Exploring the Growing Use of Technology in the Audit, with a Focus on Data Analytics

In September 2016, the International Auditing and Assurance Standards Board (IAASB)’s Data Analytics Working Group (DAWG) released a Working Group Paper, Exploring the Growing Use of Technology in the Audit, with a Focus on Data Analytics. The Paper is open for comment until February 15, 2017. In addition, this publication is a call for nominations for a newly formed Project Advisory Panel to further advise the IAASB and the DAWG on developments relevant to standard setting.

The Paper provides insights into the opportunities and challenges with the use of data analytics in the audit of financial statements and outlines the insights gained from the activities to date. The purpose of the Request for Input is to:

• Inform stakeholders about the IAASB’s ongoing work to explore effective and appropriate use of technology, with a focus on data analytics, in the audit of financial statements; and 

• Obtain stakeholder input and perspectives on whether all the considerations relevant to the use of data analytics in a financial statement audit have been identified.

The DAWG paper (page 16) emphasizes that: “The use of data analytics in an audit of financial statements will not replace the need for the auditor to exercise appropriate professional judgment and professional skepticism. Strong views have been expressed by the IAASB CAG and at IAASB roundtables about the importance of the auditor having a thorough understanding of the entity and its environment in order to facilitate a high-quality audit in which professional skepticism is appropriately applied.”

For additional insights, refer to the June 2016 Audit Data Analytics Alert  issued by CPA Canada.

Defining the “Public Interest” - Financial Reporting and Assurance Standards Canada

The accounting profession serves the “public interest” but what exactly does the term mean? Canada’s Auditing and Assurance Standards Oversight Council (AASOC) has clarified how it defines the “public interest” in a newly-released paper. The paper, “AASOC’s Consideration of the Public Interest,” outlines who is the public, what are the interests of the public and how the AASOC evaluates whether an action, decision or policy is in the public interest.

To provide a structure for the consideration of the “public,” a stakeholder approach was adopted.  Fostering trust, economic growth and long-term financial stability are of immense importance to the public at large. This makes the public at large, even those who do not invest in capital markets, a stakeholder in our work. The broader public, including those who do not invest in stocks and bonds of individual companies, are also often stakeholders through investment funds, pension plans and as taxpayers.

Present and potential investors, financial institutions and other creditors of private entities and public institutions, including government related bodies and not-for-profit organizations, have a prominence as stakeholders in our considerations. In short, those economic participants who entrust or consider entrusting their money to an entity.

Additional stakeholder groups that are integral to the functioning of audit and assurance services in Canada, each with roles in serving and protecting the public interest, include:

•    audit committees and similar bodies or persons charged with governance, including parliamentary committees;

•    management and financial information preparers;

•    providers of audit and assurance services; and

•    various financial regulators and inspectors.

The paper notes that, "Ultimately, the consideration of whether a particular activity is in the public interest requires the exercise of professional judgment." The exercise of professional judgment includes that we stand back from the full suite of criteria (for example, transparency, public accountability, competence, independence, due process and balancing of potential outcomes) to consider whether the final result is in the public interest." Read the AASOC paper to learn more about the interests of the public and how the AASOC evaluates whether an action, decision or policy is in the public interest.

A Process for Professional Judgment

The initial post About this Blog on June 18, 2011 states: “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.”

It also states: “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.” 

In August 2014, the US Center for Audit Quality (CAQ) published a Professional Judgment Resource that is entirely consistent with this view of professional judgment. The CAQ is an autonomous, nonpartisan public policy organization dedicated to enhancing investor confidence and public trust in the global capital markets. The CAQ fosters high quality performance by public company auditors, convenes and collaborates with other stakeholders to advance the discussion of critical issues requiring action and intervention, and advocates policies and standards that promote public company auditors’ objectivity, effectiveness and responsiveness to dynamic market conditions. Based in Washington, DC, the CAQ is affiliated with the American Institute of Certified Public Accountants (AICPA).

Applying IFRS - Online guidance and resource materials

The Chartered Professional Accountants of Canada (CPA Canada) maintain an IFRS web section to provide guidance and support for understanding and applying International Financial Reporting Standards (IFRS). Whether applying an existing standard, searching for information on new standards, preparing financial statements or communicating with clients or lenders about IFRS, check out these free online resources. The Reporting Alerts series summarizes new and revised standards.

