What is Materiality
The materiality of a transaction amount or a financial statement line item is determined based on the impact of a misstatement of information on the intended users of that information. If the stakeholder is most likely to alter their actions if we presented the information correctly, the mistake is considered material. And, on the other hand, if the error wouldn’t have mattered to the user of the information, it is deemed to be immaterial.
There’s no detailed definition of what materiality is, and the line between immaterial and material is subject to lengthy discussions. Financial record items are material when they could affect the decisions of users of the financial information. We usually implement the concept also to ensure that firms will not hide critical information from their shareholders and other stakeholders.
The concept is frequently used in deciding whether to exclude minor transactions from the financial statement close process, management accounting analysis, and others. Materiality also improves the efficiency of a company’s internal reporting process.
We need to remember that the materiality concept is meaningful only as much as its relevance to the intended audience and use of the financial information we apply it to.
Materiality in Audit and Accounting
Materiality aids companies in filtering information disclosed in the financial statements and making them more relevant and less cluttered.
The International Standards on Auditing (ISA) are professional standards for the performance of a financial audit of financial information. As per ISA 200, the goal of an audit is to increase the confidence of stakeholders in the financial information. The end goal of an audit is to provide an opinion on whether the financial statements are presented, in all material aspects, per the applicable financial reporting framework. ISA 320 stipulates the process of assessing materiality is a matter of professional judgment. The correlation between materiality and audit risk is negative. When risk increases, the materiality treshold decreases, and vice versa.
Other core principles and concepts in accounting also affect materiality:
- Relevance – material information influences decisions and is therefore relevant for the users of the financial statements;
- Reliability – misstated or omitted information impairs the ability of the user to make correct decisions, affecting the accuracy of such information.
Setting a Materiality Level
Items are material when they could individually or in the aggregate influence the decisions of stakeholders.
Companies often find it hard to judge the materiality for each item, so they usually refer to the terms of the applicable financial reporting and accounting standards and principles as a guiding checklist.
The International Accounting Standards Board (IASB) has amended its definition of materiality. The new definition is applicable from the 1st of January, 2020. The IASB has no intention to change the concept and doesn’t expect the amended meaning to result in significant changes.
It states that “information is material if omitting, misstating or obscuring it could reasonably be expected to influence decisions that the primary users of general purpose financial statements make on the basis of those financial statements, which provide financial information about a specific reporting entity.”
The amended definition shows materiality is to depend on the nature or magnitude of the affected information. Companies have to assess if the information, individually or together with other information, is material in the current context. Materiality is a convention relating to the significance of a discrepancy, or a specific transaction.
Judgement and Subjectivity
Figuring out the appropriate materiality levels can be less objective and subject to uncertainty. It is hard to estimate whether certain misstatements or omissions could influence a specific decision-making process.
Drawing conclusions related to materiality is likely to have a subjective element. Therefore different people can reach different decisions about materiality. Here are some groups that might have contradicting opinions on which items are material and which are not:
- Board of Directors;
- Chief Executive Officer, Chief Financial Officer, Chief Operations Officer, and other officers in the company;
- Representatives of the middle management;
- Auditors and government agencies’ employees;
- Shareholders and potential investors.
Abusing the Materiality Concept
Abusing the materiality concept can have serious legal consequences. There is no precise error size that we are to consider as materiality abuse.
However, there are some more popular percentages we can use.
For misstatements or omissions in Income Statement line items, generally, we will set materiality at 5% of profit or 0.5% of total revenue. When dealing with Balance Sheet items, we may use 0.5% of total assets or 1% of total shareholder equity.
Apart from the size of the error, we need to consider other factors as well when judging for materiality abuse:
- The motivation for the mistake – does it benefit the way the firm appears to stakeholders;
- Was there intent – was the error intentional or not;
- Likely effect on how users perceive the misstated items.
Materiality in Financial Modeling and Analysis
It is crucial to have a good grasp of the materiality concept, as we continuously apply it in financial analysis and financial modeling.
Applying materiality helps us to create our models faster, as we only consider material assumptions. This leads to cleaner workings, with a focus on the significant areas. Skipping the immaterial accounts helps reduce analysis clutter.
Example Application in Financial Modeling
To better grasp the benefit of applying the materiality concept in our financial analysis and modeling, let us take a look at an example.
As part of our annual budget preparation, we are currently working on our revenues forecast for FY 2020. We are using the actual FY 2019 performance as a reference point, as well as some other information we have.
We have forecasted our sale of goods and transport services based on quantities, sales price and transport charge per item. The sale of parts is a fixed order based on a long-term contract with one specific client.
We are left to forecast the two line items – Maintenance services and Other revenue.
What we know for maintenance services is that we provide those only in cases where the item is not covered by warranty. By performing some analysis of our records, we identify that these are 25% of all goods that require maintenance. We also know based on our records that 12% of sold products would require some maintenance. We calculate the average charge for repairs per item for FY 2019. On top of this, we apply a 5% expected increase in our maintenance charges, as we expect a slight increase in labor costs that we need to cover. Now we can calculate the Maintenance services revenue, based on the quantities we plan to sell in FY 2020.
Next, let’s look at the following breakdown of Other revenue for FY 2019. To make a better estimate of these for FY 2020, we can review them on a per-line basis. We expect sales of assets and consulting services to increase by 25% and 20%, respectively. The Doubtful Debt Allowance (DDA) balance we have left in our balance is EUR 40 thousand. We expect to recognize the whole amount in FY 2020. The company anticipates no other revenues.
This completes our Revenue forecast for FY 2020. Let’s review Maintenance services and Other revenue as percentages of Total revenue.
Maintenance remains at 0.81%, and Other revenue drops from 0.17% to 0.14%. Although we are looking at a simplified example, we still spent much time calculating estimations for two lines, that account for less than 1% of our total revenue. We rarely have the time to do so in reality.
What we can do in such circumstances is assume that these two lines will remain at the same values. These two revenue sources are not part of the primary operations of the company, which is the sale of goods, so we do not expect significant changes in their value.
This method gives us different values as a percentage of total revenues for maintenance services and other revenues. However, in such a case, we will usually not go into so much detail and spend many resources on forecasting line items that represent such a tiny portion of total revenues.
By simplifying our approach, we are essentially generating a misstatement in the presented data. We can easily illustrate that it is immaterial by calculating the deviation as a percentage of total revenues.
The concept of materiality has a strong presence in financial modeling and analysis. In such activities, time is almost always limited, and it is up to us to prioritize the more important line items over the immaterial ones. We have to use our professional judgment to assess how detailed our estimations need to be for each item.
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