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.

How Are Really Great Decisions Actually Made?

An April 2012 article in Forbes raises a number of questions about recent judgment calls. For example, “Who cannot be troubled at the lack of judgment in business schools that continue to instill the principles of traditional management when the very principles they are teaching are killing the institutions they are meant to assist.” And, “Who can watch with anything but disbelief as most large corporations continue to espouse maximizing shareholder value as their goal, when there is overwhelming evidence that it is the dumbest idea in the world.” It is hard not to conclude that judgment has fled to brutish beasts and men have lost their reason.

A new book on Judgment Calls: Twelve Stories of Big Decisions and the Teams That Got Them Right by Thomas H. Davenport and Brook Manville (2012, Harvard, Business Review Press) contains twelve diverse parables of instances where good judgment was exercised and an organization “got it right.” One of the advantages of the book is that it is written in a narrative style. In each case, a careful reading of the story points to the wider set of factors that are involved in making the decision. What the narratives bring out is that judgment is important but so is having the right goals, having the right values, and having good leaders.

For a thought-provoking overview of the book, read the article “How Are Really Great Decisions Actually Made?” at Forbes online.

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.

About this Blog

Judgment defines a profession! In fact, the ability to make good judgment calls is paramount to the success of any professional. For Chartered Accountants (CAs), sound "professional judgment" is based on ethical behaviour together with an appropriate foundation of technical skills and critical thought processes, sustained and enhanced by professional development.

Professional judgment requires a commitment to gather all the pertinent facts, the discipline to examine the fact patterns in relation to a consistently-applied framework, and the willingness to consider alternative positions. In addition, it requires the application of relevant knowledge, expertise and practical experience in selecting a rational course of action.

The aim of this blog is to support CAs by:

• opening a global communication channel to collaborate on professional judgment matters;
• examining the theory, concepts and factors that influence the professional judgment process; 
• highlighting research and guidance that may help improve the quality of professional judgment.

After all, professional judgment matters!