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.

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.

Professional Scepticism in an Audit of a Financial Report

In August 2012, the Australian Auditing and Assurances Standards Board (AUASB) issued a Bulletin called Professional Scepticism in an Audit of a Financial Report. The AUASB took this opportunity to emphasize to both auditors and others, the important and fundamental role that professional skepticism has to play in the audits of financial reports. It also reminded audit firms of their role in education, mentoring and inspiring partners and staff to cultivate a skeptical mindset, recognizing that it is a vital ingredient in performing high quality audit engagements.

According to the Bulletin, the inspection programs of the Australian Securities and Investments Commission (ASIC) have raised concerns about whether professional skepticism is being applied properly in practice. The findings question whether auditors: respond appropriately to unreliable audit evidence; seek to corroborate evidence rather than challenge it; and adequately demonstrate in the audit working papers how professional skepticism has been applied.

The ASIC refers to key areas of audit judgment where the level of professional skepticism exercized or evidenced in the audit files needs to be improved, particularly: fair value measurement of assets; impairment calculations; and going concern assessments. Importantly, audit committees play a significant influencing role and commonly seek to foster appropriate professional skepticism in the external audit. Auditors, in turn, should demonstrate the value of their audit by seeking to convince audit committees that they have properly exercized professional skepticism in the conduct of the audit.

In light of these concerns, this 8-page Bulletin, which is presented in Question and Answer format, encourages auditors to bring “professional skepticism” to front-of-mind in the conduct of their audit engagements. The test for auditors, especially in an uncertain economic environment, is to remain alert, to improve audit documentation and to continually and critically re-assess the application of professional judgment.

The Background of Professional Judgment in Statutory Audit

According to a recent doctoral thesis, the issues of the professional judgment, known in the international literature as “judgment and decision–making process” have an inter-disciplinary character, being treated in such domains as psychology, medicine, law and accounting. The professional approach to this process offers a high level of complexity, which is also revealed by the large number of research papers from the specialized literature. This highlights the diversity of the factors that contribute to the substantiation of the professional judgment and of the decision making process.

The thesis continues this research, focusing on the auditing-accounting activity area. Accordingly, it studies the notion of professional judgment seen both as a general concept and as a multi-professional perspective, in order to be able to identify the general elements that define and characterize the process of the professional judgment. The most discussed subjects refer to the wide range of factors that contribute to the reasoning realization or to the divergent opinions regarding the approach based on principles or rules. The application of a professional reasoning which starts from well defined principles offers a broader scope for auditors to apply their experience, knowledge and abilities acquired over time, while constraining the activity in a set of strict rules that encompass the perspective of a diversified approach to the problems that professionals face.

To learn more, refer to the 2012 thesis on “The Background of Professional Judgment in Statutory Audit” by Phd Student Georgeta Ancuţa Șpan, Faculty of Economic Sciences and Business Administration, Department of Accounting and Auditing, Babeș-Bolyai University.

Enhancing Audit Quality: Canadian Perspectives - Conclusions and Recommendations 2013

The Enhancing Audit Quality (EAQ) initiative, headed by the Chartered Professional Accountants of Canada (CPA Canada) and the Canadian Public Accountability Board (CPAB), has been completed. This initiative arose following the audit symposium organized by CPAB in December 2011. Work commenced in February 2012 and the final report, Enhancing Audit Quality: Canadian Perspectives - Conclusions and Recommendations, was published in May 2013.

The conclusions in the report will be reviewed and appropriate action will be taken by the pertinent competent bodies in Canada. Reforms introduced in other jurisdictions, such as Europe and the United States, will have to be carefully monitored to ensure that Canadian reforms are not in direct conflict with those proposed elsewhere, frustrating attempts to harmonize the solutions ultimately implemented. Recommendations on how best to maintain auditor independence and support professional skepticism are among the key findings aimed at adding value to financial reporting.

