SEC Views on a Framework for Professional Judgment – Part 3 of 3

According to the US Securities and Exchange Commission (SEC) Committee on Improvements to Financial Reporting (“CiFR”) accounting judgments should be based on a critical and reasoned evaluation made in good faith and in a rigorous, thoughtful and deliberate manner. Preparers should have appropriate controls in place to ensure adequate consideration of all relevant factors (see Final Report, pages 88-96).

Factors applicable to the making of an accounting judgment include the following:

·       the preparer’s analysis of the transaction, including the substance and business purpose of the transaction;

·       the material facts reasonably available at the time that the financial statements are issued;

·       the preparer’s review and analysis of relevant literature, including the relevant underlying principles;

·       the preparer’s analysis of alternative views or estimates, including pros and cons for reasonable alternatives;

·       the preparer’s rationale for the choice selected, including reasons for the alternative or estimate selected and linkage of the rationale to investors’ information needs and the judgments of competent external parties;

·       linkage of the alternative or estimate selected to the substance and business purpose of the transaction or issue being evaluated;

·       the level of input from people with an appropriate level of professional expertise;

·       the preparer’s consideration of known diversity in practice regarding the alternatives or estimate;

·       the preparer’s consistency of application of alternatives or estimates to similar transactions;

·       the appropriateness and reliability of the assumptions and data used;

·       the adequacy of the amount of time and effort spent to consider the judgment.

When considering these factors, it would be expected that the amount of documentation, disclosure, input from professional experts, and level of effort in making a judgment would vary based on the complexity, nature (routine versus non-routine), and materiality of a transaction or issue requiring judgment. Material issues or transactions should be disclosed appropriately. Existing disclosure requirements should be sufficient to generate transparent disclosure that enables an investor to understand the transaction and assumptions that were critical to the judgment. In addition, when evaluating the reasonableness of a judgment, regulators should take into account the disclosure relevant to the judgment. 

It is imperative that the alternatives considered and the conclusions reached should be documented contemporaneously. This will ensure that the evaluation of the judgment is based on the same facts that were reasonably available at the time the judgment was made. The lack of contemporaneous documentation may not mean that a judgment was incorrect, but would complicate an explanation of the nature and propriety of a judgment made at the time of the release of the financial statements.

SEC Views on a Framework for Professional Judgment – Part 2 of 3

According to the US Securities and Exchange Commission (SEC) Committee on Improvements to Financial Reporting (“CiFR”), there are many categories of accounting and auditing judgments that are made in preparing financial statements. Any guidance should encompass all of these categories, if practicable (see Final Report, pages 88-96).

Some of the categories of accounting judgment are as follows:

·       selection of accounting standard;

·       implementation of an accounting standard;

·       lack of applicable accounting standards;

·       financial statement presentation;

·       estimating the actual amount to record; and

·       evaluating the sufficiency of evidence.

In addition, there are many levels of professional judgment that occur related to accounting matters. Preparers must make initial judgments about uncertain accounting issues; the preparer’s judgment may then be evaluated or challenged by auditors, investors, regulators, legal claimants and even others, such as the media. Guidance should not suggest that those who evaluate a judgment must re-perform the judgment according to the guidance. Instead, guidance should provide clarity to those who would make a judgment on factors that those who would evaluate the judgment would consider while making that evaluation.

Judgment, with respect to accounting matters, should be exercised by a person or persons who have the appropriate level of knowledge, experience, and objectivity to form an opinion based on the relevant facts and circumstances within the context provided by applicable accounting standards. Judgments could differ between knowledgeable, experienced, and objective persons. Such differences between reasonable judgments do not, in themselves, suggest that one judgment is wrong and the other is correct.

SEC Views on a Framework for Professional Judgment – Part 1 of 3

According to the US Securities and Exchange Commission (SEC) Committee on Improvements to Financial Reporting (“CiFR”), professional judgment is not new to the areas of accounting, auditing or securities regulation. The criteria for making and evaluating judgment have been a topic of discussion for many years. The recent increased focus, however, comes from several different developments, including changes in the regulation of auditors, more use of fair value estimates, and a focus on more principles-based standards (see Final Report, pages 88-96).

Investors are likely to benefit from more emphasis on principles-based standards, since rules-based standards may provide a method, such as through exceptions and bright-line tests, to avoid the accounting objectives underlying the standards. In other words, without the exercise of professional judgment, rules in the form of bright lines may result in a false consistency – that is, ostensibly uniform accounting for differing fact patterns. If properly implemented, principles-based standards should improve the information provided to investors while reducing investor concerns about “financial engineering” by companies using the rules to avoid accounting for the substance of a transaction.

While preparers appear supportive of a move to less prescriptive guidance, they have expressed concern regarding the perception that current practice by regulators in evaluating judgments does not provide an environment in which such judgments may be generally respected. This, in turn, can lead to repeated calls for more rules, so that the standards can be comfortably implemented. 