In addition, the Viewpoint series discusses circumstances unique to the mining and the oil and gas sectors. CPA Canada and the Prospectors and Developers Association of Canada (PDAC) created the Mining Industry Task Force to share views on IFRS application issues of relevance to junior mining companies. CPA Canada, the Canadian Association of Petroleum Producers (CAPP) and the Explorers and Producers Association of Canada (EPAC) created the Oil and Gas Industry Task Force to share views on IFRS application issues of relevance to junior oil and gas companies. In addition, learn more about the importance of applying professional judgment when preparing or auditing IFRS-based financial reporting.

IASB Discussion Paper - A Review of the Conceptual Framework for Financial Reporting

In July 2013, the International Accounting Standards Board (IASB) issued a Discussion Paper called “A Review of the Conceptual Framework for Financial Reporting.” The Paper sets out the principles underpinning the International Financial Reporting Standards (IFRS). It provides stakeholders with an opportunity to shape the future of financial reporting. The 239-page Discussion Paper, providing 26 questions for respondents to consider, is available for public comment until January 14, 2014.

In 2011, the IASB carried out a public consultation on its agenda. Most respondents to that consultation identified the Conceptual Framework as a priority project for the IASB. Consequently, the IASB decided to restart its Conceptual Framework project, which had been suspended in 2010.

This Discussion Paper is the first step towards issuing a revised Conceptual Framework. It is designed to obtain initial views and comments on a number of matters, and focuses on areas that have caused the IASB problems in practice. Consequently, this Discussion Paper does not cover all the issues that the IASB would expect to cover in an Exposure Draft of the Conceptual Framework. The Discussion Paper sets out the IASB’s preliminary views on some of the topics discussed. However, the IASB has not reached preliminary views on all of the issues discussed in this Discussion Paper.

The Discussion Paper addresses the definitions of assets and liabilities, recognition and de-recognition, the distinction between equity and liabilities, measurement, presentation and disclosure, and other comprehensive income. For an overview, see the July 23, 2013 article “IASB seeks feedback on conceptual framework revision” in the Journal of Accountancy online.

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.

Ethical leadership: Doing what is right for the long-term benefit of all stakeholders

A Special Feature article in Accountancy SA states that: “Ethics can be defined as the body of knowledge that deals with the study of universal principles that determine right from wrong. Ethics concerns itself with the moral principles that govern behaviour... Leadership can be defined as the art of helping, guiding and influencing people to act toward achieving a common goal. By combining the two definitions, one quickly derives a simple definition for ethical leadership: the art of helping, guiding and influencing people to achieve a common goal in a morally acceptable way.”

According to the article, “Ethical leadership is about doing what is right for the long-term benefit of all stakeholders. It is about balancing the organization's short-term goals and longer-term aspirations in a way that achieves a positive result for all those who could be affected by the organization and the decisions of its leader. It is not only about ensuring that others are not adversely affected by the leader's decisions and actions, but also actively looking for ways to make sure that others benefit from these decisions. It goes without saying that the more senior the leadership role, the more influence and impact that leader's decisions will have on a broader group of stakeholders.”

Therefore, the more senior the leader, the more careful and circumspect they should be in reaching decisions. This is the very essence of establishing sound oversight and governance. Structures should be in place to provide the leader with a sounding board and advisory conscience. This will help to prevent them from taking ill-advised decisions and actions which may ultimately cause harm.

The research suggests that there are several levels of behaviour, from the unethical through to the highly ethical, as follows:

Level 1: Rejection. Exploit, use and abuse others, and especially their relative disadvantages, for your own gain, without any regard for consequence.

Level 2: Non-responsiveness. Operate from a position that measures success only in terms of one’s own gain; exploit others where there is a power or monetary gain to be had; little real concern for the law of regulation.

Level 3: Compliance. Do the minimum required by the relevant law of the land, and continue to exploit others, but minimize consequential risk. In other words, don’t get caught.

Level 4: Efficiency. Regard yourself as a good citizen (individual or corporate) and act in a manner that respects and upholds the morals, values, regulations, customs and styles of wider society; act in a holistic, integrated way across all areas of activity.

