What is materiality in accounting?

Materiality is a concept that accountants use while preparing a company’s financial statements. It’s a gauge for whether financial information is significant enough that getting it wrong, leaving it out, or presenting it differently could influence someone who’s relying on the financial statements.

As a founder, understanding materiality can help you understand how financial information can impact reporting and business decisions. Here’s what you need to know about this accounting principle.

Materiality fits into the broader principles behind generally accepted accounting principles (GAAP), which are standards set by the Financial Accounting Standards Board in the U.S., with the aim of making financial reporting reliable, consistent, and comparable. Materiality is a concept that helps accountants determine whether financial discrepancies are significant or not.

This is important because information in a company’s financial reports can influence anyone who’s using their financial statements to make decisions, such as a prospective investor. So, an omission or misstatement that’s significant in this way is considered “material.” This could include an incorrect amount, a missing transaction, an improper classification, or a disclosure that doesn’t accurately represent the business.

A $500 accounting error, for example, won’t mean the same thing for every business. To a startup generating $10,000 in monthly revenue, this mistake could materially distort the numbers. But for a company that’s generating $1 million a month, it might barely register.

Examples of materiality in accounting

Consider these two sample errors:

1. A $100 software subscription got recorded as an office expense.
2. An unprofitable startup recognized $100,000 of revenue in the wrong period, making the company appear profitable.

Both of these mistakes make the books inaccurate, but they don’t have the same gravity. The first mistake might be deemed immaterial because correcting it wouldn’t meaningfully change the company’s financial statements. The second error is much more likely to be considered material because it changes the company’s reported performance and could mislead potential investors, for example.

As a company grows, its financial activity will likely spread across more places, such as bank accounts, cards, payroll, expense tools, payment processors, and accounting software. With more activity happening in more places, that means there are more chances for discrepancies to crop up. But discrepancies will carry different weight, particularly when your financial statements feed into bigger decisions, such as raising capital, taking on debt, filing taxes, or reporting to your board. For example, misclassifying a $75 subscription expense will have far less impact on how you think about burn or runway than failing to record a $50,000 customer invoice in accounts receivable.

To determine materiality, accountants look at both the size and nature of an item, along with the circumstances around it. They might consider:

• The amount relative to revenue, expenses, assets, or profit
• Whether it changes a key financial trend or turns a profit into a loss
• Whether it affects a metric investors or lenders rely on
• Whether it affects compliance with a loan covenant or contractual requirement
• Whether it involves fraud, an unlawful transaction, or another sensitive issue
• Whether several small errors will become more significant when considered together

In short, to determine materiality, the number matters, and so does what that number could change.

Quantitative vs. qualitative materiality

There are different ways to assess materiality, including through a quantitative or a quantitative lens:

• Quantitative materiality focuses on size. An accountant might compare an error with revenue, assets, expenses, or income to understand its significance relative to the business.For example, a $20,000 error equals 10% of $200,000 in annual revenue, but just 0.2% of $10 million. So, the same error can have a very different financial impact, depending on the circumstances.
• Qualitative materiality looks at context. A relatively small error could cause a company to appear compliant with a contractual requirement that it actually missed. Or it could change a metric included in an investor update. The amount might be small, but the consequences aren’t.

There’s no universal materiality threshold in accounting. Accountants and auditors sometimes use percentages or other benchmarks as a starting point, but those benchmarks don’t replace good judgment. The SEC, for example, has cautioned against assuming that a misstatement below a particular percentage, including the commonly cited 5% threshold, is automatically immaterial.

The appropriate benchmark can also depend on the company. A pre-revenue startup may pay closer attention to cash, assets, or expenses, whereas a growing company may use revenue or another operating measure.

Setting a threshold can help your team identify which variances deserve scrutiny. But don’t treat your threshold as a blanket rule and don’t ignore everything below it.

The easiest way to understand the meaning of materiality in accounting is to look at what an error changes. Here are a few examples.

