Understanding Auditor Judgment and Decision-Making Research

 

“Critics argue that audit research rarely impacts practice, in part due to challenges associated with synthesizing and interpreting research.”

According to the authors of a 2018 academic research article, using the Elaboration Likelihood Model (ELM) as a metatheoretical framework can help in understanding the collective findings within auditor judgment and decision-making (JDM) research. The goal was to demonstrate the utility of the ELM by interpreting the results of two samples of studies on client cooperation and auditors’ moods. The synthesis of client cooperation studies suggests cooperation on a current issue affects auditors’ judgments only when auditors lack motivation to think carefully about the task. In contrast, a history of client cooperation tends to bias even highly motivated auditors’ judgments. Furthermore, the synthesis of mood studies suggests motivational interventions are necessary, but not sufficient, to mitigate mood’s effects on judgments. The ELM interpretations offer theoretical explanations for seemingly unrelated predictions and findings that can inform future research and practice.

 

For more information, refer to the research article titled The Elaboration Likelihood Model: A Meta-Theory for Synthesizing Auditor Judgment and Decision-Making Research by Emily E. Griffith (University of Wisconsin–Madison), Christine J. Nolder (Suffolk University) and Richard E. Petty (The Ohio State University). The article was published by the American Accounting Association in Auditing: A Journal of Practice & Theory, Volume 37, Number 4, November 2018, pp. 169–186.

Professional Judgment: Examining how accounting professionals make decisions

 

The discipline of accounting and auditing has increasingly recognized judgment and decision making as highly important attributes in the profession because individuals such as managers, auditors, financial analysts, accountants and standard setters make pivotal judgments and decisions.

As an Associate Professor of Accounting at the Edwards School of Business, University of Saskatchewan, Regan Schmidt, Ph.D, CPA, CA, undertakes research on accounting professionals’ judgment and decision making using experimental methods. He currently serves as an Associate Editor for Issues in Accounting Education and is on Editorial Boards for Behavioral Research in Accounting, Accounting Education, and Accounting Perspectives. 

He collaborates with public accounting firms and accounting professionals to improve accounting practices. These collaborations have contributed to advances in the fields of auditing, financial reporting and taxation. His research tries to “understand, explain, predict, and ultimately improve how accounting professionals make judgments and decisions.” Accounting professionals include auditors, financial statement preparers, financial statement users, tax professionals, and others (for example, accountants serving on professional committees). The research primarily uses experimental methods to examine and extend psychology theories in the accounting institutional context.

For more information, refer to the 2019 article by Joelena Leader entitled 

Professional Judgment: Examining how auditors, accountants and professional committees make decisions. Also, read the article Judgment and Decision-Making Research in Auditing and Accounting: Future Research Implications of Person, Task, and Environment Perspective by Rajni Mala and Parmod Chand. The article was published in the March 2015 edition of the Canadian Academic Accounting Association (CAAA) publication Accounting Perspectives which is available at the Wiley Online Library.

BDO Professional Judgment Framework

 

According to a June 2019 BDO press release, "Professional Judgment can be described as the capacity to logically assess situations or circumstances and to draw sound, objective conclusions that are not influenced by cognitive traps and biases or by emotion. Good judgment takes experience, but it also takes awareness, repetition and consistent application."

The BDO Professional Judgment Framework (shown below) offers a shared conceptual foundation and common vocabulary for audit professionals. It encourages consistent behavior in striving for desired outcomes, supported by justifiable conclusions and effective documentation. As well, it aids in dealing with and clearly communicating complex issues. When all of the elements of the BDO Professional Judgment Framework are effectively in place, they maximize the likelihood of consistently exercising high-quality professional judgment.

To learn more, download the 4-page Mini-Guide or the 40-page Full Conceptual Guide.

Guidance for Applying a Professional Judgment Framework

Enhanced Communication and Collaboration
on Professional Judgment Matters

In 2011, the Institute of Chartered Accountants of Scotland (ICAS) sponsored the research report Professional Judgment Matters: Assessing the Need for Enhanced Communication and Collaboration. This guidance blog is an integral part of that research report which is available on Google Docs and on the Social Science Research Network (SSRN). The ICAS then published A Professional Judgement Framework for Financial Reporting in 2012. It was primarily targeted at accountants (both preparers and auditors) determining the appropriate accounting treatment for particular transactions.

In 2016, the ICAS released a new, up-to-date publication  A Professional Judgement Framework for Financial Reporting Decision Making to replaces the 2012 edition. It offers practical guidance for decision makers involved in narrative and financial reporting. The new edition has been broadened to make it more universally applicable to decision makers involved in financial reporting, whether accountants or nonaccountants, in the private or not-for-profit sectors. It also includes a new section on audit committees and further context on ethical decision making. Furthermore, the 2016 edition is shorter and more interactive for online readers.

