Materiality is defined in relation to financial information underlying financial statement and its users. Financial information is considered material if its omission or misstatement can potentially affect economic decision making process of the users i.e. mislead users of financial statements. This qualitative characteristic of financial information is called materiality.
Materiality is an important concept for both accountants while preparing financial statement while measuring and reporting components of financial statements. And auditors while assessing if financial statements give true and fair view of entity and its business.
Deciding what is material involves judgment exercised by management and depends on several factors including:
- Nature of misstatement
- Size of misstatement
- Intended use of financial information by the user. For example financial statements prepared under general purpose financial statements may not cater the specific needs of the user and absence of such specific information will not amount to material misstatement.
All three aspects mentioned above are relative to many factors including entity, its size of operations and circumstances surrounding it.
In short, both quantitative and qualitative characteristics of financial information help judge the materiality of financial information.
Almost every framework for accounting or auditing purposes has avoided to give clear definition on what makes an information material. It is left on the skill and experience of the practitioner to exercise judgment and decide accordingly.
Example: Materiality by size
An entity has 150 tons of graphene in the closing stock. It is currently valued at 2 million. Entity is hopeful that demand for graphene will sky rocket in the near future and therefore valuing it at cost is reasonable. Fact of the matter is entity still has no order or customer who is willing to buy this material. An independent evaluation has revealed that current market price is not more than 150,000 although its price hike is probable once the market for this material matures in future. Entity’s year end stock is overall 20 million.
Stock currently valuing at 2 million that should be written down to 150,000 can slate financial statements towards material misstatement. Instead of valuing assets on future expectations, measurement should be based on year end scenario as users will use and make decisions in the same scenario and time. Information is material and must be written down.
Example: Materiality due to nature
Fuel expense of vehicles are now charged as selling and distribution expense in the financial statements. Previously it was considered administration expense.
This is change in accounting policy related to certain type of expenses. Disclosure of such change is material and must be made in the notes to the financial statements for better understanding of the users.