Guidance on the exercise of professional judgment may help address the following issues:
(1) Investors’ lack of confidence in the use of judgment – Guidance may provide investors with greater comfort that there is an acceptable rigor that companies follow in exercising reasonable judgment. (2) Preparers’ concern regarding whether reasonable judgments are respected – In the current environment, preparers may be afraid to exercise professional judgment for fear of having their judgment overruled, after the fact, by regulators. (3) Lack of agreement in principle on the criteria for evaluating professional judgment – Identification of the criteria for evaluating reasonable judgments, including the appropriate role of hindsight in the evaluation, may not be clearly defined, which may lead to increased uncertainty. (4) Concern over increased use of principles-based standards – Companies may be less comfortable with their ability to implement more principles-based standards if they are concerned about how reasonable judgments are reached and how they will be assessed. 

There are many different ways that potential guidance on professional judgment could be provided. To be successful, however, that guidance should not eliminate debate, nor be inflexible or mechanical in application. Rather, the guidance should encourage preparers to organize their analysis and focus preparers and others on areas to be addressed, thereby improving the quality of the judgment and likelihood that regulators will accept the judgment. Any guidance issued should be designed to stimulate a rigorous, thoughtful and deliberate process rather than a checklist-based approach for making and evaluating professional judgment.

Judgment Sustained

The preparation and audit of financial statements have always required the exercise of judgment. The trend entails a move away from prescriptive guidance toward greater use of judgment – for example, fair value involves estimates that may be less objectively determined than historical cost measures. Similarly, auditing standards on internal control over financial reporting emphasize the need for professional judgment in taking a risk-based approach to internal control audits. Moreover, International Financial Reporting Standards (IFRS) rely on general principles.

Poor judgment in accounting can be costly. Despite the use of rules-based standards, poor judgment is one of the leading reasons for failed financial reporting. A 2006 study suggests that poor judgment is the second-leading contributing factor for restatements (refer to Stephen Taub, “Study Points Restatement Blame Back at Cos.,” Compliance Week, March 25, 2008). Flawed financial reporting is a serious outcome in itself, but many other aspects of business performance, such as financial planning, brand and reputation, are also exposed to significant risk through poor judgment.

Broadly speaking, there are two ways of reasoning (Stanovich and West, “Individual differences in reasoning: Implications for the rationality debate,” Behavioral & Brain Sciences, 23, 2000, 645–665). The first is an intuitive “gut feeling” about situations. This method of decision processing works quickly and instinctively, but it is sometimes an emotional reaction. The second is a more analytic, holistic, thoughtful approach to making decisions, perhaps using a framework. Clearly, a judgment framework is not a silver bullet, but research shows that it can work in various contexts, particularly ethics. While everyone has biases, there are some explicit strategies that can ameliorate some of the most common ones.

According to the US Securities and Exchange Commission (SEC) Committee on the Improvement of Financial Reporting (“CiFR”), a judgment framework is a critical and good faith thought process (see Final Report, pages 88-96). It is important to remember, however, that professional judgment is not formulaic. No judgment framework will result in consistently correct and effective decisions, but using a judgment framework could lead to greater consistency in decision making and practice.

To learn more, read “Judgment Sustained” in Deloitte Review online. This web article offers a view on using a judgment framework. It was prepared by: Shelley Barrows, partner, Assurance Services, Deloitte & Touche LLP and a fellow with Deloitte Idea Labs; Vikram Mahidhar, senior research manager and director of operations for Deloitte Research, Deloitte Services LP; and Ajit Kambil, global research director for the CFO Services, Deloitte Services LP.

Professional Judgment – A CPAB Perspective

The Canadian Public Accountability Board (CPAB) was incorporated in 2003 under the Canada Corporations Act. Its mission is “To contribute to public confidence in the integrity of financial reporting of reporting issuers in Canada by effective regulation and promoting quality, independent auditing.”



CPAB is based in Toronto with operations in Montreal and Vancouver, and industry involvement nationally and internationally. It oversees auditors of Canadian reporting issuers, that is, companies that have raised funds from the Canadian investing public and who, for that reason, must file financial statements with one or more provincial securities commissions. Under the Canadian Securities Administrators Rule 52-108, accounting firms that audit reporting issuers must be participants in CPAB’s oversight program.

In 2008, CPAB delivered two presentations that offer a perspective on professional judgment. First was the May 30, 2008 Presentation to Canadian Academic Accounting Association (CAAA) 2008 Conference in Winnipeg, Manitoba by Keith Boocock. Titled "CPAB - Five Years On," it addressed the need for documentation of professional judgment (slide 25), the importance of developing research into professional judgment (slide 46), and a possible area for future study - how to assess and measure professional judgment (slide 49).

The second was the August 7, 2008 Presentation to CICA – SME (Professional Judgment) by Paul Lohnes. Titled "Professional Judgment - A CPAB Perspective," it explained what professional judgment is and referred to the proposed definition in ISA 200 "The application of relevant training, knowledge and experience, within the context provided by auditing, accounting and ethical standards, in making informed decisions about the courses of action that are appropriate in the circumstances of the audit engagement." The presentation also explained why professional judgment is important to CPAB, and then discussed how professional judgment is applied, the importance of consultation, and CPAB's expectations for professional judgments.