What Is Materiality in Accounting? (2024)

Accounting is a world that follows many rules. But amid all the “musts,” a bit ofsubjectivity is also permitted when it comes to deciding what is important or relevantenough to include in a company’s financial reports. This determination is based on aconcept known as materiality, and it is guided by whether the exclusion of information willhave a detrimental effect on “reasonable users” who are basing their decisionson these reports.

Materiality can be thought of as a filter applied to financial reporting, transactionalaccounting and auditing that considers whether information is relevant for readers.Significant pieces of information are considered material, though what is deemed significantto one business may be considered immaterial for another, based on a company’s size,industry and the nature of the information. Suffice to say, anyone who relies on accountinginformation to make business decisions, as well as those in charge of what to include andnot include, must understand materiality and its implications.

What Is Materiality?

Materiality is a key accounting principle thatdetermines whether a discrepancy, such as an omission or misstatement, would impact areasonable user’s decision-making. If it would, the information is material. If theinformation is insignificant or irrelevant, it is said to be immaterial. Many types ofinterested parties — for example, potential investors, lenders and business partners,as well as internal business management — examine a company’s financialstatements for decision-making purposes. They need to be able to trust that the informationis accurate and presented fairly. But even audited financial statements can be less thanperfect.

Both quantitative and qualitative factors are relevant when determining whether a discrepancyis important to a reader. Quantitative materiality refers to an item’s dollar amount,where a very small transaction might not make a difference to the readers of theinformation. Qualitative materiality considers the nature of an item, regardless of itsamount, to determine whether it matters, such as a pending lawsuit. The Financial AccountingStandards Board (FASB) has issued several concept statements defining materiality, and otherstandards bodies have suggested certain quantitative “rules of thumb,” but,ultimately, materiality is a matter of judgment and circ*mstance.

Material vs. Immaterial Information

Material information is anything of importance that would affect an interested party’sdecisions. If errors or omissions of information would cause a reasonable user to come to adifferent conclusion, then the information is said to be material. If it would not have animpact, it is considered immaterial. While the litmus test for determining materiality issubjective and not a formulaic threshold, as a practical matter, material information tendsto be significant relative to a company’s size.

For example, purchasing $25,000 of equipment is likely a material event for a business with$500,000 in annual revenue. However, the same transaction might be considered immaterial fora $500 million business. However, the nature of a transaction can also influence whether itis material or immaterial. For example, the Securities and Exchange Commission (SEC), whichregulates financial disclosures of public companies, suggests that certain items should beconsidered material even in insubstantial amounts. These include:

• Errors or misstatements that affect a company’s compliance with loan covenants,other contractual requirements or regulatory requirements.
• Errors or misstatements that flip a business’s net loss for a period into netincome or vice versa.
• Errors or misstatements that artificially increase compensation for company management.
• Errors or misstatements that involve fraud or illegal transactions.

Key Takeaways

• Materiality is a GAAP principle that determines whether discrepancies in financialreporting, such as an omission or misstatement, would impact a reasonable user’sdecision-making.
• Quantitative and qualitative characteristics can determine whether information ismaterial.
• Businesses use materiality when setting accounting policies in order to help manageworkload and focus.

Materiality Explained

Materiality is not only a consideration for accounting errors, omissions and misstatements,it is also a factor when setting accounting policies. A company may determine that it isexpedient to apply different policies according to an item’s materiality. For example,a company could set a policy that all asset purchases under a certain threshold are expensedimmediately, rather than capitalized and depreciated over time in accordance with GAAP. Such a policy would cause thecompany’s asset values to be understated and current period expenses to be overstated.But if the levels are immaterial to its overall financial statements— including its balance sheet, income statement and statement of cash flows— a company may prioritize the benefit of reducing the accounting workload overaccuracy. Using materiality in this way is common but can become tricky, because too high avolume of immaterial items can become material in the aggregate.

What Is the Materiality Concept?

The materiality concept recognizes that certain items are too small to make a difference inthe overall financial picture. It is a “close enough” approach and is a delicatematter of judgment. The concept of materiality might be invoked during an accountreconciliation, requiring larger items to be investigated and those below a certainthreshold accepted as is. In other cases, a company may choose to ignore a GAAP rule becausethe underlying matter is immaterial to its business. (More on this later.)

