Materiality is a business concept that relates to the importance of recording an event or transaction. Ideally, all financial transactions would be entered correctly and on time. However, when this does not occur, a business must ask itself whether it is worth fixing the error and address the issue of materiality.
Example of Materiality
Suppose that you are entering your wage expenses for the period into your financial system. Some employees took time off, so their pay was split between various expense accounts. Upon posting the charges, you realize an additional $7 was coded to vacation expense instead of regular wages. In this situation, an error occurs. However, the dollar amount may not be considered material, so the adjustment does not need to be made.
Purpose of Addressing Materiality
The reasoning behind materiality is that a few small transactions will not have an overall impact on the financial statements. In the situation above, the difference between reporting $25,000 of regular wage expense and $24,993 of wage expense is extremely minimal to a financial statement user. The general information is correct and your financial statements are not materially misstated, so the transaction can stand as it is.
Establishing Materiality Thresholds
Materiality is subjective and varies from company to company. There are no industry standards establishing dollar-amount thresholds for materiality. Therefore, these levels are often up to management’s professional judgement to determine. In addition, calculated rates should be used as benchmarks. For example, any transaction greater than 0.4 percent of last year’s sales transactions is material. In addition, you may elect to have all balance sheet account transactions considered material.
The overall basis of materiality is based on your professional judgement. Based on your experience and exposure to your business, you know what makes a difference in reporting. More importantly, you are familiar with the balances in accounts, the total dollar level activity on your financial statements and the importance of misstated figures. Gauge the position of your company, the strength of your internal controls and your comfort level in the accuracy in what is reported. The challenge with professional judgment is maintaining a neutral position. Limit biased activity and be willing to address all material mistakes, especially those that make your financial statements more unfavorable.
Audits and Reviews
The end goal of addressing materiality relates to how external parties see your information. If you plan to use your financial statements for external investing, you will likely have to have a third party look at your records. This auditor will address materiality just like you do: the financial statements do not need to be perfect. As long as you avoid material misstatements, your financial statements will be certified.
Materiality covers the dollar amount as well as the number of errors. Having dozens of $2 errors will eventually add up. Be prepared for an auditor to test dollar amounts and frequency, too.