What Is Materiality in Accounting? (Plus When To Use It)
There are many accounting concepts to take into consideration when documenting expenses, purchases or losses for your organization. Many accounting professionals track these items to understand more about their company's financial health and to improve financial audit performance. Learning about materiality in accounting can help you further understand when to track items for your company. In this article, we review what materiality in accounting is, discuss when to apply this concept, explore the benefits of this accounting practice and examine four examples to help you apply this concept to your company's financial statements.
What is materiality in accounting?
Materiality in accounting is the significance of an account to a company. Accountants or other financial professionals determine an account's materiality or immateriality in financial reports. In general, an account is material if it can influence user decisions. Users who review financial reports to make decisions include:
Materiality thresholds differ between companies. Factors that financial professionals review when determining materiality include size, industry, financial performance and internal controls. Sometimes, these professionals consult third-party finance experts to help them determine their organization's materiality.
When to apply the materiality concept
Accounting professionals often use this concept to improve the efficiency of accounting activities. Some common instances that these professionals use this concept include:
Minor financial transactions
Accounting professionals review journal entries often, including when they complete these entries after every month. These financial controllers can skip reviewing minor journal entries that have minimal or no effect on the organization's financial statements. This can help reduce the time taken to complete monthly journal entries and increase the availability of the controller for other tasks.
Related: 80 Common Accounting Terms
Accounting standards application
Accounting standards include general principles, assets, liabilities, equity, revenue and expenses. Financial professionals can ignore these standards if the expense has a minimal or trivial effect on the company. Examples of trivial items that might not require the application of accounting standards include:
The difference between estimated and actual costs has little variation.
The cost of replacing common office items has little effect on company expenses.
An accounting error has no effect on financial statement readers.
Companies can charge small expenditures to a larger expense account instead of tracking them individually. These expenditures, which a company would normally capitalize and depreciate over a period, are generally too small to justify tracking each expense by itself. Some expense accounts professionals might charge these minor expenditures to include:
Cost of goods sold: This expense account includes the costs and expenses a company incurs that correlate to the production of the company's products, materials or goods.
Operating expenses: Operating expenses are the expenses a company accumulates to conduct normal business operations and may include rent, equipment, inventory costs, payroll, insurance and marketing costs.
Finance expenses: A finance expense account helps a company track the costs incurred from borrowing financial resources from lenders, creditors or other financial institutions.
Non-operating expenses: These types of expense accounts include incurred costs that aren't directly related to production and might include inventory write-offs, interest payments and restructuring costs.
Accrued expenses: This expense account is how a company recognizes company expenses before they're settled and is useful when a company purchases an item and is awaiting an invoice.
Benefits of using the materiality concept
There are many benefits of implementing the materiality concept in your organization's financial accounts. In addition to improved efficiency, benefits include:
Enhanced stakeholder discussions: Applying materiality to your organization's accounts can help your company identify and discuss important accounts. Reducing the number of unnecessary information can also help your company improve the interactions with organization stakeholders.
Improved decision-making processes: Many leadership teams review financial information before making critical decisions. Applying this concept can help leaders quickly review financial statements and make decisions that can benefit the business.
Reduced workload: Reducing the workload for financial professionals through the application of materiality can help enhance employee satisfaction. This can also enable these professionals the ability to focus their efforts on other accounting tasks, such as payroll, accounts receivable or account audits.
Examples of materiality in accounting
Review these four examples of the materiality concept to help you understand and apply this accounting technique to your organization's financial statements:
1. Small expense example
Review this example to understand more about minor expenses on financial statements:
Granite Hills Manufacturing is a manufacturing company that incurs $400,000 in operating expenses monthly. The company purchases two rolls of blue tape at $5 each, which helps production associates mark any product defects after the manufacturing process. One of the company's accountants reviews this transaction to determine the materiality of this transaction.
They calculate the total costs, which is $10, and divide it by the total operating expenses. This equates to 0.000025, and they multiply this result by 100 to discover the percentage of this purchase. Since the total purchase was 0.0025%, the accountant determines this purchase is too trivial to include in the company's financial statements.
2. Large expenditure example
Understanding this example can help you determine what significant expenses a company might include in its financial statements:
Quaint Express is a food service company that purchases a new fryer to replace an outdated appliance. The company incurs a total of $200,000 in annual expenses. The total for the purchase of the new commercial fryer cost $15,000. To determine how significant this purchase is, one of the company's accountants compares this cost with the annual expenditures of the organization.
They divide $200,000 by $15,000, which results in a value of 0.075. To find the percentage of this expense, the accountant multiplies this result by 100, which equals 7.5%. Since this percentage is above 5%, which the company decided was a significant amount, the accountant includes this transaction in the company's financial records.
3. Minimal product loss example
If a company experiences an inventory or product loss, reviewing this example can help you determine if you want to include it in your company's income statement:
New Age Outfitters is a clothing company and has a net income of $750,000 in a year. The business stores its overflow inventory in the facility's basement and the basement floods and causes the company to lose $5,000 in product inventory. The company determines this loss equals 0.66% of their total net income and decides the loss is immaterial and they can exclude it from the income statement.
4. Company liability example
Many companies incur debt when funding operations, so reviewing this example can help you determine when to include debts or liabilities in your organization's financial statements:
Tennent Industries currently owes another company $2,000 for a recent purchase. The organization's asset value equals $30 million. Accountants with Tennent Industries calculate the significance of this debt by dividing $30 million by $2,000. This equals 0.0000667, and they multiply this by 100 to discover the percentage amount of 0.0067%. According to the company's asset value, the debt has minimal effect on the company's financial performance, so the accounting team excludes this debt from the organization's financial accounts.
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