Materiality convention explained

Materiality convention explains why accountants must ensure that each line item in the financial statements can help users make informed decisions. In many cases, a disclosure in the notes to the FS is necessary in applying the materiality principle.

1. What's materiality convention

Materiality means the removal of an item in a financial statement can distort the decision of users of those statements. The materiality convention explains that only items that can affect users of financial information should be reported in the FS. This principle results in summarizing the amount of information presented in the statements. It also means that items of similar nature that are immaterial will be aggregated into a single material item.

For example, administrative expenses is a combination of several expenses relating to administration and operations of the business. All these expenses are combined into one to comply with the principle. There are other ways the materiality convention is applied. Such as in the area of losses and expenses. If a loss is material, it is important to let users be aware of such via the financial statement.

Also, some items with long term nature can be regarded as expenses because it is below the business' materiality level. For example, an office telephone can last for a long time, this doesn't mean it must be regarded as an asset. This is because its value is immaterial.

2. Applying materiality concept to financial statements

2.1 Non current assets and Depreciation

Items of property, plants, and equipment are aggregated into one item in the statement of financial position as well as their depreciation. Some items of non current assets may be classified as expenses because they are not material enough to classify them as such. As explained earlier, a company might buy a smartphone to call customers.

Although the phone qualifies as non-current assets, it is treated as expenses. This is also true with POS machines bought by a company to receive money from customers through their debit or credit cards. These items are immaterial and therefore treated as expenses.

2.2 Similar items

Items that have similar nature may be aggregated as one to make them material. All items of PPE are classified as one. For example, furniture and fittings, generators, computers, and other plants and equipment of the entity are aggregated for property, plant, and machinery. Also, expenses may be classified according to their function or nature in the income statement. This includes the revenue, cost of sales, administrative expenses, distribution expenses, finance cost and so on.

For example, interest paid on debentures and loans can be aggregated together as finance cost. Also, a company may have several revenue sources. But will list them as a single item in the income statement as revenue. To illustrate, MTN Nigeria has several lines of business, starting from data, airtime to fintech (momo agent). However, they are classified as a single line item in the statement of profit or loss.

2.3 Losses

If an entity makes an inventory loss of 500,000 Naira and has an income of 200 million, the 500,000 Naira loss is immaterial therefore, will not require additional disclosure in the financial statement. However, if the company's revenue is less than 10 million, it becomes a material loss and additional disclosure may be required to help users make better decisions.

2.4 Contingency

Contingency may be material or immaterial. A lawsuit against a company may lead to a huge fine that has an impact on the profitability of the entity. Although the lawsuit is yet to be decided on, the principle of materiality is applied. Therefore, an estimate of the figure is computed. If it is material, then it must be disclosed in the note to the financial statement.

3. Materiality and aggregation

Materiality convention applies when dealing with business transactions, events, and conditions. Only items of material nature are reported as a line item in the financial statement. This is to ensure that users are well informed about transactions that may have an impact on the company either positively or negatively. Thereby enhancing users' decision making process.

Aggregation is the cumulation of several transactions into a single item in the financial statement. Aggregation arises from the materiality principle. Items that are immaterial are aggregated into a single item. Also, similar items with lower value are accumulated to give them weight. However, they are later disclosed on the notes to the financial statement.