What is meant by materiality in accounting?
2. Determining materiality
There is no strict quantitative threshold set by US GAAP. Judgment about materiality is subjective and reflect assessments of risks associated with the business. However, it may often be helpful to apply a percentage to a chosen benchmark as a first step in determining materiality levels. Examples of such benchmarks are presented in the table below:
Entity type |
Benchmark |
Percentage |
|
Listed |
Not listed |
||
Profit-oriented entities |
Profit/loss before tax |
Up to 5% |
Up to 10% |
Profit-oriented entities where a profit/loss metric is not considered to be appropriate /or non-profit organizations |
Total
revenues or |
Up to 1% |
Up to 2% |
Total assets |
Up to 1% |
Up to 2% |
|
Entities
(i.e., mutual funds) where |
Net assets |
Up to 0.5% |
Up to 1% |
For most profit seeking enterprises, income from continuing operations may be a more appropriate benchmark. Ordinarily, up to 5% of pre-tax profit or loss is taken as the basis for calculations, but for non-listed entities this may be higher (i.e., up to 10%). At the same time, the profit/loss basis may not be an appropriate benchmark, for instance, for start-up entities, for companies with near zero income, or for entities whose products are in the development stage; for such entities 1-2% of revenues/expenses may be a more meaningful basis. For asset-based entities (such as mutual funds) a good benchmark may be up to 0.5% of net assets. In addition, nothing prevents management from using more than one benchmark in calculating materiality.
Being a starting point that is subsequently adjusted, a lower percentage may be used for entities where materiality would otherwise be a very high absolute amount and smaller amounts would lead investors to change their economic decisions. For example, if the net assets of a company fluctuate a lot over periods (e.g., investment funds), it would be reasonable to take the average net assets benchmark for setting materiality.
Materiality is not simply a formula application. As it involves determination of what will affect the decision of a knowledgeable user, qualitative factors should also be considered. Therefore, professional judgment is an essential component of materiality calculation.
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