What are the exceptions to basic accounting principles

2. Materiality in accounting

Materiality refers to a relative significance or importance of an item - dependent on individualís judgment - to the overall financial condition of a company.

An item is considered material, according to the American Accounting Association, when the knowledge of it would influence the decision of informed investor. Generally speaking, a material item would influence the judgment and decision-making process of a reasonable person. As the result, all material information should be disclosed.

Important to note, materiality is relative. †It depends on both quantitative and qualitative factors:

  • Financial data
  • Personal subjective view and judgment (e.g., companyís management, auditors, analysts, creditors)
  • Qualitative factors such as (non-exhaustive list):
    • Measurement precision (e.g., estimates)
    • Earnings effects (e.g., hiding loss to meet analysts expectation, presenting loss as income, and vice versa)
    • Compliance with contracts and regulatory requirements
    • Managementsí compensation effects
  • Business aspects (e.g., nature, size)
  • Time period

Traditionally, the materiality of an item is based on quantitative thresholds (e.g., 5% of net income).

An item can be material for one business and immaterial for another one. For example, a $200,000 piece of equipment may be material for a mid-sized manufacturing company, but may be immaterial for a large oil producing company.

An item can be material in one year and immaterial in subsequent years (i.e., the same amount). Because materiality is often assessed in comparison to specific financial data (e.g., net income, total assets, total liabilities), the same amount could yield different relative percentages (e.g., % of total assets) in different years:† $100,000 bad debt can be material this year and immaterial in other years.

To illustrate an example of materiality application, letís assume that Manila Company (a fictitious paper manufacturer) has annual sales of $250 million. The company expenses its low-cost plant assets under $1,000. On May 1, 20X2, the company bought on account 15 shelves for its office space for $600. Because in this case the cost of book shelves is under the threshold, they are expensed immediately. The company would make the following journal entry:

Account Titles

Debit

Credit

Office Expense

600

 

      Accounts Payable

 

600

According to basic accounting principles plant assets represent fixed assets, not an expense: they must be recorded in the asset section on the balance sheet (i.e., versus office expenses are reported on the income statement) and depreciated over time (i.e., are expensed over time, not immediately). However, as we can see from this example, the company is pretty big (i.e., annual sales of $250 million) and its materiality level is relatively high. So, the materiality constraint allows the company to not follow basic accounting principles. Even if the company expenses the cost of purchased assets under $1,000, users of financial information would not find such a deviation from accounting principles significant because the cost of such assets for a period will probably be immaterial.

Materiality in accounting is relative. For Manila Company, plants assets under $1,000 are considered immaterial. For large companies with billions in assets and income, $1,0000,000 or more could be immaterial, and as the result, do not have to be disclosed or follow accounting principles.

In general, immaterial items are not relevant for decision making purposes. Because an immaterial item would not make a difference in the total financial condition of a company and would not influence the decision of a reasonable prudent investor (or creditor), accounting principles do not have to be followed.

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