Another emerging version of the materiality concept worth noting, though tangential to accounting, relates to environmental, social andgovernance (ESG) reporting. ESG materiality considers a company’s impact on theenvironment, society and the economy, especially regarding the sustainability of theiractivities. Several international regulations require companies to disclose their ESGactivity as part of their corporate reporting, using materiality to prioritize activitiesthat support a company’s ESG strategy. Like the materiality concept in accounting, ESGmateriality is a way to focus on major, meaningful information that is significant toreaders of the report.

Applications of the Materiality Concept

Materiality is always at the forefront of accountants’ minds as they work to ensurethat any financial reporting conveys the most comprehensive and accurate picture to itsreaders. At the same time, it is generally accepted that there needs to be a level ofefficiency and speed within the accounting process. Materiality can help ease that inherenttension and is commonly applied in the following ways:

Accounting standards

GAAP-compliant companies must try to reasonably apply all the GAAP accounting standards,especially those that are material to their businesses. However, in practice, somebusinesses ignore standards concerning immaterial parts of their business, because they bankon the assumption that the errors that arise from doing so are immaterial. For example, asmall bakery may choose to ignore inventory standards for valuingfinished goods and not include unsold bakery items that spoil quickly, because theirvalue is immaterial. It’s important to note that public companies are more restrictedin their ability to ignore standards, in accordance with SEC guidance.

Minor transactions

Minor transactions are often bypassed during the accounting close process if they are immaterial inamount and in nature. This is most often the case during interim fiscal periods andespecially when an immaterial transaction would normally be captured in the next period. Anexample would be a single outstanding travel and expense report from one of 50 salespeoplethat was submitted after the accounting close and wasn’t properly accrued.

Capitalization limits

Capitalization limits are an everyday application of the materiality concept. In this case, acompany sets a materiality threshold value for asset purchases. Amounts over the thresholdare capitalized and amounts under it are immediately expensed. Capitalization and depreciation is a more accurateway to spread costs over the periods the assets serve, but it requires tracking the asset,establishing its useful life and regularly recording depreciation journal entries.Capitalization limits reduce the workload for items that are too small to make a materialdifference. For example, a construction company may set a capitalization limit of $20because the aggregated cost of small tools is immaterial to the overall value of equipment.

Materiality and GAAP

Materiality is one of the 10 principles of GAAP. It acts as a quality control to the othernine interrelated principles. At its core, materiality requires all significant informationto be included in financial reporting to ensure reporting usefulness. At the same time, themateriality concept helps businesses achieve the objective of providing complete, accuratefinancial information while managing the cost, effort and time needed to provide theinformation. In other words, materiality helps keep accounting processes from getting lostin the weeds of minutiae to instead focus on providing meaningful, reliable content.

Nevertheless, materiality is not an excuse for shoddy bookkeeping. When applying materialityor when errors and omissions are identified, it’s important to remember that theultimate test of whether information is material is whether its absence or misstatementmisleads a reasonable reader.

It’s noteworthy that the definition of materiality for GAAP differs slightly from thedefinition under International Financial Reporting Standards (IFRS). Whereas GAAP focuses onerrors, omissions and misstatements, the IFRS version is a little broader by also includingobscuring data, in addition to omitting or misstating.

Examples of Materiality

Most companies use varying forms of materiality, regardless of their size. Some commonexamples include:

Expensing vs. depreciating assets:

A company that uses a capitalization limit, as described above, fully expenses immaterialitems when they’re purchased, rather than depreciating them over their useful lives.For example, a boutique fitness studio might choose to fully expense the $20 cost of fivenew yoga mats in a single period, rather than set them up as fixed assets and depreciatethem over their two-year useful lives.

Losses compared to net income:

A business can use materiality to determine whether to report a loss on its income statement.In this case, materiality is based on the size of the loss relative to the amount of thebusiness’s net income. For example, if a bakery’s refrigerator breaks down,causing $1,000 worth of butter, eggs and other ingredients to spoil, it may elect to leavethis loss out of its financial statements because it is immaterial compared to thebakery’s $1 million of net income. However, if the bakery’s net income for theyear is only $10,000, the loss would likely be a significant item on the income statement.