Remember, these aren’t fixed rules. A missing invoice that’s considered material for one small business could be immaterial for a much larger company.

An accounting error is considered material when its size, nature, or both could meaningfully affect how someone interprets the financial statements or shape a decision that they make from them.

Errors can also become material in aggregate. Ten small errors, for example, may add up to a meaningful misstatement. A pattern of similar mistakes can also expose a bookkeeping or controls problem, even if no single individual transaction materially affects the financial statements.

Conducting regular reconciliations and implementing a consistent close process can help catch these issues before they accumulate. If you’ve fallen behind on your books, doing a bookkeeping cleanup can help you surface missing transactions, duplicate entries, unreconciled accounts, and other discrepancies.

Materiality can influence how you and your team prepare, review, correct, and disclose financial statements. If a material misstatement happens, you’ll need to correct it so that the financial statements accurately represent the company’s financial position and performance.

Materiality can also affect whether certain information warrants making a separate presentation or disclosure. This scenario is more likely as the audience for your financial statements grows, and investors, lenders, board members, auditors, and potential acquirers may all rely on your numbers.

Avoiding common financial pitfalls from the start can make it easier to keep your books reliable as the company grows.

Both accountants and auditors use the concept of materiality to determine which errors and inconsistencies need more scrutiny and how they should evaluate any errors. Accountants use the principle of materiality when preparing and reviewing financial information, including deciding which discrepancies need correction or investigation. Auditors use this concept to plan and perform an audit. Rather than verifying every transaction, auditors design procedures to obtain reasonable assurance that the financial statements as a whole are free from material misstatement.

As your company’s accounting gets more complex, choosing the right accountant can help you build processes that fit your business’s stage and reporting needs.

Because whether or not an error has significance will depend on context and judgment, it’s easy to mistake the idea of materiality as a hard-and-fast rule. Here, we correct three common sources of confusion about materiality..

“Material” doesn’t mean “large”

A mistake that’s considered material isn't necessarily a large one. Size is one factor, but a relatively small error can be material if its context or consequences make it significant.

“Immaterial” doesn’t mean “unimportant”

An error can be immaterial to the financial statements and still be worth fixing. Recurring small errors can signal a weak process or unreliable data.

If something is below your materiality threshold, don’t ignore it

If you or your accountant have deemed an error to be immaterial, that doesn’t mean you have a free pass for inaccurate accounting. Numerical thresholds can help your accountant make judgments, but these guidelines aren’t hard lines between what matters and what doesn’t.

You don’t need to calculate an audit materiality threshold every time something looks off in your books. Instead, ask these questions to gauge whether the discrepancy matters:

1. How big is it relative to the business? Compare it with relevant figures such as revenue, expenses, cash, assets, or profit.
2. What does it change? Would correcting the discrepancy alter a trend, KPI, financial statement balance, or your overall understanding of the company?
3. Who relies on this number? Could investors, lenders, your board, or other stakeholders potentially make a different decision with the corrected information?
4. Does the context raise the stakes? Errors involving covenants, compliance requirements, related-party transactions, or potential fraud can matter beyond their dollar value.
5. Is it isolated or part of a pattern? Small discrepancies can add up or reveal a larger bookkeeping problem that needs to be addressed.

When the answer isn’t obvious, bring the issue to your accountant rather than relying on a percentage alone.

Materiality is all about significance. A miscoded software subscription or an error that changes reported revenue, for example, may both be mistakes, but they don’t warrant the same response. Understanding the difference between a material and immaterial discrepancies will help you recognize when something in your books needs a closer look and when your financial records need to be amended. Of course, you can only make this call when you have a reliable view of your finances.

Keeping your books current and organized will make it easier to spot discrepancies and understand their potential impact. To streamline your bookkeeping process, Mercury Books brings banking and bookkeeping together in one place. With everything in one place, your books stay complete, current, and accurate.