Question

Question: BE2-5 (L03) Presented below are three different transactions related to materiality. Explain whether you would classify these transactions as material.(

a) Blair Co. has reported a positive trend in earnings over the last 3 years. In the current year, it reduces its bad debt allowance to ensure another positive earnings year. The impact of this adjustment is equal to 3% of net income.

(b) Hindi Co. has an unusual gain of \(3.1 million on the sale of plant assets and a \)3.3 million loss on the sale of investments. It decides to net the gain and loss because the net effect is considered immaterial. Hindi Co.'s income for the current year was \(10 million.

(c) Damon Co. expenses all capital equipment under \)25,000 on the basis that it is immaterial. The company has followed this practice for a number of years.

Short answer

Answer

Step-by-step solution

Materiality 

Materiality is one of the ingredients of the fundamental quality-relevance. It means that the transaction is not recorded or misstated which can influence the decision making of the users of financial statements.

It depends on the individual company to decide about the particular information to be material or irrelevant that can influence the decision making of the users of financial statements. In general, the transactions are considered material if the amount involved in such transaction is more than the percent of the net income for the period.

(a)

In current year, the allowance for bad debts is reduced to increase the net income. The impact of the transaction is percent of the net income for the current year which is less than the material transaction that is percent of the net income. Hence, the item is immaterial. However, the item is related to the bad debt allowance which will impact the decision making of the user of financial statement.

Thus, the transaction ismaterial.

(b)

The given statement has two transactions and the amount of income for the current year. Every transaction has to be analyzed separately to decide about the materiality. Two transactions are extraordinary items which will have impact on the decision making of the users of financial statements.

Thus, the transaction ismaterial.

(c)

In the current year, the Co. expenses all capital equipment on the basis of previous year’s practice. The transaction is of regular practice which does not impact the decision of the user of financial statement.

Thus, the transaction isimmaterial.