The principle of materiality is essential in preparing financial statements, as it helps companies determine what information to include and what to exclude to prepare the entity's financial reports. Materiality is one of the four constraints of GAAP (Generally Accepted Accounting Principle). Companies use the materiality principle when accounting and measuring their transaction and expense in a year.
Discover what is the principle of materiality, its importance, the difference between materiality and immateriality, also some examples of the materiality principle in this article!
What is the principle of materiality?
The principle of materiality is taken from the financial audit register. It was originally characterized by the choice of accounting indicators to measure the level of performance and reliability of a company.
Materiality principles stipulate that accountants must collect, process, and provide sufficient information of a material nature, otherwise information that has little effect or has no impact significant to the user's decision can be ignored.
In the world of CSR and GRI (Global Reporting Initiative), the principle of materiality aims to establish a relevant hierarchy of the challenges of a sustainable development strategy, with regard to the priorities of a company or other type of firm as well as the expectations of the various stakeholders, shareholders, and investors.
The difference between materiality and immateriality
In accounting rules, it is necessary to understand how materiality and immateriality differ because the stability of a business can be based on these concepts.
According to the International Accounting Standards Board (1989), information that is considered material is as follows:
Information is material if its omission or misstatement could influence the economic decisions of users of the financial statements. Materiality depends on the size of the item or error judged under specific conditions. Materiality refers to the magnitude or nature of a misstatement (including omission of financial information) either singly or in aggregate) that results in the possibility that investment decisions are made.
In other words, information is considered material in cases where the lack of information or inaccurate information could significantly distort the income statements, affecting the economic decisions of the users of the information. The materiality of information is considered both quantitatively and qualitatively, depending on the size and nature of the information or the accounting errors assessed in the particular circumstances.
Why is it important?
Materiality is exercised in the general context of the objectives assigned to financial reporting in the conceptual framework, namely to give users useful information on the financial position, financial performance, and cash flows of the company in their decision-making.
Applying the concept of materiality is not new. Materiality applies to most decisions related to business activities. Since the 1800s, UK courts have emphasized the importance of presenting information to users of financial statements. In the United States, the importance and influence of materiality were hotly debated after the enactment of the Security Act of 1933.
The concept of materiality is crucial to all business decisions. The influence of materiality is the key to understanding and applying International Financial Reporting Standards (IFRS), and preparing and analyzing the information contained in the financial statements. To determine the materiality information or amount, companies need professional judgment because $10,000 could be significant to small businesses but it doesn't have the same value as big companies for example.
Two objectives for the principle of materiality:
- explanations on the elements included in the summary statements;
- additional information to meet the general objective assigned to the financial statements.
Example of the principle of materiality
For example, if the company stocks a labor tool for use in the production workshop worth $50, the auditor will record the production cost at the time of shipment as $50.
Every day of use, that tool is certain to wear out some of it, but accountants will not track and record that wear and tear. In practice, tracking, assessing, and recording such wear and tear is impossible. Given that it is a "trivial", unimportant thing that accountants can ignore. But if a fixed asset or a batch of goods is found to be no longer worth it, the accountant will disclose this matter.
On the other hand, for an instrument of great value that can be used over a long period of time, in order to avoid fluctuations in costs and affect reported profits between periods, the value of that instrument will be “allocated” over several periods.