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In an ideal world, accounting data would always be perfectly accurate and the concept ofmateriality would be, well, immaterial. However, manual accounting processes and disjointedaccounting systems create environments where errors, omissions and inconsistent applicationof accounting standards become more likely. A solution like NetSuite Cloud AccountingSoftware increases accounting accuracy by eliminating duplicated and miscalculatedinformation, which improves the quality of information in a company’s financialreports and, therefore, their usefulness. In addition, NetSuite helps to ensure consistentapplication of accounting rules, improving compliance. At the same time, companies can setmateriality rules and risk ratings per account within the accounting software, whichstreamlines accounting processes like account reconciliations and variance analysis, makingthem more efficient and faster. It also strengthens the control environment by identifyinganomalies and issuing alerts in real-time.

Materiality boils down to a judgment of whether an omission or misstatement of quantitativeand qualitative information in financial statements would impact a reasonable user’sdecision-making. It can be thought of as a “close enough” approach thattolerates certain items that are too small to make a difference in the overall financialpicture. Materiality is a matter of efficiency and expediency that helps businesses managethe objective of providing complete, accurate financial information within the cost, effortand time parameters needed to produce that information.

Materiality FAQs

How do you measure materiality?

Materiality is a relative measure. It is considered in the context of a business’ssize, typically using total assets and net income as guidelines. However, there is no setformula for determining materiality.

Why do we need materiality?

Materiality helps businesses manage the objective of providing complete, accurate financialinformation within the amount of cost, effort and time needed to produce the information. Itis a way to keep accounting processes from getting bogged down by minutiae and instead focuson providing meaningful financial information. When applying materiality, it’simportant to remember that the ultimate test of whether something is material is whether itsomission or misstatement could mislead a reasonable user.

What is the difference between planning materiality and performancemateriality?

Planning materiality is an audit term that refers to the tolerable aggregate value of errorsand misstatements that would still allow financial statements to be materially accurate andearn a positive audit opinion. Even an unqualified, or “clean,” audit opinionasserts only that the financial statements are free of material misstatements, not that theyare 100% accurate. Performance materiality is a smaller dollar value than the planningmateriality that auditors use at a detailed level. The gap between planning and performancemateriality is a risk cushion intended to compensate for undetected errors, sampling riskand uncorrected findings. The performance materiality is the “working” valueused to determine statistical samples and tests at an account level.

How is materiality defined?

Materiality is a concept that determines whether the omission or misstatement of informationin a financial report would impact a reasonable user’s decision-making. If informationis significant, it is material. If the information is insignificant or irrelevant, it issaid to be immaterial. Materiality is both quantitative and qualitative. The definition ofmateriality under the Generally Accepted Accounting Principles differs slightly from thedefinition under International Financial Reporting Standards (IFRS). The IFRS version is alittle broader in that it includes obscuring data, in addition to omitting or misstating it.

What are the 3 types of materiality?

In general, materiality is both quantitative and qualitative. There are three types ofmateriality that are specific to audits: planning materiality, performance materiality andspecific materiality. Planning materiality refers to the tolerable aggregate value of errorsand misstatements that would still allow financial statements to be materially accurate andearn a positive audit opinion. Performance materiality is a smaller dollar value than theplanning materiality that auditors use at a detailed level. Specific materiality is aparticular threshold set for a certain account or category of accounts. For example, arelated party transaction might be audited using a specific (often lower) materialitythreshold because of the sensitivity of those transactions.

What is an example of materiality?

A common example of materiality is when a business chooses to expense small assets instead ofcapitalizing and depreciating them. Typically, a company sets a capitalization limit andexpenses immaterial items when purchased. For example, an insurance agency with $1 millionannual net profit might choose to fully expense a newly purchased $200 fax machine in asingle period, rather than set it up as fixed asset and depreciate it over its estimatedthree-year useful life.

What does materiality mean in auditing?

Audits do not verify that the financial statements are perfectly accurate. Instead, anunqualified, or “clean,” audit opinion asserts only that the financialstatements are free of material misstatements. Materiality means that the financialstatements are useful and do not contain or omit any information that would cause areasonable user to be misled. Auditors use several versions of materiality during theirwork.