What is the Materiality Principle?

The materiality principle states that an accounting standard can be ignored if the net impact of doing so has such a small impact on the financial statements that a user of the statements would not be misled. Under generally accepted accounting principles (GAAP), you do not have to implement the provisions of an accounting standard if an item is immaterial. This definition does not provide definitive guidance in distinguishing material information from immaterial information, so it is necessary to exercise judgment in deciding if a transaction is material.

The Securities and Exchange Commission has suggested for presentation purposes that an item representing at least 5% of total assets should be separately disclosed in the balance sheet. However, much smaller items may be considered material. For example, if a minor item would have changed a net profit to a net loss, then it could be considered material, no matter how small it might be. Similarly, a transaction would be considered material if its inclusion in the financial statements would change a ratio sufficiently to bring an entity out of compliance with its lender covenants.

The materiality concept varies based on the size of the entity. A massive multi-national company may consider a $1 million transaction to be immaterial in proportion to its total activity, but $1 million could exceed the revenues of a small local firm, and so would be very material for that smaller company.

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Materiality in Closing the Books

The materiality principle is especially important when deciding whether a transaction should be recorded as part of the closing process, since eliminating some transactions can significantly reduce the amount of time required to issue financial statements. It is an especially important issue when conducting a soft close, where many closing steps are skipped. You should discuss with the company's auditors what constitutes a material item, so that there will be no issues with these items when the financial statements are audited.

Example of the Materiality Principle

Here are several examples of the materiality principle in action:

Immaterial items charged to expense. You may have prepaid $100 of rent on a post office box that covers the next six months; under the matching principle, you should charge the rent to expense over six months. However, the amount of the expense is so small that no reader of the financial statements will be misled if the entire $100 is charged to expense in the current period, rather than spreading it over the usage period. In fact, if the financial statements are rounded to the nearest thousand or million dollars, this transaction would not alter the financial statements at all.
Capitalization limit. A business sets up a capitalization limit of $5,000. Below this amount, all expenditures are automatically charged to expense. Above this threshold, expenditures are capitalized if they also have a prolonged useful life. This policy is centered on the concept that very small expenditures are immaterial to the reported results of a business, while charging them off at once also eliminates the paperwork associated with tracking capitalized assets.