issued by the Securities and Exchange Commission in one of its staff accounting bulletins; the SEC's comments only apply to publicly-held companies.

Examples of Materiality

Here are several examples of materiality in accounting information:

• A company encounters an accounting error that will require retrospective application, but the amount is so small that altering prior financial statements will have no impact on the readers of those statements.

• A controller could wait to receive all supplier invoices before closing the books, but instead elects to accrue an estimate of invoices yet to be received in order to close the books more quickly; the accrual is likely to be somewhat inaccurate, but the variance from the actual amount will not be material.

• A company could capitalize a tablet computer, but the cost falls below the corporate capitalization limit, so the computer is charged to office supplies expense instead.

5. How is materiality (or immateriality) related to the properpresentation of financial statements? What factors and measures should beconsidered in assessing the materiality of a misstatement in the presentationof a financial statement?

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What is materiality and immateriality?

How does materiality affect financial statement?

What is materiality and immateriality in auditing?

What factors and measures should be considered in assessing the materiality of misstatement in the presentation of a financial statements?