Convention of Materiality
Convention of materiality states that items of small significance need not to be given strict theoretically correct treatment. There are many events in business which are insignificant in nature. Moreover, it is one of the most important accounting convention.
The cost of recording and showing in financial statement such events may not be well justified by the utility derived from that information. This convention unnecessarily burden the accountants in case they are not able to distinguish between material and immaterial events. The most important to note is that an item for a party can be immaterial however for another a material item.
There are no hard and fast rules in order to differentiate between material and immaterial item. It is just a matter of judgement and some common sense. While following the convention of materiality, keep in mind the full disclosure concept.
Materiality Convention Example
Suppose a calculator used in business costing Rs 100 can be utilize for say next 8 years. However the effort in order to allocate its cost over the eight year period is not worth the benefit in comparison to the benefit derive from its operation. So treat the expense of calculator in the year it was purchased.
What If you Abuse Materiality Concept in Accounting
Abusing or neglecting materiality concept in accounting, it results in serious legal consequences. Courts and auditors use following rule of thumb to consider it the abuse of concept of materiality. These are as follows –
- Errors greater than 5% of before-tax Profit, or 0.5% of sales revenues, are large enough in case of Income Statement.
- A questionable entry more than 0.3 to 0.5% of total assets, or more than 1% of total equity in Balance Sheet is suspicious.
It is also very important that while considering abuse of materiality concept, one must also consider other factors besides error magnitude. The two factors that must be considered are as follows –
- What motivates and the intention behind the error.
- Likely effect on user perceptions and judgement