Level 5: Proactivity. Be a proactive agent for values-led leadership in the context of wider society in all areas of activity, recognizing this as a point of personal or corporate distinction. Or, be a role model by going “above and beyond.”

Level 6: Sustaining. Recognize one’s place in the grander scheme of things, and the inter-connectedness of everyone and everything; act as a co-evolutionary element to foster greater effectiveness for the whole.

The article observes that: “They are mindsets, attitudes or ways of being. And this goes to the heart of the matter. An ethical leader operates from Level 4, 5 or 6. They have a sense of mission in life. They operate according to their identity, and the values and morals they clearly possess. They are marked out by the perspectives they bring to problem-solving, the capabilities they develop in themselves and others, the choices they make and how this is all expressed in their behaviour...a leader operating from Levels 1, 2 or 3 is not an ethical leader.”

Learn more by reading the full article “Instilling ethical leadership” in the June 2013 issue of Accountancy SA, the premier stakeholder communication vehicle of the South African Institute of Chartered Accountants (SAICA). Also, see the article on “The Art of Ethical Leadership” and refer to other guidance materials about “ethics and integrity.”

Do Auditing Standards Matter?

Understanding the economic role of auditing standards is essential for improving audit effectiveness and efficiency. In fact, auditing standards are most important when an auditor may have an incentive to under-audit. However, the conditions under which standards may, or may not, have a desirable effect on audit quality are less obvious.

 

A recently-completed research paper discusses what standards can do: (1) compensate for the lack of observability of the audit outcome by focusing on the audit process; (2) partially mitigate the information advantage possessed by the auditor as a professional expert that might motivate the auditor to under-audit; (3) counterbalance the diversity of demand across multiple stakeholders that might drive the audit to the lowest common denominator and create a market based on adverse selection; and (4) provide a benchmark that facilitates the calibration of an auditor’s legal liability in the event of a substandard audit.

 

The paper also presents a number of observations about what standards should not do: (1) discourage the use of judgment by auditors; (2) limit the potential demand for economically valuable alternative levels of assurance; (3) lead to excessive procedural routine or standardization in the conduct of the audit; and (4) be based on an enforcement agenda. In the end, standards overreach may undermine the economic value of the audit to many stakeholders and lead to fee pressure for audit firms.

 

Hopefully, these insights can inform future debates about the level and types of standards that are appropriate for the auditing profession. For more information, read the article “Do Auditing Standards Matter?” by W. Robert Knechel, PhD, University of Florida. This manuscript has been accepted for publication in an American Accounting Association (AAA) journal. The author has posted this preliminary version of the manuscript in the interest of making the information available for distribution and citation on a timely basis.

Information Integrity – January 2013: An AICPA-CICA White Paper

Various types of information are increasingly being made available by business entities to stakeholders, including management, investors, regulators, shareholders and other interested parties. This information may include: excerpts from financial statements, such as inventories or accounts receivable; data from the company records, such as production volumes; and key performance indicators. Stakeholders use this information in making decisions, interpreting or using other information and generally increasing their knowledge about the subject matter.

To make the best decisions, users need to have confidence in the integrity of the information. With this in mind, the AICPA Trust Information Integrity Task Force, in conjunction with the Canadian Institute of Chartered Accountants (CICA), prepared a white paper called Information Integrity in January 2013. The purpose of this white paper is to define what information integrity means and to provide context for it to users, preparers and practitioners.

The 28-page white paper offers insight on how information can have integrity and discusses how information integrity can be achieved and maintained. It should be of interest to professional accountants in the accounting profession as a whole, including those in public practice, in business and industry, and other participants in the business reporting process, such as producers and consumers of business information.

Guidance for Professional Accountants in Business

According to the International Federation of Accountants (IFAC):
“Professional accountants in business (PAIBs) are a very diverse constituency, and can be found working as employees or consultants in commerce, industry, financial services, education, and the public and not-for-profit sectors. Many are in a position of strategic or functional leadership, or are otherwise well-placed to collaborate with colleagues in other disciplines to help their organizations toward long-term sustainable success.”


The PAIB Committee provides leadership and guidance on relevant issues pertaining to professional accountants in business and the business environments in which they work. This guidance is helpful because “Professional accountants support their organizations in a wide range of job functions at various levels, including leadership and management; operational; management control; and accounting and stakeholder communications.”