The ICAS firmly believes that a principles-based approach to standard setting is a key driver of quality reporting. Therefore, the guidance includes recommendations for standard setters to ensure that standards provide the appropriate scope for professional judgment.

In this regard, it is entirely consistent with the 1995 Research Report Professional Judgment and the Auditor prepared by staff of the Canadian Institute of Chartered Accountants (CICA), Research Studies Department (J. Paul-Emile Roy, CA) under the direction of an 8-member Study Group of professionals. The 1995 Report identified many sources of information regarding the issues surrounding professional judgment. It developed a framework for professional judgment and discussed key factors that influence the judgment process. In addition, it provided valuable guidance to practitioners regarding their professional obligations when exercising professional judgment. Other blog postings regarding a “professional judgment framework” may also be useful for improving decision-making.

Strategies for efficient, effective audit documentation

An AICPA study found that the most common audit issue is a lack of adequate documentation. Although some auditors may think that documenting the nature, timing, extent and results of audit procedures will break the audit budget, many practitioners have found that this is not the case.

In fact, strong documentation will facilitate compliance with auditing standards and it usually leads to a more efficient engagement. The time spent documenting in accordance with the standards is an investment that will pay dividends later. Complying with the requirements while implementing the best practices will help auditors and audit firms perform high-quality work while increasing overall efficiency. In other words, take a smart approach to planning, embrace standardization, document now and save time later, and be prepared for what's ahead.

For more information, read the November 2017 article “4 strategies for efficient, effective audit documentation” in the Journal of Accountancy online. As well, review the additional AICPA guidance and resources at the end of that article. Further guidance on audit documentation in the context of exercising professional judgment is also available in previous posts on this blog.

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.

Guidance for Teaching Professional Judgment and Ethics

In 2015, Pearson Canada published the textbook Auditing: The Art and Science of Assurance Engagements,Thirteenth Canadian Edition by Professor Alvin A. Arens (Michigan State University), Randal J. Elder (Syracuse University), Mark S. Beasley (North Carolina State University) and Joanne C. Jones (York University). Chapter 4 (on pages 63-91) covers Professional Judgment and Ethics. The Chapter presents A Framework for Professional Judgment, discusses the Auditor’s Mindset and Judgment Tendencies, presents A Framework for Ethical Reasoning, and offers Professional Guidance on Ethical Conduct.

The authors note (see page 65) that “In its research report, Professional Judgment and the Auditor, the Canadian Institute of Chartered Accountants (now CPA Canada) said: Professional judgment in auditing is the application of relevant knowledge and experience, within the context provided by auditing and accounting standards and Rules of Professional Conduct, in reaching decisions where a choice must be made between alternative possible courses of action.”

The report further explained that professional judgment is analytical and systematic, objective, prudent, and carried out with integrity and recognition of responsibility to those affected by its consequences. This means that auditors must be able to justify a decision on the basis that it:

• Is well thought out;

• Is objective;

• Meets the underlying principles of GAAP and GAAS;

• Has evidence to support the decision;

• Maximizes the likelihood of “good” consequences;

• Is carried out with truthfulness and forthrightness; and

• Considers the impact on the financial statement users.

Accordingly, this type of decision making can be both complex and difficult. To assist auditors and firms, several professional associations such as CPA Canada, the Institute of Chartered Accountants of Australia, and the Institute of Chartered Accountants of Scotland, as well as the American Center for Audit Quality, have issued professional judgment and professional skepticism frameworks that provide auditors with a methodical approach.

The approach depicted in Figure 4-1 above (see page 66) is based on those various frameworks. Although the framework may seem to be simple, such frameworks are considered effective tools in guiding thinking and encouraging auditors to be aware of their own judgment biases and traps and what can go wrong. Judgment biases and traps are considered in more detail as part of the auditor mindset component of the framework (see page 67).

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.

Enhancing Auditor Professional Skepticism: The Professional Skepticism Continuum

A 2014 academic research paper published by the American Accounting Association notes that “Due to past high-profile audit failures, reported audit deficiencies in regulator inspection reports, and the growing number and size of complex estimates in the financial statements, there is a growing need for reliability and trust in financial reports and a corresponding increased demand for enhanced audit quality. Enhancing the level of professional skepticism applied in practice is one important means of improving audit quality, but there is a lack of practical guidance around the appropriate application and documentation of professional skepticism in the professional literature.”

The following graphic offers a proposed skepticism continuum. Such a continuum enables the auditor to take the perspective that is most appropriate considering the circumstances applicable to each audit area and assertion. Applying a continuum to a specific account and assertion takes place after a careful and rigorous initial risk assessment, and a continued re-evaluation of the risk throughout the audit to ensure that appropriate skepticism is applied to the collection and evaluation of audit evidence.

According to the paper, “A shared understanding would allow audit professionals to identify, communicate, and exercise a level of professional skepticism appropriate for the risks involved, and would enable regulators to fairly evaluate, after the fact, the level of skepticism applied. The skepticism continuum we propose represents a potential step forward in understanding the nature of professional skepticism and in applying it appropriately under varying circumstances.”