The EAQ initiative gained stakeholder input on developments taking place in jurisdictions  hardest hit by the financial crisis, such as Europe and the United States, where  regulators have suggested a number of remedies such as subjecting  audit firms to term limits and calling for mandatory re-tendering of audits. The EAQ initiative concluded that the preferred approach is having audit committees perform a periodic review of their audit firm at least every five years, resulting in a recommendation to retain or replace the audit firm. A report summarizing the results of the comprehensive review should then be included in an entity’s public disclosures, which would strengthen transparency.

CPAB is Canada’s audit regulator, dedicated to protecting the investing public’s interests and to delivering value to its various stakeholders through world class audit regulation. It regulates the auditors of Canadian public companies through its national inspection program. CPAB delivers value by promoting high-quality, independent auditing. As a champion of audit quality, CPAB contributes to public confidence in the integrity of financial reporting, which supports Canada’s capital markets.

CPA Canada is the national organization representing the Chartered Professional Accountants (CPA) profession in Canada. The Canadian Institute of Chartered Accountants (CICA) and The Society of Management Accountants of Canada (CMA Canada) created the organization on January 1, 2013, to support unification of the Canadian accounting profession under the CPA banner.

Professional Judgment Matters: Collaboration by Academics, Accounting Organizations, Regulators, Standard-Setters and Others

Chartered Accountants (CAs) practice in a wide variety of fields including public accounting, business, government, education, research, consulting, regulation and standard setting. In each of these areas, CAs are recognized for their expertise and for their ability to exercise sound “professional judgment” in a multitude of different contexts.

About one year ago, the research report Professional Judgment Matters: Assessing the Need for Enhanced Communication and Collaboration was completed. It is available on Google Docs and on the Social Science Research Network (SSRN). As noted in the abstract to the report, the goal was to answer the research question: “With regard to professional judgment matters, is there a need for enhanced communication and collaboration by Chartered Accountants?” Based on the results of the academic and professional literature review, the collective views expressed by CAs in face-to-face meetings and by an online survey, and the interest shown in the communications blog, it’s time to collaborate!

Interest in this blog is growing. The blog has about 100 postings to date but the number of pageviews is now more than 13,000. Also, it is encouraging to see that the interest is by professional accountants from around the world. The top 10 countries are the United States, Canada, Russia, the United Kingdom, Australia, Germany, France, Malaysia, Philippines and India, in that order.

Because CAs practice in a wide variety of fields, the guidance addresses many different professional judgment matters. For example, the guidance covers the following topics: research, professionalism, judgment, expertise, ethics, skepticism, biases, principles vs rules, education and teaching. It also covers a number of practice areas, such as accounting and auditing, financial reporting, taxation, business and internal auditing.

This guidance is drawn from many diverse sources, including academics, accounting organizations, regulators and standard-setters. For example, refer to the Global Accounting Alliance (GAA Accounting), the Institute of Chartered Accountants in England and Wales (ICAEW) and the UK Financial Reporting Council (FRC), the Institute of Chartered Accountants of Scotland (ICAS), the Institute of Chartered Accountants of Australia (ICAA), the New Zealand Auditing and Assurance Standards Board (NZAuASB), the American Institute of Certified Public Accountants (AICPA), the US Public Company Accounting Oversight Board (PCAOB), the US Securities and Exchange Commission (SEC), the Committee of Sponsoring Organizations of the Treadway Commission (COSO) and the Canadian Institute of Chartered Accountants / Canadian Public Accountability Board (CICA / CPAB). It is apparent, however, that the current guidance is both limited and piecemeal, with inadequate attention to national and international collaboration.

Clearly, there is an ongoing need for enhanced collaboration on professional judgment matters. How can this be done? The AICPA and ICAS website pages on professional judgment provide a beginning. Constructive feedback and suggestions for improvement are welcome and appreciated (please e-mail your comments to paul.emile.roy@gmail.com).

Professional Scepticism Paramount for Auditors

Research undertaken by the Institute of Chartered Accountants of Australia (ICAA) has found that “The value of exercising professional scepticism in auditing is front and foremost for auditors in practice, yet more work can be done to build capability in this area.” Using an innovative review approach, the ICAA has prepared a 16-page publication Preserving capital market confidence through audit quality, based on quantitative research on auditors from five major accounting firms in Australia.