The key roles and expected areas of competency of PAIBs are discussed in Competent and Versatile: How Professional Accountants in Business Drive Sustainable Organizational Success and an accompanying employer-focused brochure. This discussion explains how professional accountants can broadly be categorized as creators, enablers, preservers, and reporters of sustainable value for their organizations, and the wide scope of their activities in organizations can be better promoted by the profession. In addition, it highlights the importance of the professional accountant’s mindset that needs to embrace: professionalism and ethical behaviour; professional judgment; an investor and wider stakeholder focus; organizational and environmental awareness; and change, uncertainty, and complexity.

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

Integrated Reporting: the challenge of assurance

A recent news article on the website of the Institute of Chartered Accountants of Scotland (ICAS) observes that: “Integrated reporting (IR) continues to move forward.  There are now 83 pilot companies across the world which are testing out the integrated thinking processes necessary to deliver integrated reports and experimenting with how best to communicate the resulting information.” It also states that: “A prototype IR Framework was released at the end of November, which shows the direction of travel, and a 3 month consultation on a proposed framework will be published in April 2013.  It is hoped that a final version of the Framework will be published in early 2014.”

 

According to this article, the integrated report is likely to replace today's annual report as the main communication to the company’s stakeholders.  It is likely to contain a varied mix of different types of information - past, present and forward looking, financial and non financial. Some of the information may be extracted from the financial statements, CSR report, Governance report, etc. But, how will users know whether the report contains all the most important information or whether it is so slanted towards the positive that it is not really giving a realistic view?

 

In this regard, auditors could express a “balanced and reasonable” opinion on an integrated report. This would provide slightly less assurance than the opinion on the financial statements, reflecting the more judgmental basis of the information in the integrated report, the mix of different types of information, and the fact that less of the information will be objectively verifiable, thereby relying much more on the auditor’s judgment.  Also, with a greater degree of forward looking information, the inherent inability of anyone to predict the future means that a lower level of assurance is inherent.

“... it is important, though, that a positive opinion is clearly expressed, so that users can understand the nature of assurance being given, and that this will underlie the credibility of integrated reports...negative assurance and reporting by exception are too confusing to users. The auditing profession is perfectly capable of making the necessary judgments to express a positive opinion in this way, although greater judgment will be involved, and the auditor liability regime in some countries may make the auditors slightly reluctant.”

Learn more by reading the online article “Integrated Reporting: the challenge of assurance” by David Wood, ICAS Executive Director of Technical Policy and Services. In addition, see the related articles “A Template for Integrated Reporting” and “A professional judgment framework for financial reporting.”

A Template for Integrated Reporting

In an era in which news spreads as it happens over the Internet and social media networks, investors, society and governments are increasingly demanding that organizations be accountable to stakeholders, not merely shareholders, and be transparent about their activities. A forthcoming research paper outlines the concept of integrated reporting and proposes a template for integrated reporting. The model is based on the concepts in the King Report on Governance for South Africa (King III), and the International Integrated Reporting Council in the United Kingdom.

According to the author, an integrated report should explain the story of reaching the organization’s vision, underpinned by its values, enacted by management, monitored by governance and using facets of resources relating to financial capital, intellectual capital, social capital and environmental capital. The paper proposes an integrated reporting framework and provides an example of a template to use. Apparently, this is the first academic paper that provides a coherent framework on integrated reporting, along with a template.

The author supports a concise report that informs significant performance implications on the organizational vision during the reporting period. The paper does not define significance as it is an outcome of inquiry into reporting, rather than a rule, and instead leaves it up to preparers to use their professional judgment. Learn more by reading the online 48-page research article “A template for integrated reporting” by I. Abeysekera to be published in the Journal of Intellectual Capital, 14 (2), in May 2013.

IAESB - Revised standard on professional values, ethics and attitudes

The International Accounting Education Standards Board (IAESB) of the International Federation of Accountants (IFAC) has released for public exposure a proposed revision of International Education Standard (IES) 4, Initial Professional Development-Professional Values, Ethics and Attitudes. IES 4, part of the IAESB’s project to improve the clarity of its standards, is aimed at educational organizations, employers, regulators, government authorities and other stakeholders who support the development of professional accountants.

