What is Materiality in Accounting?

Materiality is the threshold above which missing or incorrect information in financial statements is considered to have an impact on the decision making of users. When this is not the case, then missing or incorrect information is considered to be immaterial. Materiality is sometimes construed in terms of net impact on reported profits, or the percentage or dollar change in a specific line item in the financial statements.

Examples of Materiality

It is helpful to review several examples of the materiality concept, to better understand how it impacts a business. Examples of materiality are as follows:

Profit materiality. A company reports a profit of exactly $10,000, which is the point at which earnings per share exactly meet analyst expectations. Any reduction in profit below this point would have triggered a sell off of company shares, and so would be considered material.
Inventory materiality. A manufacturing company overstates its inventory by $10,000. If the company has total assets of $5 million, this error might not be material, as it represents only 0.2% of total assets. However, if the company’s net income is $25,000, this overstatement would be material because it represents 40% of the net income and could mislead investors about profitability.
Covenant materiality. A company reports a current ratio of exactly 2:1, which is the amount needed to meet its loan covenants. Any current asset or current liability amounts resulting in a ratio of less than 2:1 would be considered material, since the loan could then be called by the lender.
Lawsuit materiality. A company omits the existence of a lawsuit from its financial statement disclosures that indicates the potential for a large settlement that could bankrupt it.

Based on the preceding examples, it should be clear that sometimes even quite a small change in financial information can be considered material, as well as a simple omission of information. Thus, it is essential to consider all impacts of transactions before electing not to report them in the financial statements or accompanying footnotes.