Announcing PCAOB’s new auditor’s reporting model

In June 2017,  the United States Public Company Accounting Oversight Board (PCAOB ) issued a new standard and related amendments called “The Auditor's Report on an Audit of Financial Statements When the Auditor Expresses an Unqualified Opinion and Related Amendments to PCAOB Standards”. The new standard creates the first significant change to the standard form auditor’s report in 70 years. Reports prepared by public company auditors will contain more information for investors and other financial statement users as a result of new rules.

Under the new standard, the auditor's report will retain the pass/fail opinion of the existing auditor’s report but will also include a new description of “critical audit matters,” providing financial statement users with information about complex aspects of the audit. Critical audit matters are any matters arising from the current period's audit of the financial statements that were communicated or required to be communicated to the audit committee, and that (1) Relate to accounts or disclosures that are material to the financial statements, and (2) Involved especially challenging, subjective or complex auditor judgment.

The US Center for Audit Quality (CAQ), affiliated with the AICPA, views the new standard as a positive step toward continuous improvement of the audit to better serve investors and capital markets. The CAQ welcomes the enhanced auditor’s reporting model to provide additional information to investors and other stakeholders in an increasingly complex and global business environment. It noted the PCAOB’s responsiveness to the auditing profession’s concerns and recommendations throughout the proposal process, including observations from the CAQ’s field-testing.

In October 2017, the US Securities and Exchange Commission (SEC) unanimously approved the PCAOB’s new auditor’s reporting standard, supporting the communication of “critical audit matters” as a way for auditors to provide more information to investors and the public.

For more information on the work of the PCAOB with regards to professional judgment and the auditor, review previous blog postings.

Do auditor judgment frameworks help in constraining aggressive reporting?

A 2016 research paper investigates whether alternative judgment frameworks help Big 4 audit managers and partners constrain management’s aggressive financial reporting under accounting standards that differ in their precision. The authors found that a framework based on the SEC’s Advisory Committee on Improvements to Financial Reporting (CIFiR) recommendation that auditors critically evaluate the pros and cons of alternative accounting methods helps auditors constrain aggressive reporting under less precise standards.

Although the results highlight a limitation of counterfactual reasoning on its own at enhancing auditor constraint of aggressive reporting, this study provides evidence on how structured thinking can overcome this limitation. In particular, combining this consideration of the alternatives with a structured thought process that encourages auditors to think about the issue at increasing levels of abstraction effectively shifts auditor focus away from client considerations and towards substance-over-form considerations, thereby incrementally enhancing auditor constraint of aggressive reporting across different levels of accounting standard precision.

These research findings should be of interest to academics, regulators, standard-setters and auditors as they continue to contemplate ways to improve auditor professional judgment under different levels of accounting standard precision. For more information, read the research paper, Do Auditor Judgment Frameworks Help in Constraining Aggressive Reporting? Evidence under More Precise and Less Precise Accounting Standards by Ann G. Backof (University of Virginia - McIntire School of Commerce), E. Michael Bamber (University of Georgia) and Tina Carpenter (University of Georgia - C. Herman and Mary Virginia Terry College of Business) published in the journal, Accounting, Organizations and Society, Volume 51, May 2016, Pages 1–11.

Perceptions of CPAs and CFOs about Principles-Based versus Rules-Based Accounting Standards

Although there appears to be a widespread agreement that principles-based standards are superior to rules-based standards, little has been done to test this consensus. Accordingly, recent research was done to investigate the perceptions of CPAs and CFOs in the United States. A survey was sent to a random sample of 500 CPAs who were practicing auditors from public accounting firms that have substantial publicly-traded companies as clients. The research instrument was also sent to 500 CFOs from the Fortune 1000.

The survey comprised 11 brief definitions of qualitative characteristics of financial reporting along with demographic questions. To place the respondents’ observations in context, the research focused on their views regarding whether the two regimes were likely to attain the qualitative characteristics of financial reporting included in the Conceptual Framework for Financial Reporting updated by FASB in September 2010 and the corresponding document updated by the IASB at the same time. Also included was a question on professional judgment that was derived from a white paper, “Principles- Based Accounting Standards” published by the major accounting firms in 2008.

