The purpose of financial statements is to provide user with information which is relevant and adequate, however, at the same time it should not be excessive.
The standard of materiality means the threshold up to which errors/omissions would not influence the users of financial statements.The materiality limit determines whether a company needs to correct errors or restate prior results under different accounting procedures. Similarly, while preparing the disclosures, materiality principle determines whether particular information will be merged with some item or disclosed separately.
The level of materiality is largely based on judgement, however, in order to define a benchmark materiality levels are most commonly defined by management as a percentage of balance sheet total or of net profit figure. Moreover, nature of item dictates whether it will be considered as material or not.
Let’s assume that a company has a net profit of $ 500,000 and following is the breakup of administrative expense of the business.
|Rent, rates and taxes||140,000|
|Legal and professional expenses||10,000|
|Repair and maintenance||2,500|
Application of materiality principle in above example is as follows:
- If company has omitted booking of an expense amounting to $ 25,000 then it is material item as compared to the bottom line profitability of $ 500,000 and company need to adjust the accounts.
- For the purpose of breakup of expenses, company can merge communication, repair & maintenance and stationery expense as one item to reduce the unnecessary detail.
- However, legal and professional expenses should not be merged. Although the amount is not very material but the nature of item is such that it should be disclosed separately so that user must know that there are some legal matters for which these expenses are being incurred.