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 cross-border 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 1 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.” AuG 7 states that materiality guidance is selective and “is not to be used as a substitute for the auditor’s professional judgment.” Specific references to materiality appear in two CICA Research Studies: “Materiality—The Concept and its Application to Auditing” (1985) and “Extent of Audit Testing” (1980). In describing the determination of materiality, AuG 7 cross-references Section 5130 of the CICA Hand book:

The auditor is required to determine materiality by reference to what he or she believes will probably change or influence the decision of a person who is relying on the financial statements and who has a reasonable knowledge of business and economic activities. Ultimately, therefore, materiality decisions are based on professional judgment.

Some reporting decisions inherently require judgment because they depend on estimates. Canadian standards explicitly provide for measurement uncertainty by encouraging the reporting of sensitivity analyses and ranges when the difference between a reported amount and a “reasonably possible” outer limit is material. The language that invokes the probability estimate of what is “reasonably possible” is consistent with the U.S. standard for disclosing loss contingencies in SFAS 5. The Canadian use of the term is more extensive, however, in that it applies not only to contingent losses, but also to estimation errors both above and below the reported amount:

A decision about whether a measurement uncertainty has a material effect on the financial statements is a matter of judgment. Management would consider information such as the range of reasonably possible amounts; whether the difference between the recognized amount and the outer limits of the range of reasonably possible amounts is material or whether the recognized amount could change by a material amount; the impact of other reasonably possible amounts on the entity’s economic resources, obligations (e.g., debt covenants) and equity/net assets; and the possible timing of the impact. A judgment about the materiality of measurement uncertainty would be made considering the effect that a different reasonably possible amount would have on the financial statements. [CICA Handbook, para. 1508.10, #12]

The reporting of “reasonably possible amounts” by which measurements could be in error is necessary if these variations are material, because such variations in reported economic resources, obligations, equity, and timing could alter users’ decisions. Therefore, by extension, Canadian standards identify the primary reporting elements upon which users base their decisions—assets, liabilities, and equity—as well as a nonaccounting factor, timing. The emphasis on balance sheet elements is consistent with the trend in U.S. standards setting, a trend toward a balance-sheet valuation approach.

New Zealand

The differences between AG 14 and IAG 25 are interesting, especially since AG 14 was explicitly adapted from the international standard: it includes the term “probable,” nature is explicitly mentioned alongside magnitude, and it uses the narrow term “reasonable person relying on the information.”

Australia

In Australian guidance, “material personal interest” is linked directly to conflict of interest in decision making. ASC Policy Statement 76, Related Party Transactions (para. 15–21), cites a string of important court precedents to elaborate on the definition of material personal interest, underscoring the importance of circumstances, legal considerations, and the role of theoretical conflict:

At common law, a person in a fiduciary position, such as a director of a company, has a duty not to profit from a position of trust or place himself or herself in a position where duty and interest might conflict. The vast range of types of transactions to which the rule might apply means it is not possible to define “interests.” However, the conflict rule must be applied realistically to a state of affairs which discloses a real conflict of duty and interest and not some theoretical conflict. In other words, an interest will not be material if it is remote or contingent.…

Ultimately, whether a director has a material personal interest will depend on the particular circumstances. If in doubt, directors should seek specific legal advice.

The explicit use of “remote” and “contingent” to define materiality introduces probability to evaluating such circumstances.

United States

Another area in which language concerning materiality has developed can be seen in the Accounting Standards Executive Committee’s (AcSEC) call for the disclosure of any event with potential near-term financial consequences if it is a “reasonably possible” event associated with risks and uncertainties. The following issues are associated with implementing this guidance:

Some believe the litigation burdens attendant on the proposals due to scope and auditability issues are problematic. Specifically, is the definition of “severe impact” workable: a significant effect that is or will be financially disruptive to the functioning of the entity? Similarly, should the financial flexibility disclosure be required when the entity’s line of credit will expire within the year, even if it is probable that the line of credit will be reviewed? [Wanda A. Wallace, Auditing, Third Edition, p. 975 (International Thomson Publishing, 1995)]

Regulators continue to debate the proper specifications of materiality as they relate to likelihood. The following excerpt from an attachment to a 1996 AcSEC draft letter, “SEC Proposal on Derivatives Disclosures,” includes effective illustrations of the practice queries that emerge from a single area of proposed implementation.

The qualitative and quantitative disclosures would not be required if … reasonably possible losses of future cash flows, earnings, or fair values are not material.…

What method, time period, and point of reference (for example, daily, quarterly, annual earnings) would a registrant be allowed to use to assess the “reasonably possible” threshold?…

For value-at-risk disclosures, is it logical for the materiality threshold to be based on measurements (“reasonably possible” losses of future cash flows, earnings, or fair values) that are more precise than the measures disclosed (potential losses in fair value, earnings, or cash flows from market movements)?

Suggestions

Consistently map likelihood with materiality. There are numerous examples within professional guidance where likely items or possible events are described as material. Because many numerical estimates, particularly for softer accounts, will involve expected value computations, a likelihood dimension should be explicitly built into the materiality guidance. This would entail a parallel treatment of likelihood in a set of prescribed terms, create ranges with which such terms are associated, define proscribed terms that might otherwise confuse, and draw attention to the aggregation of likelihoods, with the goal of transparency in communication with users.

A discussion of materiality and probability in litigation settings can be found in Duties and Liabilities of Public Accountants, Sixth Edition, by Denzil Y. Causey, Jr., and Sandra A. Causey (Accountants’ Press, 1999). The authors present an analytical scale of materiality (Exhibit 2-8, p. 40) for assessing its effect on a reasonable investor that ranges from 1 (remote effect) to 5 (probable loss of investment). The probability scale is then linked to a legal-based materiality description. Matters of minor importance (1 on the scale ) would have a remote effect on a reasonable investor. A substantial decision factor (2) has a possible effect on value. A decisive factor (3) is a major effect of information on value. No warning of disaster (4) is noted as a possible loss of investment. Probable loss of investment (5) corresponds to information calculated to deceive. This scale is interesting in its integration of probability, magnitude, omission, and intent.

Kenneth C. Fang and Brad Jacobs trace the legal development of the concept of materiality forward from the Supreme Court’s decision in TSC Industries, Inc. v. Northway, Inc. [426 U.S. 438 (1976)], in which the court recognized a qualitative dimension, through SAB 99, which links substantial likelihood and importance to materiality [The Business Lawyer (May 2000, pp. 1039-1064)]. They observe the following in SAB 99:

The staff states that … plainly it is “reasonable” to treat misstatements whose effects are clearly inconsequential differently than more significant ones.… Is not “clearly inconsequential” the same as “immaterial”?

Such references to “plainly,” “reasonable,” and “clearly” imply clarity and likelihood dimensions. Does clearly mean certainty? Does plainly imply probable? Does reasonable moderate?

Reneé Price, PhD, teaches financial accounting, international accounting, and valuation on the faculty at the University of Nebraska.
Wanda A. Wallace, PhD, CMA, CIA, CPA, is the John N. Dalton Professor of Business Administration at the College of William and Mary and has served on the Financial Accounting Standards Advisory Council.

The authors have recently completed a three-year study of over 3,000 documents in seven English-speaking countries, as well as international pronouncements, comparing and analyzing the literature on the definition and application of materiality concepts. This article is drawn from that project (Monograph 24, forthcoming). The authors appreciate the financial support of this research by the CGA Canada Research Foundation.