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The Materiality Principle

The materiality principle recognizes that in some trivial items, following GAAP would be exceedingly expensive or difficult. In these cases, if the item that needs to be reported is non-material - that is, it will not have an affect on the decision making processes of users of the financial statements - then an accountant can depart from GAAP.

Materiality is an important component of relevance in accounting. Relevance means that financial information is capable in making a difference in the decisions made by users. Materiality is the threshold that, if not past, allows for non-relevant items to be excluded from the financial statements.

According to FASB Statement of Concepts No. 8, there is no 'bar' or quantifiable amount that can be predetermined to define material vs non-material items. This is because materiality will always vary based on context:

     Information is material if omitting it or misstating it could influence decisions that users make on the basis of the financial information of a    
     specific reporting entity. In other words, materiality is an entity-specific aspect of relevance based on the nature or magnitude or both of the
     items to which the information relates in the context of an individual entity's financial report. Consequently, the Board cannot specify a    
     uniform qualitative threshold for materiality or predetermine what could be material in a particular situation.1

Similarly, the Board recognizes that there are cost contraints to reporting financial information, and financial information that is reported can be weighed on a cost-benefit scale. However, the Board ntoes that "because of the inherent subjectivity, different individuals' assessments of the costs and benefits of reporting particular items of financial information will vary".2

Items that are material must be either reported in the financial statements or disclosed in the notes to the financial statements. For example, pending lawsuits (which might reflect future liabilities), changes in government or regulatory policies that will affect the business, and the accounting policies a firm uses are all material, and are disclosed in the notes to the financial statements. 

For example, the specifics of collection efforts for a small overdue trade account are probably not material, but if the account was a significant proportion of a firm's sales, or the firm had ongoing problems collecting its accounts receivables, these items would be material. 

Similarly, a business is required to depreciate furniture under GAAP.3 This follows from the matching principle. However, a large business that purchases a new chair for one employee for $50 might expense this immediately. Expensing, rather than depreciating the chair over its useful life, won't mislead investors, so would be allowed under the materiality principle. However, a larger purchase of furniture, say for an entire office, should be depreciated over its useful like. 

As well, some items might be material in aggregate, and are reported as one line-item on the financial statements. However, if items are large enough to be material on their own, they would be reported as separate line items. For example, employee compensation from stock options is definitely material. Furthermore, the amount of executive stock options is not only an important part of total employee compensation, but an important item on its own. The statement of owner's equity then might include two line items: executive stock options, and other employee stock options. 


References:

1. FASB CON8 QC11
2. FASC CON8 QC39
3. FASB ASC 360-10-35-1

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