Definition of Materiality and Its Objectives

Definition: Materiality is a fundamental accounting principle that requires disclosure and recognition of information and operations that may affect the decisions of financial statement users, while allowing for the omission or simplified treatment of non-material elements. An item is determined to be material if its omission or misstatement could influence the economic decisions of users. The application of this principle varies according to company size, nature of activity, and surrounding context, requiring professional judgment from accountants to determine the appropriate materiality threshold.

Objectives:

Improving Report Quality: Focusing on influential information and avoiding unnecessary details.

Cost and Effort Savings: Reducing report preparation costs by not focusing on minor items.

Information Clarity: Avoiding overwhelming users with details that don't affect their decisions.

Application Flexibility: Allowing simplified treatment for small operations.

Decision-Making Effectiveness: Helping investors and creditors focus on important information.

Characteristics and Criteria for Determining Materiality

Materiality in accounting means determining whether an item or information is important enough to influence the decisions of financial statement users. Its determination depends on interconnected quantitative and qualitative criteria that require professional judgment from the accountant.

Quantitative Criteria include common percentages such as 5-10% of total assets or net income, and 0.5-1% of revenues. These percentages are not rigid rules but guidance indicators that vary according to company size and nature of activity. A large company might consider one million riyals unimportant, while a small company might consider one thousand riyals relatively material.

Qualitative Criteria focus on the nature of the item and its qualitative impact regardless of its financial size. For example, a legal violation with a small value might be material due to its impact on company reputation. Related party transactions and accounting errors are considered material even if their amounts are small.

Influencing Factors include user expectations, market sensitivity, and economic conditions. During crises, smaller amounts may become relatively material. Practical application requires the accountant to combine all these factors and use professional judgment to make a balanced decision while documenting reasons and periodically reviewing decisions to ensure their appropriateness.

Methods of Calculating and Measuring Materiality

Several methods exist for calculating and measuring materiality in accounting, including:

Percentage Method: Calculating a percentage from a specific financial base such as 5% of net income, 0.5% of revenues, or 5-10% of total assets.

Mixed Method: Using several percentages and taking the average or smaller value to obtain a more accurate materiality threshold.

Fixed Method: Determining a fixed amount as a minimum materiality threshold based on accountant experience and company nature.

Professional Judgment Method: Qualitative assessment considering circumstances of each case and its potential impact on decisions.

Standard Models: Using tables or formulas approved by professional bodies according to company size and type of activity.

Periodic Review: Re-evaluating materiality thresholds annually or when material company circumstances change.

Applications and Uses of Materiality

Materiality is considered one of the most important accounting principles that helps accountants and auditors make practical decisions about the level of detail required in financial statements and accounting procedures. Materiality applies in multiple areas within the accounting system to ensure efficiency and focus efforts on items with material impact, including:

In Financial Statement Preparation: Materiality helps determine items that need separate disclosure, group small items under one heading, and choose accounting methods for simple operations.

In Auditing: Used to determine sample size for testing, evaluate discovered errors, and determine acceptable risk levels.

In Error Treatment: Guides decisions to correct or ignore errors and determine error impact on decisions.

In Internal Control: Helps design control procedures and determine financial authority limits.

In Management Decisions: Affects accounting policy choices and investment and asset evaluations.

Practical Examples from Accounting Practice for Materiality

Example 1 - Inventory: A company with 50 million riyal revenues finds inventory shortage of 10,000 riyals (0.02%). Considered not relatively material and doesn't require separate adjustment.

Example 2 - Fixed Assets: Depreciation calculation error of 250,000 riyals for a company with 20 million riyal assets (1.25%). Considered material and requires correction.

Example 3 - Related Party Transactions: Loan from major shareholder worth 50,000 riyals. Despite small amount, considered material for disclosure due to its nature.

Example 4 - Revenues: Revenue recording error of 300,000 riyals for company with 100 million riyal revenues (0.3%). May not be considered quantitatively material but corrected for accuracy.

Example 5 - Item Grouping: Various administrative expenses less than 1% of revenues grouped under one item instead of detailed breakdown.