Materiality concept 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 accountant and are not relevant for the users.
Explanation with example:
According to the concept of materiality, all the financial information that is significant and can have major impact on the business and on the related persons like investors, lenders, suppliers etc., should be disclosed in the financial statements of the company.
Further, we can say that the materiality principle is an exception to the full disclosure principle. The materiality concept is actually very subjective as the materiality of an item is based on the judgments of the management. Management should decide wisely depending upon the size, nature and level of transaction that the transaction is material or immaterial. Even similar transaction or same cost can be material to one company and immaterial for another.
For example, there is a fire in a company that causes damage of stock worth $500,000. The company is a small company whose total turnover for a year is around $2,500,000 and net income of $700,000. Therefore, the loss of stock worth $500,000 is a huge loss and is material event that has to be disclosed in the financial statements as it can affect investor’s decisions.
Suppose in the above case, the company is a large company whose total turnover for a year is around $15,000,000 and net income of $2,000,000. Therefore, the loss of stock worth $500,000 is a not a major loss and it is immaterial for the company. Therefore, this event may or may not be disclosed in the financial statements as it may not have impact on investor’s decisions.
The advantages of Materiality concept are as follows:
1. The concept of materiality directs the company to identify the material or significant business transactions and report them into their financial statements.
2. Materiality concept clarifies that every business transaction is not required to be reported because it is of no use. Therefore, it reduces the time & efforts of the management as they need to focus on the reporting of only material items.
The disadvantages of Materiality concept are as follows:
1. Whether an item is material or not is decided by the management. The decision of the management is purely based on their judgment. Therefore, there can be difference of opinion and chance of error while making the decision regarding the materiality of the information.
2. Sometimes it is time consuming to disclose the material items because there are high chances that management cannot choose between material and immaterial item and end up in reporting many business transactions.