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.

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.

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.

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.

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.

Promoting Judgment through Objectives-Oriented Accounting Standards

A recently-published study analyzes how the International Accounting Standards Board (IASB) promotes professional judgment by issuing objectives-oriented accounting standards and exposure drafts. The authors focus on the role of judgment as outlined in Phase I of the IASB Conceptual Framework, Chapter 1, “Objective of General Purpose Financial Statements” and Chapter 3, “Qualitative Characteristics of Useful Financial Information” (IASB 2010).

This study discusses how the Conceptual Framework encourages professional judgment, when viewed through the prism of objectives-oriented accounting standards. Such an approach was recommended by the United States Securities and Exchange Commission (SEC) Report in its “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” (July 2003).

The study also analyzes International Financial Reporting Standards (IFRS) and Exposure Drafts issued by the IASB since its inception in 2002 to determine if those documents are consistent with objectives-oriented accounting standards. This analysis is useful for gaining insights into how the IASB integrates the Conceptual Framework with the SEC’s recommended objectives-oriented accounting approach to promote judgment in the interest of IASB/FASB convergence of accounting standards.

According to the study, “An increasingly complex financial environment demands accounting standards that narrow the range of professional judgments in accounting decisions. Although new accounting principles and approaches do not eliminate the necessity of judgments entirely, the IASB’s process of improving transparency and comparability of financial reporting hinges on its ability to promote professional judgment. Its ability depends on the standard setter and the practitioners. The IASB is issuing more objectives-based standards that provide a framework for judgment. Professional accountants, auditors and managers need to be cognizant of the IASB's efforts so they can cooperate in the pursuit to judgment.”

For more information, refer to the 15-page research article “The International Accounting Standards Board’s Progress in Promoting Judgement through Objectives-Oriented Accounting Standards” by Tanja Lakovic and Jayne Fuglister at the University of Montenegro. The article was published in the International Journal of Business and Social Research, Volume 3, No. 7, July, 2013.

Practical guidance for exercising professional skepticism

A high-quality audit requires the exercise of professional judgment by the auditor and a mindset of professional skepticism. Because it is part of the auditor’s mindset, professional skepticism depends on the personal behavioural traits of those involved in the audit and is influenced by such things as the motivation, competencies, education, training and experience of each auditor.

The International Standards on Auditing (ISA) note that professional skepticism is necessary to the critical assessment of audit evidence. This includes questioning contradictory audit evidence and the reliability of documents and responses to inquiries and other information obtained from management and those charged with governance. It also includes consideration of the sufficiency and appropriateness of audit evidence obtained in light of the circumstances.

A recently-issued paper proposes practical ways in which the exercise of professional skepticism can be enhanced in an audit of financial statements and reflected in audit documentation by setting out a series of questions for different phases of the engagement. Using the questions may help identify the best means of demonstrating the exercise of professional skepticism in an effective manner.

Read the May 2013 paper on Practical Ways to Improve the Exercise and Documentation of Professional Skepticism in an ISA Audit. This 18-page paper was prepared by the Canadian Institute of Chartered Accountants (CICA) and the Institute of Chartered Accountants in Australia (ICAA). Learn more by reviewing other guidance materials on Professional Skepticism.

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).

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.

Principles-based standards and professional judgment – Part 3 of 3

At a historic roundtable discussion in New York, the chairman (Charles B. Couchman) stated that: “For many years the leading practitioners of public accountancy have been reducing the practice of accountancy to rules and standards as far as it has been found practical and logical to do so. The elements that make up financial statements have been reduced to standard classifications to the extent permitted by complicated and constantly changing transactions of the business world. Rules have been adopted covering, to a large extent, the various entries affecting the financial classifications. These classifications and these rules have been made widely available through books, articles, addresses and accounting curricula. Practically all the progress that has been made in reducing accountancy to rules and standards has been accomplished by the public accounting profession.”

“If all of the transactions of business were susceptible to analysis into a definite and rigid number of effects that could be analyzed to an extent that would allow exact classification, then rules could be adopted that would cover correctly each one. However, that is not the case. No matter how long one is engaged in an extensive practice of accountancy, he is continually faced  by new and unexpected transactions, each legitimate but each presenting combinations of effects not previously encountered. That is why the sorting of accounting transactions is rigid classifications to which rules and standards may be applied without distortion of fact is a slow process and cannot be otherwise.”

