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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...