Elevating Professional Judgment in Auditing and Accounting: The KPMG Professional Judgment Framework

 

The KPMG University Connection website states: “With the move toward a more principles-based financial reporting framework and increased emphasis on fair value measurement, the ability to consistently make high quality professional judgments is increasingly important. KPMG has produced a monograph intended for use as a supplement in college-level auditing and accounting courses to help students understand the components of and threats to good professional judgment.”

“Elevating Professional Judgment in Auditing and Accounting: The KPMG Professional Judgment Framework will help students understand what professional judgment is and how to develop and practice it. This Framework and training are intended to elevate judgment quality and professional skepticism, and to provide a common vocabulary that facilitates implementation and mentoring on professional judgment.”

It is noteworthy that the KPMG Framework monograph is the recipient of the 2013 AAA/Deloitte Wildman Medal Award. The Wildman award, first presented in 1979, recognizes a work published within the most recent five years that the judges view as the most significant contribution to the advancement of the practice of public accountancy including audit, tax and management services.

To learn more about the KPMG Framework monograph, refer to the three-part article titled “Can you really teach good judgment?” (Part 1, Part 2 and Part 3). In addition, read the related article on “Enhancing Board Oversight by Challenging Traps and Biases in Professional Judgment” (Part 1, Part 2 and Part 3).

Exploring Principles vs. Rules-Based Accounting and Auditing Standards - Deloitte Fireside Chats

The Deloitte Fireside Chats are made possible through a partnership between Deloitte LLP and the SEC Historical Society. As noted in the previous posting (June 24, 2012), an interactive conversation on October 22, 2009 explored the role of professional judgment in accounting and auditing. On October 28, 2009, a further interactive conversation explored the issues surrounding principles versus rules-based accounting and auditing standards.

Patricia Fairfield, Associate Professor, McDonough School of Business, Georgetown University served as moderator. The two panellists were: Scott A. Taub, Managing Director, Financial Reporting Advisors, LLC and former Acting and Deputy Chief Accountant, SEC Office of the Chief Accountant; and Robert Kueppers, Deputy CEO of Deloitte and a trustee of the SEC Historical Society.

The discussion addressed a number of issues. ...What is meant by principles-based and rules-based accounting standards? What are the characteristics of ideal accounting standards? How can ideal standards be achieved? When we talk about principles versus rules, do we have any idea what we are talking about? The reality is that preparers, auditors, investors and regulators all have different needs but they would like to see the same economic substance portrayed in a way that is most useful and most transparent. There’s a lot at stake in this debate.

One of the seminal events in the debate was the Study Pursuant to Section 108(d) of the Sarbanes-Oxley Act of 2002 on the Adoption by the United States Financial Reporting System of a Principles-Based Accounting System. According to that Study, imperfections exist when standards are established on either a rules-based or a principles-only basis. "Principles-only standards may present enforcement difficulties because they provide little guidance or structure for exercising professional judgment by preparers and auditors. Rules-based standards often provide a vehicle for circumventing the intention of the standard. As a result of our study, the staff recommends that those involved in the standard-setting process more consistently develop standards on a principles-based or objectives-oriented basis."

In order to have a true principles-based accounting system, it isn’t just accounting standards that need to be written differently, but those applying the standards need to be thinking differently. There are implications for all parts of the financial reporting system, not just the writer of accounting standards. The term “objectives-based” or “objectives-oriented” recognizes that everybody has different views of what “principles-based” means. For example, a standard would set out the principles or objectives that the accounting for the particular item in the scope of that transaction is supposed to be looking towards. Then, those applying the standard would be charged with finding a method of accounting that is consistent with those objectives and principles.

...Yes, there might be implementation guidance but the purpose of the implementation guidance is to illustrate the principles and objectives, not to address specific fact patterns. An optimum amount of implementation guidance is going to require more judgment, more civil interchange with clients about what’s the best accounting and what’s the right answer. In this regard, those who look at the potential of a professional judgment framework as a panacea and those that look at it as a trap are misunderstanding the purpose of the judgment framework. The purpose is to get to better accounting answers, not to mandate a way to do things. It’s to help people who are applying accounting standards to make those judgments in an intelligent way.

To learn more about this debate, refer to the “Deloitte Fireside Chat – Part II: Exploring Principles vs. Rules-Based Accounting and Auditing Standards (October 28, 2009)” available as an Edited Transcript and as an Audio Recording 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.

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.

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.

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.