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.

Auditor Judgment Under Uncertainty: Doctoral Dissertation 2013

A recent research paper investigates how experienced auditors recognize and respond to the degree of management’s evidentiary support and the level of estimate uncertainty when assessing management estimates. Drawing on information processing research, the paper predicts that auditors can be more comfortable with management estimates, and expect a lower adjustment, when there is alignment between the degree of estimate uncertainty and management’s evidentiary support (that is, high uncertainty and more support or low uncertainty and less support). The following diagram provides a graphical representation of the theoretical predictions.

This prediction is tested using an experiment where experienced auditors evaluate an uncertain warranty estimate. The level of uncertainty is manipulated by varying the range of potential costs as either two-times or eight-times materiality. The degree of management’s evidentiary support is manipulated by management either obtaining industry information, inquiring of technicians, or doing these two plus reviewing records, and performing field inspections.

The results support the prediction. In the higher uncertainty condition, auditors were more comfortable and expected a lower adjustment when management obtained more evidential support, but in the lower uncertainty condition auditors were more comfortable and expected a lower adjustment when management obtained less evidential support. In fact, the alignment between estimate uncertainty and management’s evidentiary support can make auditors more comfortable with management estimates supported by relatively less evidence.

These findings demonstrate how audit risk factors, such as the level of uncertainty and degree of management’s support can interact and cause auditors to more readily accept less supported financial statement estimates. More broadly, these findings reveal how providing more information can actually make recipients more uncomfortable with a proposition.

For more information, refer to the 93-page Dissertation, “Auditor Judgment Under Uncertainty” by Stephen P. Rowe, submitted in partial fulfillment of the requirements for the degree of Doctor of Philosophy in Accountancy in the Graduate College of the University of Illinois at Urbana-Champaign, 2013. The Doctoral Committee included: Professor Mark Peecher, Chair; Assistant Professor Bradley Pomeroy; Professor Ken Trotman, University of New South Wales; and Professor Michel Regenwetter.

A professional judgment framework for financial reporting

The Institute of Chartered Accountants of Scotland (ICAS) has been pursuing a campaign in support of principles-based financial reporting standards since the publication of Principles not Rules: A Question of Judgement in 2006. According to the ICAS, principles-based standards provide a framework within which the economic substance of transactions can be faithfully presented and better serve the needs of business and markets, and the public interest.

 

 

The key to the effective functioning of a principles-based framework is the ability of preparers and auditors to exercise professional judgment in the application of principles to the circumstances of a particular transaction or accounting issue. The basis of such judgments needs to be properly documented, so that regulators (who also need to have the experience and expertise to consider and challenge such judgments) can assess the reasonableness of the judgments based on the facts and knowledge available at the time of the judgments.

 

In an effective principles-based environment, each party plays a key role in making their own judgments and challenging others’ judgments, building up trust that all the parties have sufficient experience and expertise and that they approach their different roles in a proportionate and sensible manner. In the light of comments received on earlier work and involvement in similar work undertaken by the Global Accounting Alliance (GAA), there is a need for guidance on how to make judgments, especially in jurisdictions which are first time adopters of International Financial Reporting Standards (IFRS) or which are used to operating in a prescriptive or rules-based environment.

 

The ICAS has therefore developed A Professional Judgement Framework for Financial Reporting: An international guide for preparers, auditors, regulators and standard setters which offers guidance that may be useful around the globe. Other postings regarding a “professional judgment framework” may also be useful.

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.

Professional scepticism: Establishing a common understanding and reaffirming its central role in delivering audit quality

In March 2012, the Auditing Practices Board (APB) of the UK Financial Reporting Council (FRC) issued guidance on professional scepticism. The document builds on the August 2010 APB Discussion Paper, Auditor Scepticism: Raising the Bar, and the subsequent Feedback Paper published in March 2011, which summarized the Responses to the Discussion Paper and outlined the actions that the APB, and other parts of the FRC, intended to take in light of the responses received.

The guidance document is written in an unusual format for an APB document, being much more discursive than is customary and drawing analogies from a diverse group of areas. This is because scepticism needs to be more broadly understood and drawing these analogies will facilitate that understanding. The APB is also keen to stimulate and provide input to an international debate on the issue of scepticism. The document will provide valuable input to that debate.

With this objective in mind, the document: explores the roots of scepticism and identifies lessons for its role in the conduct of an audit; discusses scientific scepticism and the scientific method; reviews the origins of the modern audit; and offers conclusions about professional scepticism in the audit. It also discusses the conditions necessary for auditors to demonstrate the appropriate degree of professional scepticism and lists five proposals to take these matters forward. To learn more, read the 23-page guidance Professionalscepticism: Establishing a common understanding and reaffirming its centralrole in delivering audit quality.

Professional scepticism and other key audit issues

There is an ongoing debate about whether professional accountants are sufficiently sceptical in applying professional judgment. For example, the concerns of regulators and others have been highlighted in the media and form part of the discussions on the future of the accounting profession. In this regard, the Institute of Chartered Accountants in England and Wales (ICAEW) (Audit and Assurance Faculty) is exploring the possibility of conveying key messages on the issues and has discussed this possibility with the UK Professional Oversight Board (POB).

The result is a new set of videos Professional scepticism and other key audit issues now available on the ICAEW website. The purpose of the videos is to highlight some of the concerns of the POB (and other regulators around the world) and to be constructive about how audit firms respond to the issues. In total, there are ten videos with one compilation video (about 40 minutes long). It is hoped that, in addition to individual auditors watching them, some firms will play the videos as part of training activities and team meetings.

The longest video (about 17 minutes) highlights the fundamental importance of professional scepticism. The video provides key messages on the issues that will be of interest to firms at the current time. Martyn Jones (ICAEW Vice-President) speaks about how auditors should be dealing with the challenges and the need to understand that scepticism is a behavioural issue for the entire audit team. John Kellas (POB Chairman) talks about what the Audit Inspection Unit (AIU) has been looking at in the current climate and describes the ways a lack of scepticism can be apparent. Myles Thompson (Chairman of the faculty’s Technical and Practical Auditing Committee) outlines the personality traits that auditors need to have and gives tips on how to produce documentation that demonstrates scepticism.

The messages are relevant to auditors from firms of all sizes and the personal qualities that are spoken about are needed for all types and sizes of audit. The key points also apply internationally, not just in the UK. Other subjects covered in the videos are group audits, quality control, audit committee reporting, audit documentation, ethical matters and concluding remarks.

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.