Probability and Materiality

By Price, Renee; Wallace, Wanda A. | The CPA Journal, June 2001 | Go to article overview

Probability and Materiality


Price, Renee, Wallace, Wanda A., The CPA Journal


In Brief

Clarifying a Complex Relationship

No GAAP pronouncements quite match those that require probability assessments for evoking the ire of the accountants that must apply them. Nonetheless, there is an inherent relationship between probability and materiality, inescapable for accurate financial reporting and auditing. However, I.S. and international standards arc so imprecise that quantitative applications are rare. The authors analyzed over 3,000 documents from seven English-speaking countries, as well as international pronouncements, and found that the language of likelihood varies greatly within the reporting and auditing literature, making comparisons across different contexts difficult. They conclude that the lack of clarity and specificity regarding probability as it relates to materiality creates an obstacle for auditors. They suggest building an explicit likelihood dimension into materiality guidance. Additionally, more attention must he focused on the area in order for the convergence of international standards to be successful.

LIKELIHOOD IS INTRINSICALLY LINKED TO MATERIALITY. SFAS 5, Accounting for Contingencies, sets forth a continuum for the recognition of liabilities:

* Probable and estimable liabilities are to appear on the face of the financial statements.

* Possible and estimable liabilities are to appear in the notes to the financial statements.

* Remote and estimable liabilities are neither reported nor disclosed.

In each case, the probability of occurrence triggers disclosure and determines where that disclosure appears.

FASB introduced the "more likely than not" criterion in the context of defining deferred tax assets:

The Board intends more likely than not to mean a level of likelihood that is more than 50 percent. Selection of more likely than not as the criterion for measurement of a deferred tax asset is intended to virtually eliminate any distinction between the impairment and affirmative judgment approaches. In practice, there should be no substantive difference between the accounting results of either:

a) Recognition of a deferred tax asset if the likelihood of realizing the future tax benefit is more than 50 percent (the affirmative judgment approach);

b) Recognition of a deferred tax asset unless the likelihood of not realizing the future tax benefit is more than 50 percent (the impairment approach). [SFAS 109, Accounting for Income Taxes, para. 97]

This approach suggests that FASB intended symmetry of likelihood. In other words, increases and decreases in book value would be triggered on either side of a 50% point on a continuum.

Although the standards do not translate the likelihood continuum in SFAS 5 into a quantitative value, Wallace reports that "probable" is generally interpreted to be approximately 78% [see Wanda A. Wallace, Auditing, Third Edition, pp. 955-959 (International Thomson Publishing, 1995)]. In the early 1990s, the General Accounting Office urged FASB to further clarify the continuum in SFAS 5 because it had found that, in practice, "probable" meant as high as 95%.

The current environment of crossborder standards harmonization raises the following question: Do the materiality standards of other countries use probability references? In addition, if so, how do these references compare to those in SFAS 5 and SFAS 109? Exhibit I profiles the major materiality guidance in seven different settings (United Kingdom and ICAEW guidance overlap). Exhibit 2 places the language on an eight-point continuum from remote to probable, illustrating the intersection of probability and materiality. Exhibit 1 also introduces a relative time dimension when it states "should such a misstatement become material in the future" as a consideration in both Canada and the United States.

Canada

Auditing Guideline (AuG) 7, Applying Materiality and Audit Risk Concepts in Conducting an Audit (March 1990; adjusted with regard to control terminology in May 1992), is intended to be read in conjunction with the CICA Handbook's "Introduction to Auditing and Related Services Guidelines. …

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