“No fixed rule may be laid down until all of the accounting elements that may fall within its scope have been studied and their effects determined so completely as to bring exact knowledge that the rule, when applied to them, will result in a proper statement of financial facts. Even then the rule must be subject to possible exception, as there is always the possibility that a new and unexpected set of circumstances may arise to which the rigid application of this rule would result in distortion of truth.”

“It is true, not only of accountancy, but of almost every other complicated subject, that the one who has only a smattering of knowledge of it considers that the subject is reasonably simple and that he can readily devise rules governing each phase thereof. To the simple, all things are simple. It is only when one goes deeply into the subject, whatever it may be, that he becomes aware of the complications and the difficulties of proper treatment that is applicable to each element.”

To learn more about the history of the principles versus rules debate, read the transcript of an October 19, 1937 roundtable at the Waldorf-Astoria, New York titled “To What Extent Can the Practice of Accounting Be Reduced to Rules and Standards?” For more information and different perspectives regarding this ongoing debate, refer to Part 1 and Part 2 of this three-part posting as well as previous postings during the past year.

Principles-based standards and professional judgment – Part 2 of 3

Accounting research has shown that the distinction between rules-based and principles-based standards is not well defined and is subject to a variety of interpretations. Nonetheless, there is a commonly-held view that accounting standards in the United States are rules-based and International Financial Reporting Standards (IFRS) issued by the International Accounting Standards Board (IASB) are principles-based.

A research paper published in 2006 identifies the basis of this distinction. For research and development, the paper compares the US standard issued by the Financial Accounting Standards Board (FASB) with two principles-based standards. For each standard, the researchers identify and classify rules and judgments, and observe the level of justifications for the rules and assistance to support the judgments. The three standards have rules, are based on principles, and require the exercise of professional judgment; the less conservative standard requires more judgments and, unexpectedly, more rules.

The results suggest that the rules-based versus principles-based distinction is not meaningful, except in relative terms. The paper concludes that a relatively more principles-based standards regime requires professional judgment at both the transaction level (substance over form) and at the financial statement level (‘true and fair view’ override). Furthermore, it suggests that any IASB and FASB convergence will require agreement on the weightings given to the qualitative characteristics.

Read the SSRN abstract and the full research article “Rules, Principles and Judgments in Accounting Standards” by Bruce Bennett (General Manager Admissions/Standards and Quality Assurance at the New Zealand Institute of Chartered Accountants), Michael Bradbury (Professor, School of Accountancy, Law and Finance, UNITEC Institute of Technology in Auckland, New Zealand, and a member of the International Financial Reporting Interpretations Committee of the IASB and the Financial Reporting Standards Board of the Institute of Chartered Accountants of New Zealand) and Helen Prangnell (a Senior Lecturer in the School of Accountancy, Law and Finance, UNITEC New Zealand, and a member of the Professional Practices Board of the Institute of Chartered Accountants of New Zealand).

This 16-page article and other articles on this debate were published in ABACUS, Vol. 42, No. 2, June 2006. For more information and different perspectives regarding this ongoing debate, refer to Part 1 of this three-part posting and previous postings during the past year.

Principles-based standards and professional judgment – Part 1 of 3

A recently-released research paper states that: “Although there is considerable support for the idea that a financial reporting system should be based upon ‘principles-based’ standards, progress in achieving this end has been slow. This paper argues that one of the reasons for the lack of progress is the vagueness of the idea of standards being ‘principles-based’.”

Furthermore, “The characteristics of such standards are identified through a conceptual enquiry into how standard setters, regulators and academics explain their nature. Superficial agreement on these characteristics masks disagreement about the reasons why these characteristics are thought to be desirable. These depend upon underlying assumptions about the nature of prescriptions in standards and about the purpose of providing implementation guidance in an accounting standard. The apparent agreement that ‘principles-based’ standards are a good thing is facilitated by the fact that this concept refers to a ‘boundary object’. With such concepts common characteristics allow for communication between parties who have different underlying interests and start from different assumptions about how those interests can be achieved.”

Nonetheless, “The failure to agree on these assumptions manifests itself in disagreement in the application of the concept to particular standards. This means that the concept is vague. Boundary objects may be useful for certain purposes, including political ones, but are not helpful in achieving the objectives of the current project of converging accounting standards. The paper concludes that a debate about fundamental issues about standard setting and accounting standards would be facilitated if the concept of ‘principles-based’ standards was abandoned.”

Read the 35-page research paper “Principles-based standards and judgement” published in 2012 by Dr Ian Dennis, Senior Lecturer in Accounting and Finance,, Oxford Brookes University Business School. For more information and different perspectives regarding this ongoing debate, refer to previous postings during the past year.

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.