Principles-Based Reasoning about Accounting Estimates

Wally Smieliauskas, PhD

According to the abstract, this research article proposes a key principle and related concepts for reasoning about accounting estimates. The reasoning is consistent with a principles-based professional judgment framework proposed by Ross Skinner and the Institute of Chartered Accountants of Scotland. The principle deals with reasonable ranges and related risk assessments in the audit of accounting estimates. It does so by using concepts first introduced by Boritz and Skinner and updates them for the requirements of CAS/ISA No. 540 and International Financial Reporting Standards (IFRS).

The article identifies the conditions for the existence of the benchmark ranges proposed by Wally Smieliauskas in identifying fairly presented estimates. The need for a professional judgment framework and related guidance has been recognized recently by the International Federation of Accountants (IFAC), a 2010 EU Green Paper, and the Public Company Accounting Oversight Board (PCAOB) as a result of challenges auditors have been facing in the current reporting environment. This recognition echoes calls first made by Ross Skinner in his pioneering 1995 article, and reinforced by the FASB/IASB 2006 proposal for principles-based accounting standards.

The full article “Principles-Based Reasoning about Accounting Estimates” by Wally Smieliauskas is available from the Wiley Online Library (published in AccountingPerspectives, Volume 11, Issue 4, pages 259–296, Winter 2012).

Using a conceptual framework in setting accounting standards

A current research paper examines the nature and role of a conceptual framework for financial reporting. Although much has been written about such frameworks and their purported role, there are still questions about what it is and how it is used in setting accounting standards. It is noteworthy that the US Financial Accounting Standards Board (FASB) and the International Accounting Standards Board (IASB) are currently revising and converging their frameworks.

Using insights from the philosophical literature, this paper considers the nature of the statements that appear in the chapters of the conceptual framework on objectives and qualitative characteristics. It then considers how these statements are used by standard setters in reasoning towards accounting standards. The kind of reasoning involved and the type of statements that are used in such reasoning is examined.

The idea that some of the statements in the conceptual framework express desires that are to be fulfilled by financial reporting, regulated by accounting standards, is explored. These should be conceived as expressing general desires that are used in practical or instrumental reasoning towards accounting standards, rather than as universal desires that enable the deduction of such standards. The need for the exercise of judgment in such reasoning is explored.

The nature of the other statements in the conceptual framework is ambiguous. They are sometimes taken to be empirical statements about how the desires are to be fulfilled and sometimes taken as statements about the meaning of expressions used to express these desires. The paper suggests that the development of the conceptual framework would be easier and the final product would have more credibility if its nature and role was more clearly understood.


Dr Ian Dennis

This paper makes reference to the research study Professional Judgment in Financial Reporting by Michael Gibbins, PhD, FCA and Alister K. Mason, PhD, FCA, published in 1988 by the Canadian Institute of Chartered Accountants (CICA). It also makes reference to the Ross Skinner article Judgment in Jeopardy, first published in CA Magazine in November 1995 and reprinted in Canadian Accounting Perspectives in 2005. For more information, read the 33-page article “Using a conceptual framework in setting accounting standards” by Dr Ian Dennis, Senior Lecturer in Accounting and Finance, Oxford Brookes University Business School.

 

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.

"Judgment in Jeopardy" by Ross Skinner

Ross Skinner, FCA, had a significant impact on Canadian accounting standards. He was inducted to the Accounting Hall of Fame (see “A Rare Induction to Fame” in CAmagazine online) in 2000.

In a 1995 CAmagazine article “Judgment in Jeopardy:Why Detailed Rules Will Never Replace a CharteredAccountant’s Professional Judgment in Financial Reporting,” Ross argued that judgment in financial accounting cannot be eliminated by detailed rule making, and that sound judgment requires a thorough understanding of the objectives and theory of accounting (which theory must be complete and specific enough to provide a proper grounding for judgment). These were fundamental beliefs of his accounting philosophy.

In 2005, the “Judgment in Jeopardy” article was re-published (with permission) in Canadian Accounting Perspectives (CAP), a journal of the Canadian Academic Accounting Association. The special edition of CAP includes eight commentaries, available online. Two commentaries focus on the meaning of professional judgment and how it has evolved or will evolve. Another looks to the future of accounting practice, exploring Ross’s suggestion that the establishment of an interpretation panel could improve the application of accounting standards and professional judgment. It provides evidence to support this proposal, arguing that an interpretation panel would enhance the information environment that underlies the market’s allocation of capital.

Several commentaries focus primarily on the role of professional judgment in present-day accounting and auditing. For example, one notes that the very nature of professional judgment is changing. It argues that measurements or estimates made by people other than professional accountants, such as managers, open financial statements to potential earnings management and may undermine accountants’ professional judgment. Another discusses several critical issues raised by Ross’s article, including the difficulty of fully resolving judgment problems. It argues that ideological choices, competition and fundamental measurement problems support the conclusion that solutions will remain “forever elusive."