Drafted in 2004, IES 4 prescribes the values, ethics and attitudes that professional accountants should acquire during the education program leading to qualification. A revised draft of IES 4 was exposed for public comment in May 2011 and, although respondents’ comments were generally supportive, further clarification was requested to explain the requirements on learning outcomes, assessment and reflective activity (the recurring process of reviewing experiences with a view to improve future actions). As a result, the IAESB has made substantial changes to the content of IES 4.

In addition to addressing these issues, the proposed revised IES 4 requires IFAC member bodies to regularly review and update their professional accounting education programs, including formal education and workplace training. Updating the knowledge content of professional accounting education programs and the content of workplace training on a regular basis improves the likelihood of learning outcomes being relevant and developing appropriate competence.

In a continuing effort to improve the clarity of its standards, the IAESB has undertaken a project to redraft all eight of its IESs in accordance with its new clarity drafting conventions. IES 7, Continuing Professional Development, is the first clarified standard to be released since the project began in December 2010. Under the current timetable, the IAESB anticipates that all IESs will have been revised and redrafted, or redrafted only, by the third quarter of 2013. The IAESB invites all stakeholders to comment on its proposals at www.iaesb.org. Comments are requested by October 11, 2012.

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.

Learning about Professional Skepticism – Part 1 of 3

With the move toward a more principles-based financial reporting framework and increased emphasis on fair value measurement, along with increased expectations from stakeholders and regulators, the ability to consistently make high quality professional judgments is increasingly important. In response, KPMG has launched a professional judgment initiative, which includes development of a Professional Judgment Framework and training all assurance professionals on a good judgment process, as well as common threats to good judgment. This Framework and training are intended to elevate judgment quality and professional skepticism across the firm and to provide a common vocabulary that facilitates implementation and mentoring on professional judgment.

“Professional scepticism” may be defined as an attitude that includes a questioning mind and a critical assessment of the supporting evidence. Professional skepticism helps to frame the professional accountant’s mindset. If that mindset is aligned with the objectives of the accounting profession and the duty to the public trust, professional judgments are also likely to be appropriately aligned with those objectives.

According to the KPMG monograph (on page 16): “Professional skepticism refers to the ability of the auditor to approach issues in an objective, balanced way, with a questioning mind and an appropriate level of critical evaluation. Accordingly, it is important that you learn what professional skepticism is and how to develop and improve your own sense of professional skepticism. It is important to understand that professional skepticism does not mean that auditors should adopt a cynical attitude toward client management. To the contrary, professional standards indicate that auditors should neither assume that management is dishonest nor assume unquestioned honesty.”

The accompanying exhibit sets out six characteristics of scepticism, summarized from the current research, as follows:

·       Questioning Mind - A disposition to inquiry, with some sense of doubt;

·       Suspension of Judgment - Withholding judgment until appropriate evidence is obtained;

·       Search for Knowledge - A desire to investigate beyond the obvious, with a desire to corroborate;

·       Interpersonal Understanding - Recognition that people's motivations and perceptions can lead them to provide biased or misleading information;

·       Autonomy - The self-direction, moral independence and conviction to decide for oneself, rather than accepting the claims of others;

·       Self-Esteem - The self-confidence to resist persuasion and to challenge assumptions or conclusions.

To learn more, read the research article “Development of a Scale to Measure Professional Skepticism” by R. Kathy Hurtt, PhD, CPA, in Auditing: A Journal of Practice &Theory, Vol. 29, No. 1, May 2010, pp. 149–171.

Professional Judgment – Ethical Thinking by Chartered Accountants

It is generally accepted that ethical thinking by Chartered Accountants (CAs) is based on their knowledge and the application of fair and comprehensive codes of professional conduct, such as the IFAC Handbook of the Code of Ethics for Professional Accountants. Education, training and experience, as well as professional and organizational commitment, influence a CA’s ability to utilize principled ethical thinking when exercising professional judgment.

Accounting research suggests that accountants can think about ethical issues in one of three ways that correspond to the three types of ethical thinking: pre-conventional, conventional and principled thinking. CAs use pre-conventional ethical thinking when they decide what is right or wrong based upon consequences, and often, self-interest. An example of using pre-conventional thinking is management’s decision to pad a budget because a bonus will be received if the budget is met.

