The Role of Professional Judgment in Accounting and Auditing - Deloitte Fireside Chats

The Deloitte Fireside Chats are made possible through a partnership between Deloitte LLP and the SEC Historical Society. On October 22, 2009, an interactive conversation explored the role of professional judgment in accounting and auditing. The session recognizes that the meaning of professional judgment and its application in accounting and auditing have become subjects of interest and discussion for standard setters, preparers, auditing professionals, investors, regulators, faculty and students.

Zoe-Vonna Palmrose, PricewaterhouseCoopers Auditing Professor and Professor of Accounting in the Marshall School of Business at the University of Southern California served as moderator. The two panellists were: Gregory Jonas, serving on the PCAOB Standing Advisory Group and a member of the SEC Advisory Committee on Improvements to Financial Reporting (CiFR); and RobertKueppers, Deputy CEO of Deloitte and a trustee of the SEC Historical Society.

The CiFR identified five concerns that a judgment framework could help. First, many re-statements have resulted from deemed errors in judgment. Second, regulators believed that there are many cases of unpersuasive or under-supported judgments being made by practitioners. Third, companies and auditors believed that, from time to time, regulators did not respect their reasonable judgments and they substituted the regulators’ personal preferences for reasonable judgments in requiring revisions to financial statements when citing audit deficiencies. In other words, there was some mistrust between preparers and auditors and, on the other hand, the regulatory community on the subject of judgment.

The fourth concern was confusion in practice as to what constitutes a persuasive judgment. In the auditing literature and the accounting literature, the profession has never addressed what are the qualities of a persuasive judgment. Fifth, there seems to be a demand for detailed rules as a substitute for professional judgment, which undermines the goal of principles-based standards. There is a defeatist, self re-enforcing bad loop of practice demanding ever more detailed rules, so that they won’t be second guessed by overseers about the quality of their judgments.

The CiFR suggested that a judgment framework could serve four goals. The first was to improve the quality and reliability of the judgments made in practice. The second was to improve an auditor’s confidence that regulators will indeed respect reasonable judgments. The third was to establish criteria for judgments and thereby reduce uncertainty about the characteristics of sound judgment. In other words, clarify what people are looking for from judgment. The fourth goal was to enable principles-based standards.

To learn more, refer to the “Deloitte Fireside Chat – Part I: The Role of Professional Judgment in Accounting and Auditing (October 22, 2009)” available as an Edited Transcript and as an Audio Recording (one hour) on the SEC Historical Society website. Also, refer to the August 2011 postings on SEC Views on a Framework for Professional Judgment – Part 1, Part 2 and Part 3.

How Are Really Great Decisions Actually Made?

An April 2012 article in Forbes raises a number of questions about recent judgment calls. For example, “Who cannot be troubled at the lack of judgment in business schools that continue to instill the principles of traditional management when the very principles they are teaching are killing the institutions they are meant to assist.” And, “Who can watch with anything but disbelief as most large corporations continue to espouse maximizing shareholder value as their goal, when there is overwhelming evidence that it is the dumbest idea in the world.” It is hard not to conclude that judgment has fled to brutish beasts and men have lost their reason.

A new book on Judgment Calls: Twelve Stories of Big Decisions and the Teams That Got Them Right by Thomas H. Davenport and Brook Manville (2012, Harvard, Business Review Press) contains twelve diverse parables of instances where good judgment was exercised and an organization “got it right.” One of the advantages of the book is that it is written in a narrative style. In each case, a careful reading of the story points to the wider set of factors that are involved in making the decision. What the narratives bring out is that judgment is important but so is having the right goals, having the right values, and having good leaders.

For a thought-provoking overview of the book, read the article “How Are Really Great Decisions Actually Made?” at Forbes online.

Enhancing Audit Quality: Canadian Perspectives

Since the 2008 global financial crisis, policy makers, regulators, standard setters and others around the world have been considering changes to the financial system to promote greater financial stability and to reduce systematic risk. Audit quality is among the factors being discussed, with major audit reform initiatives well underway by the European Commission; the United States’ Public Company Accounting Oversight Board; the United Kingdom’s Financial Reporting Council; and the International Auditing and Assurance Standards Board, which has launched a project on enhancing auditor reporting

Enhancing Audit Quality: Canadian Perspectives is a consultation process being led by the Canadian Public Accountability Board (CPAB) and the Canadian Institute of Chartered Accountants (CICA) to gain stakeholder input on key issues emerging with respect to enhancing audit quality globally, and the impact on Canada. To provide effective coordination and direction to this work, an enhancing audit quality steering group (chaired by David Brown, a leading securities lawyer and former chair of the Ontario Securities Commission) has been established, along with three working groups, with experts from audit committees, auditing and assurance standard setters, auditors, investors, prudential and securities regulators, financial-statement preparers, CPAB and the CICA.

