GAAP Materiality: What It Is and How It’s Determined

The principle of materiality in Generally Accepted Accounting Principles (GAAP) serves as a filter, distinguishing between significant and trivial information. It ensures financial statements are not cluttered with inconsequential details that could obscure important data. This concept allows for the presentation of a clearer and more understandable financial picture for those who rely on these reports to make informed decisions.

Materiality guides accountants and auditors on what to record, correct, and disclose. It acknowledges that financial statements do not need to be perfect to be useful, but they must be free of material misstatements. A material misstatement is an error or omission significant enough to alter the conclusions of a user of the financial statements.

The Core Principle of Materiality

Materiality is defined by whether the omission or misstatement of an item could influence the economic decisions of a reasonable person relying on the financial statements. This “reasonable person” standard refers to someone with a reasonable understanding of business and economic activities who is willing to study the information with reasonable diligence. The idea is to focus on what truly matters to investors, creditors, and other stakeholders.

The Financial Accounting Standards Board (FASB) codifies this principle in the Accounting Standards Codification (ASC). The FASB has intentionally avoided creating a rigid, universal formula for materiality, emphasizing that it is a concept based on professional judgment. The U.S. Supreme Court has defined information as material if there is a “substantial likelihood that the…fact would have been viewed by the reasonable investor as having significantly altered the ‘total mix’ of information made available.”

This principle is not just about the size of a number but also its nature. An item might be quantitatively small but qualitatively significant. For example, a small transaction that helps a company meet a contractual obligation or avoid a default on a loan could be considered material.

Quantitative Benchmarks for Assessment

While professional judgment is key, accountants and auditors often use quantitative benchmarks as a starting point to gauge materiality. These “rules of thumb” are practical tools to help standardize the initial assessment process.

Commonly used benchmarks are expressed as a percentage of a key financial statement line item. A widely applied starting point is 5% of a company’s pre-tax income. Other benchmarks include 0.5% of total assets, 1% of total equity, or 1% of total revenue. The choice of benchmark depends on the nature of the company and what its financial statement users are most likely to focus on.

For a company with a pre-tax income of $10 million, total assets of $200 million, and total equity of $50 million, applying the benchmarks yields different thresholds. A 5% rule on pre-tax income suggests a materiality level of $500,000. Using 0.5% of total assets results in a $1 million threshold, and 1% of equity gives a $500,000 figure.

An accountant would analyze these figures, considering the company’s stability and industry, to establish an appropriate overall materiality level. For example, if earnings are volatile, a benchmark based on assets might be more reliable. These quantitative assessments are the beginning of the analysis and must be considered alongside qualitative factors.

Qualitative Considerations for Materiality

The numerical size of an error is only one part of the materiality equation, as the context and nature of the item are just as important. Qualitative factors can render a quantitatively small item material. The Securities and Exchange Commission (SEC) provided guidance on this in its Staff Accounting Bulletin No. 99, which emphasizes that relying exclusively on quantitative benchmarks is inappropriate.

SAB 99 outlines several qualitative considerations. A misstatement that is otherwise small may be material if it:

• Masks a change in earnings trends, such as turning a reported profit into a loss.
• Allows a company to meet analysts’ published expectations for revenue or earnings.
• Affects a company’s compliance with regulatory requirements or loan covenants.
• Involves a key segment of the business seen as a driver of future growth.
• Arises from an illegal act or fraud, which is almost always considered material regardless of the amount.

For instance, a small error that triggers a loan default could have severe consequences and would likely be material. The character of the misstatement is also a concern because it may indicate broader issues with management integrity or internal controls.

Materiality in Practice for Companies and Auditors

Application by Companies

The established materiality threshold is a practical tool for daily accounting and reporting decisions. It guides management in determining which discovered errors must be corrected before financial statements are issued. If an uncorrected error, or the sum of several smaller errors, is below the threshold, management may decide not to adjust the financial statements.

Materiality also influences the level of detail in financial statement disclosures. Companies must disclose information about significant accounting policies, major transactions, and other events that are material to understanding the financial statements. For example, a company might set a policy to expense any asset purchase below a certain dollar amount, such as $5,000, rather than capitalizing and depreciating it. This policy is acceptable as long as the cumulative effect is immaterial.

Application by Auditors

External auditors use materiality in two stages: planning the audit and evaluating the results. At the outset, auditors establish an overall “planning materiality” for the financial statements. This figure helps them determine the nature and extent of their audit procedures, as a lower materiality level requires more extensive testing.

Auditors also set a lower threshold known as “performance materiality,” often a percentage of planning materiality (e.g., 50-75%). This is used to assess risks at the individual account balance level. This lower benchmark reduces the probability that the aggregate of uncorrected and undetected misstatements exceeds the overall materiality.

During the audit, auditors accumulate all identified misstatements, other than those that are clearly trivial. At the conclusion of the audit, they evaluate these misstatements, both individually and in aggregate, to determine if they materially misstate the financial statements. This final evaluation considers both the quantitative size of the errors and any relevant qualitative factors before the auditor issues their final opinion.