Materiality
Materiality in accounting and finance refers to the significance of a financial transaction, event, or omission of information which, if misstated, might influence the economic decisions of those using the financial statements.
Materiality is not only about the monetary value or size of a transaction, but also about the impact it could have on decisions made by investors, creditors, or other stakeholders. The concept is used by auditors when planning and performing an audit to decide which transactions to test and how extensively to test them.
For example, a company might make a small error when calculating depreciation for one piece of equipment. If the impact on the financial statements is relatively small, then this error may not be considered material because it wouldn’t likely influence a reader’s understanding of the company’s financial health.
On the other hand, suppose a company fails to disclose a significant lawsuit that could potentially result in large future liabilities. This omission would likely be considered material because it could mislead investors or creditors about the company’s future financial stability, even though the lawsuit has not yet resulted in an actual expenditure.
Materiality is a qualitative and quantitative concept, and involves a high degree of professional judgement to determine what is considered material for a particular entity or set of financial statements.
Example of Materiality
Let’s go through a couple of examples to illustrate the concept of materiality.
Example 1: Quantitative Materiality
Suppose Company A, a multinational corporation with annual revenue of $10 billion, made a mistake in its accounting records and overstated its inventory by $10,000.
In this case, the $10,000 error is likely not considered material because, relative to the company’s size and earnings, it’s unlikely to influence the decisions of investors, creditors, or other users of the financial statements.
Example 2: Qualitative Materiality
On the other hand, suppose Company B, a smaller business with annual revenue of $2 million, failed to disclose in its financial statements that its CEO, who is also its primary salesperson and the face of the company, is planning to retire in the upcoming year.
Even though the omission does not involve a specific financial amount, it could be deemed material because this information could significantly influence decisions made by stakeholders. They may have concerns about the company’s future sales and profitability, which might affect their investment or credit decisions.
These examples show that materiality can be both a matter of the size of the numbers and the nature of the information. It involves judgement, and the key question is always whether the misstatement or omission could reasonably be expected to influence economic decisions.