The working groups will focus on three aspects of audit quality and reform being discussed internationally. The working group on the role of the audit committee will focus on the reporting relationships between audit committees and their key stakeholders, along with enhancing and promoting professional skepticism by the audit committee and the auditor. The working group on auditor reporting will target enhancing the information value of the auditor’s report and expanding auditor association with management disclosures outside of the financial statements. The working group on auditor independence will focus its efforts on the options relating to the appointment and rotation of, and non-audit services provided by, auditors that will improve independence, objectivity, professional skepticism and audit quality at firms.

The Effects of Accounting Standard Precision, Auditor Task Expertise and Judgment Frameworks on Audit Firm Litigation Exposure

According to academic research: “The potential for increased audit firm litigation exposure remains a controversial aspect of the ongoing transition to imprecise accounting standards. Kadous and Mercer (2012) find that imprecise standards can increase audit firm litigation exposure when client accounting is inconsistent with industry norms, suggesting that audit firms would be motivated to herd to industry norms as a new form of rules and a safe harbor.”

A recent research paper by Grenier, Pomeroy and Stern uses a series of experiments to examine how audit firms can defend professional judgments in light of severe consequences associated with an alleged material misstatement and client accounting that is inconsistent with industry norms. It predicts and finds that, mock juror assessments of audit firm negligence can increase under imprecise relative to precise standards, but this increase is mitigated when audit firms make efforts to signal that their auditors made high quality judgments.

Importantly, audit firms can signal judgment quality in several ways: staffing engagements with recognized technical experts; utilizing professional judgment frameworks and highly reliable decision aids; and demonstrating adherence to professional standards. The results suggest that audit firms can make relatively cost effective efforts to cope with the potential for increased litigation exposure under imprecise standards. Thus, a transition to imprecise standards will not necessarily result in herding to industry norms.

To learn more, read the March 2012 SSRN research paper, The Effects of Accounting Standard Precision, Auditor Task Expertise, and Judgment Frameworks on Audit Firm Litigation Exposure (posted online October 27, 2010 and last revised April 4, 2012). The paper was prepared by: Jonathan H. Grenier, Ph.D, Miami University - Department of Accountancy; BradleyPomeroy, Ph.D, University of Illinois at Urbana-Champaign - Department of Accountancy; and Matthew Stern, Ph.D student, University of Illinois at Urbana-Champaign.

One View on Using Professional Judgment

The meaning of professional judgment and its application in an audit environment continue to be subjects of interest and discussion by auditing and accounting faculty, students, standard setters, regulators and auditing professionals alike. As accounting frameworks continue to call for increased judgment by preparers of financial statements, the auditor assessing those judgments will, in turn, need to apply professional judgment.  An article published in 2009 offers one “view from the profession” about the meaning and importance of professional judgment, as well as one approach that may be employed when applying professional judgment.

The phrase “professional judgment” is not new to the accounting and auditing profession. Recently, there has been an increased emphasis on the importance of professional judgment as a result of regulation, standard setting, inspections and a move toward more principles-based accounting and auditing standards. In its August 1, 2008 report, the Advisory Committee on Improvements to Financial Reporting recognized the “need for a cultural shift towards the acceptance of more judgment” and recommended that both the SEC and PCAOB issue statements of policy articulating how the reasonableness of accounting and auditing judgments is evaluated. So, while professional judgment may not be a new concept, its use is becoming increasingly more vital to the appropriate application of accounting and auditing standards.

For details, read the American Accounting Association (AAA) article “Using Professional Judgment” by Guy Moore, Senior Advisory Partner for Professional Practice, Deloitte & Touche LLP in The Auditor’s Report publication online (Volume 33, No. 1, Fall 2009). Also, refer to the August 2011 postings on SEC Views on a Framework for Professional Judgment – Part 1, Part 2 and Part 3.