Materiality Principle
The materiality principle in accounting states that all relatively important amounts should be reported in the financial statements and trivial amounts can be disregarded. In other words, companies are required to strictly adhere to accounting principles and rules for significant items and transactions. For items that are not materially important, less strict adherence is allowed for the sake of practicality and cost effectiveness.
Materiality involves judgement and will depend on the nature and size of the transaction. An item is considered material if its omission or misstatement could influence the economic decisions of users taken on the basis of the financial statements.
For example, consider a large corporation that has mistakenly recorded a minor expense of $500 as $550. In the grand scheme of the corporation’s financial operations, this error is probably immaterial, and the financial statements are unlikely to be misleading if the error is not corrected.
However, if that same error occurred in a very small business, it might be considered material because it could represent a significant proportion of the business’s overall expenses and could potentially influence the decisions of the business’s stakeholders.
The materiality principle is an important part of financial reporting as it helps to ensure that financial statements provide a true and fair view of a company’s financial position and performance.
Example of the Materiality Principle
Imagine you’re the owner of a large construction company, BigBuild Inc., which operates with annual revenues in the tens of millions of dollars.
During the fiscal year, an employee accidentally records a $200 hammer purchase as $2,000. While this is technically an error, it’s relatively small compared to the scale of BigBuild Inc.’s operations. In the context of multi-million dollar revenues and expenses, the $1,800 misstatement is not likely to influence the decisions of stakeholders who are using the financial statements.
According to the materiality principle, it might be acceptable not to correct this error in the financial statements, because the cost and effort of making the correction may outweigh the benefits. This is because the mistake does not materially impact users’ understanding of the company’s financial health.
However, it’s important to stress that all errors cannot be justified using the materiality principle. If multiple errors of this size accumulated over the fiscal year, they could collectively become material. And clearly, larger errors, or errors related to more significant transactions, would need to be corrected.
Remember, the key point about the materiality principle is that it requires professional judgement to determine at what point an error or omission becomes material in the context of a company’s overall financial situation.