The research assesses the importance of the main drivers of audit quality in those firms. Auditors from a range of levels across the firms, not just partners, provided a sense of where there may be different perspectives on commitment to quality. The findings reveal that professional scepticism ranks in the top three most important skills across all respondent groups.

The review approach supplements the Australian Securities and Investments Commission (ASIC)Audit Inspection Program and the firms’ national and international reviews. The ICAA will work with the firms to correlate findings from all research avenues, as well as assess whether this approach can be adapted for other practice areas.

For an overview of this research, read the article “Professional Scepticism Paramount for Auditors” by the Institute of Chartered Accountants of Australia published in the February 2013 edition of GAA Accounting. Also, review the additional research and guidance on professional scepticism currently available online.

OECD unveils plan for cross-border tax reporting

Cross-border portfolio investments are greater than $35 trillion globally, but the intended tax benefits are so difficult to claim that they often do not reach their intended targets. In response, the Organisation for Economic Cooperation and Development (OECD) has developed and approved a standardized system of relief meant to streamline processes, reduce costs and assure investors their rights, while also improving tax compliance.

The electronic system allows tax authorities to exchange information and financial institutions to report information to tax authorities. The new “Treaty Relief and Compliance Enhancement” system is based on eXtensible Markup Language (XML) technology. The United States and Canada are among the 34 countries in North and South America, Europe, Asia, Australia and New Zealand that participate in the OECD.

The135-page “Trace Implementation Package” adopted on January 23, 2013 by the OECD committee that developed it would allow authorized intermediaries to claim exemptions or reduced rates of withholding taxes on a pooled basis on behalf of their portfolio investor customers.  The package contains a complete set of tools and documents for intermediaries to begin using the system, although OECD acknowledges there are still some technology issues to resolve and, in some cases, participating countries may need to change certain domestic laws to enable intermediaries to participate. Learn more about this system at the OECD website and read the article “OECD Offers Plan for Cross-Border Investment Tax Woes” at Compliance Week online

Sarbanes-Oxley and the Accounting Profession: Public Interest Implications

A recent research article notes that “The US accounting profession was caught up in, and some say responsible for, the whirlwind of accounting and business scandals that rocked the US markets in 2002. To restore investor confidence in financial information, the Sarbanes-Oxley Act created a new Public Company Accounting Oversight Board [PCAOB] with the authority to set standards for auditors of publicly-traded companies, thus ending a century of professional regulation of auditing.”

The research uses sociological theories of professionalism to help understand the implications of the Sarbanes-Oxley legislation for the accounting profession and for the public interest. It explains why professional self-regulation is important for retaining valuable economic franchises. It also explains why the public interest orientation of the profession is important and how government take-over of auditing standards potentially erodes the public accounting profession’s commitment to the public interest.

According to the article, self-control over professional work, a key characteristic of professional status, is pre-empted by the newly created government oversight body PCAOB. With government takeover of oversight of auditing practice, claims to professional status are weakened and professional commitment to, and involvement with, vital work standards may suffer. In addition, the profession may no longer have incentives to promote the public interest or to innovate and change in response to changing conditions.

The authors trace events leading up to Sarbanes-Oxley legislation and conclude that underlying problems arising from internal work differentiation as consulting work became more profitable and glamorous, and development of a commercially-oriented work culture may continue to threaten the profession in the future.

They speculate that the greatest costs may be opportunity costs as the profession no longer has the incentives or ability to innovate and embrace new forms of accountability. Learn more by reading the research article “Sarbanes-Oxley and the Accounting Profession: Public Interest Implications” by Sara Ann Reiter (1Binghamton University, Binghamton, USA) and Paul F. Williams (North Carolina State University, Raleigh, USA) in Open Journal of Accounting, 2013, Vol. 2, pages 8-15.

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.

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.