Organizations rely on financial statements to record historical data, communicate with investors, and make data-driven decisions. Sometimes it can be difficult to know what should be included in these financial statements and what can be omitted. Luckily, the financial accounting concept of materiality makes this easier.
Materiality is a key accounting principle utilized by accountants and auditors as they create a business’s financial statements. Here’s an overview of what materiality is and examples of materiality in action.
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What Is Materiality?
Materiality is an accounting principle which states that all items that are reasonably likely to impact investors’ decision-making must be recorded or reported in detail in a business’s financial statements using GAAP standards.
Essentially, materiality is related to the significance of information within a company’s financial statements. If a transaction or business decision is significant enough to warrant reporting to investors or other users of the financial statements, that information is “material” to the business and cannot be omitted.
Material vs. Immaterial Information
What’s considered to be material and immaterial will differ based on the size and scope of the firm in question. For example, while a small, family-owned grocery store may need to record a small expense for promotional coupons, Whole Foods may not need to record a large one for a similar offer. It’s all relative.
Material items can be financial (measurable in monetary terms) or non-financial. So, a business might need to report a pending lawsuit to the same degree it reports its revenues because both pieces of information could impact investors’ view of the company.
For example, with a bigger investor focus on sustainability nowadays, a business might want to include information related to its environmental, social, and corporate governance (ESG) practices to assure shareholders that the business is a sustainable investment. As Professor Robert G. Eccles discusses in a Harvard Business Review interview, there’s been a push toward new accounting standards to better measure material information related to sustainability.
Ultimately, the type of information that’s material to an organization’s financial statements will vary and depend on the size, scope, and business priorities of the firm.
Examples of Materiality
Materiality looks slightly different for each organization, but there are certain scenarios that can be applied to all businesses.
1. Expensing vs. Depreciating
Imagine a company purchases an electric pencil sharpener for $15. Typically, the sharpener should be recorded as an asset and then depreciation expense should be recorded throughout its useful life. However, materiality allows you to expense the entire $15 at once.
In this scenario, you’re able to expense the entire transaction at once because the information is immaterial. Recording the transaction in this way is unlikely to impact the decision-making process of investors, therefore the $15 cost of the pencil sharpener is immaterial.
2. Losses Compared to Net Income
If a company were to incur a significant loss due to unforeseen circumstances, whether or not this loss is reported depends on the size of the loss compared to the company’s net income.
Imagine that a manufacturing company’s warehouse floods and $20,000 in merchandise is destroyed. If the company’s net income is $50 million a year, then the $20,000 loss is immaterial and can be left off its income statement. On the other hand, if the company’s net income is only $40,000, that would be a 50 percent loss. In this case, the loss is material, so it’s crucial that the company makes the information known to its investors and other financial statement users.
Preparing Accurate Financial Statements
By considering materiality and other key financial accounting concepts, a company’s financial statements will be more accurate and ultimately tell a clearer story of its financial health.
Whether you’re in a financial role or not, it’s important that you can speak to your organization’s profitability and performance. Knowledge of how to prepare and analyze financial statements can help you better understand your organization and become more effective in your role.
Do you want to develop your financial accounting skills and learn how to analyze financial statements? Explore our eight-week online course Financial Accounting and other finance and accounting courses to discover how managers, analysts, and entrepreneurs leverage accounting to drive strategic decision-making.
This post was updated on September 7, 2021. It was originally published on January 5, 2016.