The materiality concept requires to incorporate significant items in decision making into financial statements. This principle is to ensure reliable economic decisions by users of financial statements. It not only protects the interests of shareholders and investors but also facilitates accountants when preparing financial statements.
Omissions or misstatement of items is material if they can influence the economic decisions of users. For example, when a company acquires another business, the transaction is material. Thus, the company must report the financial effects of the acquisition.
Why the materiality concept is important
The materiality concept is fundamental. It affects the company to report whether a transaction as a separate item or not. Indeed, eliminating some transactions can significantly reduce the financial reporting process time.
Materiality is not an absolute concept. It depends on the size and nature of an item and the particular circumstances in which it arises. The company must separately report several similar accounts, but each material. But, if they are immaterial, the company can combine them into one account.
Material misstatement occurs when the information in the financial statements is incorrect. Hence it affects the economic decisions of those who rely on the report. For example, debt account misstatement misleads creditors in assessing the company’s leverage level. That makes them wrongly decide whether to extend or withdraw credit to the company.
Defines items as material
Materiality is subjective and varies depending on the size of the entity. Equivalent numbers can be considered material for small companies, but immaterial for large companies because of their asset size.
For example, a large company with assets of Rp100 trillion considers a transaction of Rp1 million as immaterial. Still, the number is material for small businesses with total assets of Rp100 million.
Because it is subjective, each company must able to determine which items are material relative to its operations.Auditors assess materiality based on surrounding circumstances. To determine the level of materiality, auditors rely on rules of thumb and professional judgment. It depends on the auditor’s perception of the financial information needs of users and the size or nature of misstatements.