LUTZ BUSINESS INSIGHTS
What is materiality and how to navigate it
JARED HARDY, audit shareholder
In its common definition, materiality relates to something being composed of matter or of being significant in some way. In terms of accounting, this definition changes only slightly.
According to Financial Forbes, the concept of materiality in relation to accounting “states that those items or transactions that are significant and can have impact on the decisions of the users of financial statements should be disclosed in the financial records of the business but not the transactions that only increase the work of the accountant and are not relevant for the users.” To put it simply, financial information that can significantly impact the business and those associated (such as investors and suppliers) should be disclosed in financial statements, but transactions that do not follow this can be left out.
This may sound reasonable, but what falls under materiality is actually quite subjective. The judgment falls under management. Just as no two businesses are exactly alike, one business may classify a transaction as material, meanwhile, the very same transaction will not classify for another company. Therefore, what circumstances constitute which transactions qualify will depend on a range of factors.
What Falls Under Materiality?
One of the most significant factors is the size of the company. For example, company A is a small company with one brick-and-mortar location and only a few investors. If a disaster struck and caused thousands of dollars worth of damage to products, company A’s revenue would take a major hit. Because this financial loss is so great, it could influence current and potential investors’ decisions, and therefore should be included in financial statements.
Meanwhile, company B is a large corporation with many brick-and-mortar establishments and a multitude of investors. If the same disaster struck and caused the same amount of loss, company B would not be as inclined to include it in their statements. In comparison to company A, the damage for company B is minimal, and so investors are less likely to be influenced.
The next question is how to determine what would be a major loss for your particular business? A good guide to follow is calculating to see what percentage of your pre-tax profits a given transaction is equal to. If it is equal to 5% or more, then it should be classified as material. If looking over a balance sheet, a transaction is material if it is equal to or greater than .05% of total assets. Again, this is only a guide. Many transactions that do not follow these rules may still be recorded depending on the individual company’s circumstances.
Why not Include Everything?
It is reasonable to see a few flaws in the concept of materiality, namely in the inevitable gray areas that will emerge and differences in judgment that could cause errors when classifying. However, even when including the process of judgment, utilizing materiality can help a business save time and effort in the long run. Furthermore, investors will greatly appreciate being able to focus on what is significantly impacting the company versus reading through pages of transactions that do not affect the business overall.
Materiality and how it is used today has a rich and interesting history best explained in this Forbes article Dynamic Materiality and Core Materiality. One of the more fascinating takeaways from this article is how investors nowadays are looking into more than just a company’s profits. Now, a company’s actions towards environmental and social issues can also have a great impact on influencing investors. And so, deciding on materiality is no longer just transactions in comparison to profits, but has an added layer.
For example, we will take another look at companies A and B. Company A decides to invest in eco-friendly packaging for their products. Their initial investment into this action cost enough to easily qualify as material to be included in a financial statement.
In juxtaposition, company B invests in the same eco-friendly packaging and invests the same amount initially as company A. The cost of this investment for company B is under the threshold usually used in determining if a transaction is worth recording, but they choose to include it anyway. Why? Because if company B’s investors are interested in eco-friendly practices, then the company will want to show their investment towards what their investors want and are looking for.
How We Help
Materiality can be difficult to determine. At the end of the day, the biggest thing to remember is that the concept of materiality focuses on what is most important for the company to record for the interest of all those involved with that company. To ensure your financial records are effective and accurate, it would be beneficial to enlist the help of a certified public accountant such as Lutz. For more information on materiality, or if you have any questions, contact us today.
Also, if you found crunch time for finalizing your books a hassle this year, be sure to check out our 7 Insightful Tips for a Successful Audit Preparation. It is never too early to plan ahead, and you can find yourself saving on both time and stress.
ABOUT THE AUTHOR
JARED HARDY + AUDIT SHAREHOLDER
Jared Hardy is an Audit Shareholder at Lutz with over 13 years of experience. He has significant experience in public accounting providing accounting, auditing and consulting services to privately-held companies in a variety of industries.
AREAS OF FOCUS
AFFILIATIONS AND CREDENTIALS
- American Institute of Certified Public Accountants, Member
- Nebraska Society of Certified Public Accountants, Member
- Certified Public Accountant
- BS in Accounting, University of Nebraska, Lincoln, NE
- NOVA Treatment, Board Member
- Knights of Columbus, Member
SIGN UP FOR OUR NEWSLETTERS!
We tap into the vast knowledge and experience within our organization to provide you with monthly content on topics and ideas that drive and challenge your company every day.