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.

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.

Principles-based standards and professional judgment – Part 2 of 3

Accounting research has shown that the distinction between rules-based and principles-based standards is not well defined and is subject to a variety of interpretations. Nonetheless, there is a commonly-held view that accounting standards in the United States are rules-based and International Financial Reporting Standards (IFRS) issued by the International Accounting Standards Board (IASB) are principles-based.

A research paper published in 2006 identifies the basis of this distinction. For research and development, the paper compares the US standard issued by the Financial Accounting Standards Board (FASB) with two principles-based standards. For each standard, the researchers identify and classify rules and judgments, and observe the level of justifications for the rules and assistance to support the judgments. The three standards have rules, are based on principles, and require the exercise of professional judgment; the less conservative standard requires more judgments and, unexpectedly, more rules.

The results suggest that the rules-based versus principles-based distinction is not meaningful, except in relative terms. The paper concludes that a relatively more principles-based standards regime requires professional judgment at both the transaction level (substance over form) and at the financial statement level (‘true and fair view’ override). Furthermore, it suggests that any IASB and FASB convergence will require agreement on the weightings given to the qualitative characteristics.

Read the SSRN abstract and the full research article “Rules, Principles and Judgments in Accounting Standards” by Bruce Bennett (General Manager Admissions/Standards and Quality Assurance at the New Zealand Institute of Chartered Accountants), Michael Bradbury (Professor, School of Accountancy, Law and Finance, UNITEC Institute of Technology in Auckland, New Zealand, and a member of the International Financial Reporting Interpretations Committee of the IASB and the Financial Reporting Standards Board of the Institute of Chartered Accountants of New Zealand) and Helen Prangnell (a Senior Lecturer in the School of Accountancy, Law and Finance, UNITEC New Zealand, and a member of the Professional Practices Board of the Institute of Chartered Accountants of New Zealand).

This 16-page article and other articles on this debate were published in ABACUS, Vol. 42, No. 2, June 2006. For more information and different perspectives regarding this ongoing debate, refer to Part 1 of this three-part posting and previous postings during the past year.

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.

Using frameworks for the application and evaluation of auditors’ professional judgments

In response to concerns that a transition towards less precise accounting standards in the United States will increase auditor litigation exposure, regulators and accounting firms have developed and implemented frameworks for the application and evaluation of auditors’ professional judgments. Regulatory frameworks include, for example, the 2008 US Securities and Exchange Commission (SEC) Committee on Improvements to Financial Reporting (see previous posts on August 17, August 24 and August 30). Accounting firm frameworks include, for example, the 2011 KPMG monograph, Elevating Professional Judgment in Auditing: The KPMG Professional Judgment Framework (see previous posts on September 7, September 14 and September 20).

Recent research predicts and provides experimental evidence that such frameworks provide clarity to evaluators about the quality of auditors’ judgments. The research found that, when no direct signals of judgment quality are available, only auditors with recognized technical expertise in specific judgment tasks (an indirect signal of judgment quality) are insulated from the increase in litigation exposure arising from less precise standards.

When a direct signal of judgment quality is available (e.g., the auditor used a judgment framework when making specific judgments), there is no longer a relative increase in litigation exposure for auditors with general expertise compared to technical expertise. Nonetheless, when accounting standards are precise, the research found that the use of judgment frameworks may result in dysfunctional outcomes by reducing litigation exposure more for auditors with general expertise, not by improving the perceived quality of their judgments relative to auditors with technical expertise, but by signaling their lack of control over the events leading to the alleged material misstatement.

It is important to note that this research examines the signaling aspects of auditors’ use of a judgment framework, not whether and how professional judgment frameworks actually improve the quality of auditors’ professional judgments. Future research could examine auditors’ willingness and ability to use judgment frameworks and the downstream effects on their professional judgments, which preliminary evidence finds to be positive but to also depend on the economic substance of the transactions.

To learn more, read the April 2011 research article “Signaling the Quality of Auditors’ Professional Judgments: The Joint Effects of Accounting Standard Precision and Auditor Task Expertise” by Jonathan H. Grenier, PhD (Miami University), Bradley Pomeroy, PhD and Matthew Stern (both at University of Illinois at Urbana-Champaign). The paper is also available online at the Social Sciences Research Network.

Principles-based standards and the consequent role of professional judgment enhance the quality of Canadian financial reporting

The academic research provides preliminary confirmation of Ross Skinner’s (1995) hypothesis that Canada’s relatively principles-based GAAP yield higher accrual quality than the US’s relatively rules-based GAAP. These results stem from a comparison of the Dechow-Dichev (2002) measure of accrual quality for cross-listed Canadian firms reporting under both Canadian and US GAAP. However, the research documents lower accrual quality for Canadian firms reporting under US GAAP than for US firms, which are subject to stronger US oversight and greater litigation risk, reporting under US GAAP.

The latter results are consistent with stronger US oversight compensating for inferior accrual quality associated with rules-based GAAP. Consistent with the positive effect of Canada’s principles-based GAAP and the offsetting negative effect of Canada’s weaker oversight, the research found no overall difference in accrual quality between Canadian firms reporting under Canadian GAAP and US firms reporting under US GAAP.

Consistent with Skinner’s writings, the results imply that it is fallacious to attribute perceived deficiencies in Canadian financial reporting to the leeway allowed by principles-based GAAP without allowing for Canada’s oversight, which is relatively weak due largely to the absence of a national securities regulator. If anything, over the 1990-2002 sample period, principles-based standards and the consequent role of professional judgment enhance the quality of Canadian firms’ financial reporting.

To learn more, read the June 2004 article “Earnings Quality under Rules- vs. Principles-Based Accounting Standards: A Test of the Skinner Hypothesis” by Erin Webster and Daniel B. Thornton, Ph.D, FCA, (pictured here). Both are at Queen’s University School of Business in Kingston, Ontario, Canada.