Materiality is the principle that financial statements need to be accurate and complete in all respects that matter to their users, but not to the last dollar. An item is material if omitting, misstating or obscuring it could reasonably be expected to influence the economic decisions of investors, lenders and other users who rely on the statements. Small errors that would not change anyone's view of a company can be left uncorrected, while larger or more sensitive ones must be fixed or disclosed.
This entry covers materiality in its financial reporting and audit sense. The term is also used in sustainability reporting, where companies assess which environmental, social and governance topics affect their value or their impact on the world; that meaning, including the idea of double materiality, is covered in the entry on financial materiality.
Materiality in accounting standards
Materiality is a pervasive concept: it affects what companies recognize, how they measure it and what they disclose. The International Accounting Standards Board (IASB) refined its definition in 2018, adding that information can be material if it is obscured by immaterial detail. The FASB amended its conceptual framework the same year to describe materiality as a legal concept, consistent with US Supreme Court rulings on securities law. In practice, materiality lets a company expense small asset purchases below a capitalization threshold, aggregate minor items into "other" lines, and leave out disclosures that would not matter to users, while the full disclosure principle requires all material information to be presented.
How auditors set materiality
An independent auditor sets materiality at the start of an audit to plan how much testing to do and to judge whether errors found are significant. The usual steps are:
- Overall materiality: a benchmark times a percentage. Common choices are about 5 percent of pre-tax income from continuing operations for profit-oriented companies, or 0.5 to 1 percent of revenue or total assets where profit is volatile or close to zero.
- Performance materiality: a lower amount, often 50 to 75 percent of overall materiality, used to plan individual tests so that the total of undetected errors stays below overall materiality.
- Clearly trivial threshold: a small amount, often around 5 percent of overall materiality, below which errors need not be accumulated.
For example, a company with pre-tax income of $40,000,000 might have overall materiality of $2,000,000, performance materiality of $1,400,000 and a trivial threshold of $100,000. If the audit finds uncorrected misstatements totalling $2,300,000, the auditor would ask management to correct them; if management refuses, the auditor would consider modifying the auditor's report. In the United States, the rules for public company audits are set in PCAOB auditing standards, including AS 2105 on materiality.
Qualitative materiality
Size is not the only test. The Securities and Exchange Commission (SEC) made clear in Staff Accounting Bulletin No. 99, issued in 1999, that relying only on a percentage rule of thumb is not enough. A small misstatement can be material if it:
- turns a loss into a profit, or lets a company just meet analysts' earnings expectations;
- hides a failure to comply with a loan covenant or regulatory requirement;
- affects management's compensation, such as a bonus target;
- involves fraud or an illegal act, however small;
- masks a change in an earnings trend or concerns a segment that is important to the business.
Common issues
Because materiality involves judgment, it is a frequent topic in enforcement cases and restatements. Companies sometimes allow many small errors to build up because each one is immaterial on its own; auditors must consider them in aggregate, and SAB 108 requires the effect on both the current balance sheet and the current income statement to be considered. Another issue is "disclosure overload": annual reports filled with immaterial detail can obscure what matters, which is why both standard-setters now encourage companies to cut immaterial disclosures. Materiality also underlies the decision of whether a past error requires restating prior audited financial statements or can simply be corrected in the current period, a choice that can significantly affect how investors view a company's reported net income.