The term materiality refers to an accounting constraint that is used to determine the relative importance or value of an item to one of the company’s financial statements. If an item is not deemed significant enough to influence the decision-making process of an individual examining the company’s financial statements, then that item is not considered material.
Material items can include the purchase price of an asset, a transaction with a supplier or customer, and even news. Materiality will also vary with the size of the company. Larger companies will have higher thresholds, since it will take greater dollar values to have any meaningful impact on the company’s financial statements. For this reason, the FASB has not issued any direct accounting guidance to indicate what is considered material.
Many companies establish internal guidelines, or constraints, for materiality. These guidelines may apply to revenue, profits, assets, and expenses. For example, a company with $10 billion in revenues might decide to expense the purchase of a $500,000 software program, even though the application is expected to provide benefits beyond the current accounting period. The work, and cost, associated with creating an asset and tracking its depreciation expense would likely outweigh any benefit.
To a smaller company, one with $5,000,000 in revenues, the purchase of a $500,000 software program will likely be deemed material, since the purchase price is 10% of the company’s revenues. A company of this size might decide to capitalized the purchase, create an asset on the balance sheet, and expense the purchase over its serviceable life.