Materiality constraint definition
/What is the Materiality Constraint?
The materiality constraint is a threshold used to determine whether business transactions are important to the financial results of a business. If a transaction is material enough to exceed the constraint threshold, then it is recorded in the financial records, and therefore appears in the financial statements. If a transaction does not meet this threshold level, it may not be recorded in the financial records or it may be treated in a different way, depending on the circumstances.
How the Materiality Constraint is Used
The materiality constraint is a key consideration in the process of closing the books, and helps accountants by allowing them to use the simplest transaction recordation alternatives for smaller items. For example, a company controller may elect not to accrue the amount of a missing supplier invoice at month-end, because the amount of the invoice is immaterial to the results that will be stated in the firm’s income statement. Instead, she ignores the accrual and simply records the supplier invoice when it eventually shows up in the mail in the following reporting period.
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Example of the Materiality Constraint
A company controller decides that the materiality constraint of the business is $20,000. An asset is purchased for $18,000. Since the size of this purchase is below the materiality level, the controller decides to charge the purchase to expense, rather than recording it as a fixed asset that will be depreciated over many years, as per the normal company policy.
As another example, the controller of the same business must decide whether to record a $50,000 medical insurance payment that applies to the following month as a prepaid expense in the current period, or charge it to expense. Since this amount exceeds the materiality level, the controller should initially record the payment as a prepaid expense, and charge it to expense in the following period, as per the normal company policy.
A larger business will have a higher materiality constraint, since its sales level is so much higher than a smaller entity. A multi-national entity might establish a materiality threshold of $1,000,000, while a small local hardware store might have a $1,000 threshold.