Business Expenses and Materiality

In order to make financial statements readable and valuable as a management and audit tool, the concepts of materiality and conservatism must be in place and strictly observed. It is important not to provide excessive detail, at the expense of clarity. This is true throughout your accounts, and business expenses are no exception. The failure to comply with these concepts could result overly complex financial statements or financials filled with errors in revenue and business expense recognition.

The materiality concept saves us all from countless trivial calculations, and allows a business to focus the financial reporting mechanism on items that drive and describe the ongoing business of the entity. The materiality concept states that a business only needs to focus on the accounting transactions that have a material effect on the financial statements. This rule is not set up to allow management to pick and choose what would be considered material; rather, this rule defines the way that we view the countless transactions that a business entity creates, and expenses are no exception.

Let’s examine the printer cartridge in the printer in the office of a business called The Computer Shop. In theory, we could measure the amount of ink used every day and calculate the daily "printer cartridge expense" and make the related journal entry, but this would be impractical, time consuming and relatively futile. Instead, we view the value of the asset, in this example the printer cartridge, as "used up" once it is purchased (we immediately show it as a business expense), and we move onto other items. Although this method is theoretically less accurate than the daily calculation it is easy to see that the materiality concept, when put into place, simplifies trivial reporting in a sensible manner, and obviates the need for excessive detail in business expenses.

The conservatism concept provides rules regarding the recording of increases and decreases in equity. For example. in July, a customer named Larry agreed to buy a $3,000 software package from The Computer Store in November. The Computer Store is in the business of selling business software and would be pleased to sell some to Larry in November, or any other month. Larry will probably purchase the software as expected in November, although there a slight possibility that he will change his mind, or purchase the product elsewhere. Due to the remote possibility that this product might not be purchased, we assume a degree of uncertainty relating to this sale, and will not record the revenue until Larry picks up the software in November. Increases in equity are to be recorded, or recognized, only when they are reasonably certain to occur.

In examining decreases in equity, we find that in order to be conservative we must recognize decreases in equity as soon as they occur, or become apparent. Suppose that The Computer Store was broken into in July and $2,000 of software inventory was stolen. Although there is a very remote chance that the stolen items will be recovered and returned to The Computer Shop in the next few months, the decrease in equity must be recognized as soon The Computer Shop realizes that the inventory has been stolen.