Today our discussion will
focus on the concept of materiality, items or events that companies are
required to report on their financial statements. This issue came up in an
article recently published in the NY Times, which I will present the link here. The article appeared in the NY Times, and the link is http://www.nytimes.com/2016/01/03/business/fasb-proposes-to-curb-what-companies-must-disclose.html?_r=0
It is interesting because the Financial Accounting Standards Board (FASB)
proposes to limit the requirements of companies from reporting materiality
changes on their financial statements. According to FASB the reasoning is that
they will like to be in accord with Supreme Court decisions and SEC rulings and
nomenclature.
The term materiality
refers to the relative importance of an event or item. An item or event is
material if knowledge of the item or event might reasonably influence the
decision of users of financial statements. The concept of materiality allows
accountants to use estimated amounts and ignore other accounting principles if
the results do not have a material effect upon the financial statements.
Materiality is a very important concept of the GAAP (Generally Accepted Accounting
Principles).
Whether or not an event
is material or not, is a matter of professional judgement. In making these
judgements, accountants consider several factors. First of all, what
constitutes material, varies with the size of the organization. For example, a
$1000 expenditure may be material in relation to the financial statements of a
small business, but immaterial for a large corporation.
Another factor is the
cumulative effect of numerous immaterial events. When considered by themselves,
a number of immaterial events may be immaterial, but when grouped together, the
combined effect may be material. The term materiality refers to the relative
importance of an event or item. An item is material if knowledge of the item
may reasonable influence the decision of users of financial statements, such as
shareholders.
An example of materiality
concept is in the manner in which companies account for low cost plant assets,
like pencil sharpeners or wastebaskets. Even though the matching principle
calls for depreciation of plant assets over their useful life, these low cost assets
are charged immediately to an expense account. The result is a distortion of
the financial statements, but are minimal.
In the case of a large
number of immaterial events occurring in the same accounting period,
accountants consider the cumulative effect. In the case that these immaterial
events become material in the financial statements (income statement), then
accountants record them to avoid material distortion.
Another example of
materiality is interest accruing, which applies not only to notes receivables
(asset) but to all interest bearing investments (i.e. bonds). In the case of
marketable securities, investors recognize interest revenue as it is earned. In
the case for notes receivable, the interest earned is accrued instead of recognized.
Why? Because the concept has to do with materiality. Interest accrues from day
to day. However, the interest revenue earned from cash equivalents and
investments in marketable securities represents a small part of the investor’s
total revenue. It is not material to the other financial statements. Notes receivables
as I mentioned above are assets, but they are mainly owned by companies, or financial
institutions. For these businesses interest revenue is material, and in most
part, it is their main source of income.
Bill T. Alexandratos
Billnyc60@gmail.com
