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Materiality Concept
Materiality is a concept in financial accounting and reporting that firms may disregard trivial matters, but they must disclose everything that is important to the report audience. Items that are important enough to matter are material items. United States GAAP, for instance, states that items are material if "they could ... influence the economic decisions of [financial statement] users…". In other words, materiality errors can mislead decision makers. Note that the materiality concept has meaning for any financial statement only concerning: When an independent auditor reviews a firm's financial statements, the best possible outcome is an auditor's opinion of Unqualified. This opinion affirms the auditor's judgment that the reports are accurate and conform to GAAP. And, this means the auditor finds no materiality issues. This article further defines, describes, and illustrates the materiality concept in the context of related concepts such as:
The materiality concept concerns omissions, errors, and misleading statements in accounting reports. The central question is this: Do they matter? Or, in other words: Are they material? Materiality Depends On the Purpose and the AudienceThe first answer to that question is the following: "Materiality depends on the purpose of the financial report and its intended audience." Consider, for instance, a firm's financial reports for the period just ended. Different versions of the statements can serve different audiences for different purposes. The Annual Report to shareholders includes one version of the firm's statements. Here, the firm is legally responsible for publishing statements that serve two purposes.
Potential lenders and bond rating agencies are another report audience. This audience, of course, must judge the firm's creditworthiness. Here, the audience tries to answer questions such as these:
The audience must have enough detail to address such questions seriously. Here, the audience needs full disclosure on the firm's creditors, liabilities, and investments. They also need full disclosure on planned changes to the firm's business model and strategies. And, they must know which financial and business risks the firm faces. With mergers and acquisitions, each potential partner must know the other 's business accurately and in detail. Each must know, in other words, the other party's:
All potential partners need this information, in advance. Everyone must know what each adds to partnership production, marketing, selling, and general management. And, they must plan together how to eliminate redundancies and overly costly operations. And, each must know the risks and liabilities that the others bring to the partnership. Only with full knowledge in these areas can they make an informed decision on going forward joining together. The definition of material refers to a particular audience and to the kinds of decisions this audience must make. In the United States, the primary rule for deciding materiality appears in GAAP (Generally Accepted Accounting Principles):
The GAAP definition is consistent with a more formal statement from the board responsible for GAAP, the United States Financial Accounting Standards Board (FASB). For FASB, materiality refers to:
The materiality concept is an established accounting convention, recognized universally. Another such principle is the historical cost convention by which firms:
Note that historical costs are usually easy to find and agree. As a result, historical values come with very little uncertainty. However, materiality judgments can be less objective and more uncertain. Here, the question is whether or not specific information could influence a particular decision. Conclusions about materiality, therefore, may include a subjective element. And this inevitably means that different people can reach different conclusions. Not surprisingly, materiality judgments can differ among the following:
Differences are especially likely when these groups have different interests, different motivations, and different objectives. Abuses of the materiality concept in accounting can have serious legal consequences. Nevertheless, GAAP and FASB have resisted stating precisely an error size that qualifies as materiality abuse. In reviewing specific cases, however, auditors and courts use several "rules of thumb."
Abuse of the Materiality ConceptThose judging materiality must also consider other factors besides error magnitude. This requirement is no doubt one reason that regulators resist setting size criteria for materiality abuse. They also take into account two other factors:
By Marty Schmidt Solution Matrix Limited® 292 Newbury St Boston MA 02115 USA |