The materiality constraint

The materiality constraint is a threshold used to determine whether business transactions are important to the financial results of a business. If a transaction is material enough to excess the constraint threshold, then it is recorded in the financial records, and therefore appears in the financial statements. If a transaction does not meet this threshold level, it may not be recorded in the financial records or it may be treated in a different way, depending on the circumstances.

For example, a company controller decides that the materiality constraint of the business is $20,000. An asset is purchased for $18,000. Since the size of this purchase is below the materiality level, the controller decides to charge the purchase to expense, rather than recording it as a fixed asset that will be depreciated over many years, as per the normal company policy.

As another example, the controller of the same business must decide whether to record a $50,000 medical insurance payment that applies to the following month as a prepaid asset in the current period, or charge it to expense. Since this amount exceeds the materiality level, the controller should record the payment as a prepaid expense, and charge it to expense in the following period, as per the normal company policy.

A larger business will have a higher materiality constraint, since its sales level is so much higher than a smaller entity. A multi-national entity might establish of materiality threshold of $1,000,000, while a small local hardware store might have a $1,000 threshold.

The materiality constraint is a key consideration in the process of closing the books, and helps accountants by allowing them to use the simplest transaction recordation alternatives for smaller items.