The paper concludes that, “In order to make the necessary changes, the profession, academics, regulators, and standard setters should work together to better understand the nature of professional skepticism, including how skepticism is threatened at various structural levels, current measures in place to mitigate those threats and, then, finally, how skepticism can be enhanced at the various structural levels. Our hope is that this paper will provide a conceptual foundation to facilitate a productive ongoing dialogue that will lead to specific actions to enhance auditor professional skepticism and, ultimately, audit quality.”

To learn more, read the full paper by Steven M. Glover and Douglas F. Prawitt, both Professors at Brigham Young University, “Enhancing Auditor Professional Skepticism: The Professional Skepticism Continuum” in Current Issues in Auditing: December 2014, Vol. 8, No. 2, pp. P1-P10.

Five ways to overcome confirmation bias

According to an article in the CPA Journal of Accountancy: “Confirmation bias—one of the five commonly occurring judgment biases—has the potential to trip up auditors, particularly during the early stages of an audit. At that time, financial information is often highly aggregated and may be too ambiguous to allow the auditor to definitively identify the reason for a change in financial information. As a result, an auditor’s initial hypothesis may not actually represent the true cause of the data fluctuation.”

The deeper the auditors get into investigating a particular hypothesis, the more difficult it becomes to consider other potential hypotheses. This is because once a potential explanation has been identified, it is common to seek evidence that supports it and ignore evidence that does not support the explanation. This is the behavior psychologists refer to as confirmation bias. As such, if auditors generate an early hypothesis, they risk overlooking important contradictory evidence that may result in a flawed evaluation of the data.

What can be done? Auditors can take several simple and pragmatic steps to overcome this bias when performing analytical procedures. Learn more by reading the online article 5 ways to overcome confirmation bias by Benjamin L. Luippold, Ph.D., Stephen Perreault, CPA, Ph.D. and James Wainberg, Ph.D. dated February 1, 2015.

I’m not biased, am I?

An article in the CPA Journal of Accountancy reports that: “Five common judgment biases have the potential to influence financial statement preparers and auditors in their work. Learning how to spot and short-circuit these biases can help CPAs maintain their objectivity.”

According to the article, decisions can be influenced by: (1) relying on information that is most readily accessible (availability); (2) focusing on a preliminary amount and making an adjustment (anchoring and adjustment); (3) overestimating abilities (overconfidence); (4) making interpretations that support pre-existing beliefs (confirmation); and (5) failing to consider all available data (rush to solve). Using a professional judgment framework can help prevent biases from creeping into your work.

The professional judgment framework developed by the US Center for Audit Quality (CAQ), which is affiliated with the AICPA, includes five steps: (1) Identify and define the issue; (2) gather the facts and information and identify the relevant literature; (3) perform the analysis and identify potential alternatives; (4) make the decision; and (5) review and complete the documentation and rationale for the conclusion. The five common judgment biases summarized in this article can manifest across any of the five steps in the judgment process. To mitigate bias in judgments, follow each step of the framework and maintain an awareness of the potential biases and an attitude of professional skepticism.

Consider the guidance in the online article I’m not biased, am I? by Rebecca Fay, CPA, Ph.D., and Norma R. Montague, Ph.D. dated February 1, 2015. Also, learn about the decision-making process by taking a short decision-making quiz.

Professionalism is Primary

In December 2003, Douglas R. Carmichael, Director of Professional Standards at the Public Company Accounting Oversight Board (PCAOB) was invited to speak about professionalism at the AICPA Annual National Conference in Washington, DC. In his presentation, he noted that: “Most organized professions have duties to clients and to the public. A lawyer has responsibilities to the court and the law as well as to individual clients. A doctor has responsibilities for public health as well as to individual patients. Poor management of duties to the public versus to individual clients can cause a lack of respect for a profession.”

Furthermore, “Some would say that is what happened to independent auditors. Intense pressure on the management of public companies to meet the earnings expectations of analysts led to intense pressure on auditors to help clients meet those expectations. There were economic incentives to preserve the relationship with the client. Building the client relationship had become the service ideal. Accommodation on questionable accounting practices was one result. There was a widespread erosion of professionalism and the profession lost the confidence of investors. This decline in professionalism did not happen overnight. Some would say it started decades ago.”

In concluding his presentation, he suggested:“One step that could be taken is to amend the ten basic auditing standards to add a new general standard that might be worded as follows: The auditor shall, in all matters related to the audit, act in a manner that places primary emphasis on protection of investors and the furtherance of the public interest in the issuance of informative, fair, and independent audit reports. This would make dedication to professionalism an overriding and mandatory obligation for the auditor of a public company.”

Learn more about professionalism by reviewing the presentation on Professionalism is Primary. Also, refer to previous postings about professionalism as part of this blog on Professional Judgment Matters.