Finance professionals always consider the materiality of a transaction to decide on what action to take. An immaterial business event will likely be of no concern to an auditor. Transactions are material if they will impact the economic decisions of the primary users. Below we explained the term in detail.
What is the materiality convention?
It is an accounting convention that states that the accountant should consider the impact of a transaction on users of financial statements. Transactions with higher impacts should be reported separately as a line item, while those without impact can be segregated.
According to the International Accounting Standards number 8 (IAS 8), a transaction or event “is material if omitting, misstating, or obscuring it could reasonably be expected to influence decisions that the primary users of general-purpose financial statements made based on those financial statements, which provide financial information about a specific reporting entity.”
From the foregoing, this convention exists because of its impact on users’ decisions. The IFRS standard states that such information must not be omitted, misstated, or obscured. Omitting it means that the preparers of financial reports do not include the information accordingly.
Misstatement implies using the wrong class for the transaction. For example, an expense has been posted as a non-current asset in the statement of financial position. Obscuring is when the information is either disaggregated or aggregated with other transactions that affect users' decisions negatively. To illustrate, aggregating two revenue streams of a business is of large value.
Users of financial statements are primarily the shareholders and potential investors. Other users are the government through the tax authority and regulatory agencies, creditors, directors, employees, and financial analysts.
How to measure materiality
Measuring materiality is subjective to the finance professional. The preparer of the statement, the financial modeller, and the auditor will need to decide what amount is material for a business. The measurement is usually unique to every organization. A material transaction for an organisation might be immaterial to another. More so, an item may be immaterial, however, if the cumulative amount is added in a year, it might result in a material figure.
Illustration on measuring materiality
Illustration one:
Assume two companies bought buildings in Lekki, Lagos for 500 million Naira each two years ago. In the current year, the State government announced that houses built in the area will be demolished due to a road construction plan.
Company A’s annual revenue is 100 billion Naira, and Company B's is 3 billion Naira.
Required: What is their materiality level?
Solution
Company A's materiality level is 500 million ÷ 100 billion × 100% = 0.5%
Company B is 500 million ÷ 3 billion × 100% = 17%
You can see that the building is immaterial to company A but much more important to company B.
Illustration two:
Monthly maintenance expenses are posted wrongly as NGN 56,000 instead of NGN 560,000. The undercast error amount is NGN 504,000 monthly. That is, NGN 6,048,000 annually. Although the figure might be small for a company in a month, the cumulative amount is material in a year if the error continues.
Some key areas of materiality on IFRS standards
Each IFRS standard that relates to a particular transaction is material. Leases in IFRS 16, IAS 16 on property, plants and equipment, and IFRS 9 on financial assets and liabilities are a few key standards.
IAS 8 focuses on the materiality convention. It further explains that when a transaction is material and there are no accounting standards that can be applied in posting it to the financial statements, then the preparer of the report should do the following accordingly:
- Examine the requirements and guidance in IFRS that deal with similar and related issues.
- The IFRS Foundation Framework defines, measures, and recognizes criteria for assets, liabilities, income, and expenses.
- And other related accounting standard setters such as the U.S GAAP.
The materiality convention is sometimes called a concept. As explained, it ensures that users are getting the right information in making economic decisions. IAS 8 defines the materiality concept and explains how to treat material value transactions with no IFRS standards.
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