The research found that there were no significant differences between the answers provided by auditors and the answers provided by CFOs for any of the questions. The first observation to draw from the data is that there is no consensus among CPAs that one accounting regime is better than another along all the dimensions analyzed. The second observation is that there is strong support for both regimes with respect to each concept. The third observation is that there are a few concepts where respondents thought one regime would have a very significant advantage over the other. For example, with respect to whether financial statements will allow for the use of professional judgment in considering whether the accounting representation is consistent with economic reality, nearly all (91%) found a principles-based regime to be preferable.

To learn more, read the article “CPAs’ and CFOs’ Perceptions Regarding Principles-Based Versus Rules-Based Accounting Standards” in the March 2012 issue of The CPA Journal. The research was undertaken by John McEnroe, DBA, CPA, and Mark Sullivan, PhD, CPA, both in the school of accountancy and management information systems at DePaul University, Chicago, Illinois, USA. Also, refer to the ICAS paper “Principles- Based or Rules-Based Accounting Standards: A Question of Judgement” published in 2006.

Promoting Professional Judgment by Objectives-Oriented Accounting Standards

A 2013 study “analyzes how the International Accounting Standards Board (IASB) promotes professional judgment by issuing objectives-oriented accounting standards and exposure drafts.” The focus is on the role of judgment as outlined in Phase I of the IASB 2010  Conceptual Framework, Chapter 1 - Objective of General Purpose Financial Statements and Chapter 3 - Qualitative Characteristics of Useful Financial Information.

This research discusses how the Conceptual Framework, through objectives-oriented accounting standards, encourages professional judgment as recommended by the United States Securities and Exchange Commission (SEC) in its 2003 Report, 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.

The research findings indicate that the five IFRS issued after the 2010 Conceptual Framework are objectives-based, but the eight issued before then are not.. Specifically, the objectives-based IFRS clearly stated the objective, they are based on the Framework without significant exceptions and bright-lines and they provide adequate application guidance. More significantly, a framework for judgment is provided.

The study concludes that: An increasingly complex financial environment demands accounting standards that narrow the range of professional judgments in accounting decisions. Although new accounting principles and approaches do not eliminate the necessity of judgments entirely, the IASB's process of improving transparency and comparability of financial reporting hinges on its ability to promote professional judgment. It depends on the standard setter and the practitioners. The IASB is issuing more objectives-based standards that provide a framework for judgment. Professional accountants, auditors and managers need to be cognizant of the IASB's efforts so they can cooperate in the pursuit to judgment.

The research paper is available online at International Journal of Business and Social Research (Vol 3, No 7 (2013). For more information, refer to The International Accounting Standards Board’s Progress in Promoting Judgement through Objectives-Oriented Accounting Standards by Tanja Lakovic and Jayne Fuglister, Faculty of Economics, University of Montenegro.

International Financial Reporting Standards and Aggressive Reporting: An Investigation of Proposed Auditor Judgment Guidance

In a recent research paper, the authors investigate auditors’ judgments under accounting standards that differ in their precision. After establishing conditions under which auditors accept managements’ aggressive financial reporting, the paper examines the effectiveness of alternative judgment frameworks in helping auditors curb this aggressive reporting under less precise International Financial Reporting Standards (IFRS) and more precise US GAAP.

 

One of the frameworks is based on the Securities and Exchange Commission’s (SEC) Advisory Committee on Improvements to Financial Reporting’s (CIFiR) recommendation to use counterfactual reasoning. Another framework based on Construal Level Theory requires auditors to think broadly about a transaction, while the last framework is based on both counterfactual reasoning and Construal Level Theory.

 

The research paper finds that auditors’ ability to restrain managers’ opportunistic judgments under less precise IFRS depends on the economic substance of the transaction. It also finds that a judgment framework helps auditors curb managements’ aggressive accounting under IFRS. Additionally, the judgment frameworks based on Construal Level Theory are more effective than the framework based on CIFiR’s proposed judgment guidance when the transaction’s economic substance is clear, while the framework based on CIFiR’s proposed guidance is just as effective when the economic substance is unclear. These results inform regulators, standard-setters and auditors on the effectiveness of different judgment guidance in improving auditors’ judgments under less precise IFRS.

 

To learn more, refer to the 45-page research article “International Financial Reporting Standards and Aggressive Reporting: An Investigation of Proposed Auditor Judgment Guidance” by Ann G. Backof (University of Virginia - McIntire School of Commerce), E. Michael Bamber (University of Georgia) and Tina Carpenter (University of Georgia) posted on January 21, 2011. Also, refer to the August 2011 postings on SEC Views on a Framework for 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.

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.