CAs use conventional ethical thinking when social consensus, such as accepted practices, rules and laws, define what is right or wrong. An example of using conventional ethical thinking is management’s structuring a contract, such as a lease, solely to achieve a particular accounting result. CAs use principled ethical thinking when they use universal ethical principles of justice and the common good to determine what is right or wrong. An example of using principled ethical thinking is management’s voluntarily disclosing to shareholders the firm’s environmental and social practices, even if they are less than flattering, because it is right or justifiable to do so. Once CAs use principled ethical thinking to determine the right thing to do, they should be encouraged to do it.

For more information, read the article “Ethics and the accountant” by Linda Thorne, PhD, CA and Dawn Massey, PhD, CPA in the premier issue of CMA Magazine online.

Principles not Rules: A Question of Judgement

The Institute of Chartered Accountants of Scotland (ICAS) published (in April 2006, updated July 2008) a research report called Principles not Rules: A Question of Judgement. The Introduction to this 27-page report was written by Hugh Shields, Chairman of the Working Group (Director and Head of Financial Reporting at Barclays Capital, a division of Barclays Bank). He states that: “The key to true and fair financial reporting is the balanced exercise of judgement. If standard setters, preparers, auditors and regulators could all exercise judgement on broadly equal terms, then this would provide the healthy tension which is needed for true and fair financial reporting and for communication with stakeholders.”

According to Shields, “Principles-based accounting standards are based on a conceptual framework, consist of a clear hierarchy of overriding principles and contain no ‘bright-line’ or anti-abuse provisions. Such an approach requires the use of judgement by preparers, auditors and regulators. ...With the safeguards afforded by such an approach, all parties should be more able to accept the consequences of exercising judgement in a principles-based accounting world.

“Against the above background, much greater simplicity in standard setting becomes possible. An interviewee in this project noted that: “Any accounting standard should be capable of being explained in one minute.” Yet some standards currently seem to defy any simple explanation at all. In the interests of all parties involved in financial reporting and, in particular, the broad range of users, such a situation should not be allowed to persist.”

Shields further notes that, “Einstein once said that ‘Everything should be made as simple as possible, but not simpler.’ This perfectly captures the Working Group's view that accounting standards should be firmly governed by high-level principles with only the absolute minimum additional guidance required to make the standard operational. Preparers and auditors would, therefore, need the courage to exercise and defend their judgements in this simplified accounting world. Users and regulators would need the wisdom to accept that there may be more than one answer and, over time, all parties would have to build the trust that this state of the world implies.”

A summary of 10 recommendations is presented in the report (page 3). A review of the professional, academic and regulatory literature on the principles versus rules debate in international accounting standard setting entitled Principles-Based or Rules-Based Accounting Standards? A Question of Judgement is available on the lCAS website. Also available is the output from the financial instrument workshop sessions Principles not Rules: Report on Proceedings of Financial Instrument Workshops.

Can you really teach good judgment? (Part 2 of 3)

The KPMG monograph, Elevating Professional Judgment in Auditing: The KPMG Professional Judgment Framework (available at the KPMG University Connection) offers a judgment framework. That framework depicts constraints, influences and biases that threaten good judgment, with the box on the outer rim of the framework labeled “Environment” and the triangle at the top labeled “Influences/Biases.” At the bottom are Knowledge and Professional Standards, as these factors provide the foundation for quality judgments. The framework includes a number of components, such as mindset, consultation, reflection and coaching. At the core, there is a five-step judgment process.

The monograph presents simple, but powerful, principles that help overcome common threats to good judgment and that enhance professional skepticism. In addition, it covers several common judgment tendencies and how they can lead to biased judgments, and offers techniques to overcome or reduce the potential impact of these biases. After laying a foundation for individual judgments, the monograph discusses common threats to good judgment in groups, and the techniques that can improve the quality of group judgments.

According to KPMG, the mindset, skills and techniques behind good judgment begin to form at a young age and can be taught and improved with experience and practice. It is critical that accounting and auditing students receive a strong foundation in the fundamentals of professional judgment. KPMG is committed to sustaining an ongoing dialogue about professional judgment. Therefore, it is now taking the important step of sharing and leveraging the content with the key stakeholder groups, including the academic community.