Putting Auditor Judgments under a Microscope

The PCAOB's advisory group tears apart an SEC group's proposal to give guidance to auditors and managers in defending their decisions.
Sarah JohnsonFebruary 27, 2008

Accounting experts could spend days on end debating which is better: a more prescriptive set of rules (like U.S. GAAP) or rules that seem to allow more judgment (international financial reporting standards, or IFRS). What’s indisputable is that standard-setters and regulators — any debate notwithstanding — have pushed hard for years to move the U.S. toward what they consider a more principles-based financial reporting system.

But do they need to issue new rules to achieve that goal?

That’s a question before the Public Company Accounting Oversight Board’s members as they contemplate whether to craft guidance that will allow auditors to comfortably incorporate their professional judgment into their work without fearing that regulators like the PCAOB will unduly second-guess them.

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It’s a tricky subject that the board placed before its advisory group on Wednesday — a placement decision that’s drawn mixed reviews.

On one hand, the specifics of any plan is almost certain to create dissention. But on the other, there’s general agreement among the experts that achieving a more principles-based system will require the behavior of the financial-statement preparers and auditors to change.

In fact, the Securities and Exchange Commission acknowledged that need in a 2003 report looking into the adoption of a less detailed reporting structure. The report listed several hurdles to making the change, such as how companies would have to stop needling their auditors into documenting all the reasons for their judgments, and how auditors would have to be “weaned away from the check-list mentality.”

Five years later, an SEC advisory committee tasked with simplifying financial reporting has come up with a plan for everyone involved to make a behavior shift: a framework for how companies come up with and document their accounting decisions. In turn, the SEC’s Advisory Committee on Improvements to Financial Reporting (CIFR) has suggested the PCAOB come up with a corollary auditing framework. Under CIFR’s proposal, managers would have to show that their thought processes involve good faith. They could do that by demonstrating that they had considered the relevant accounting literature, alternative estimates, and input from experts.

To be sure, CIFR members insist that their proposed guidelines would not diminish auditors’ or regulators’ rights to question management’s judgment or ask for corrections. But the guidelines themselves could help resolve the tug-of-war between audit firms and their clients over issues of professional pride versus accounting mishaps. “While both auditors and issuers appear supportive of a move to less prescriptive guidance, they have expressed concern regarding the perception that current practice by auditors and regulators in evaluating judgments does not provide an environment in which judgments may be generally respected,” the committee wrote in its midpoint progress report sent to the SEC this month.

Some members of the PCAOB’s own advisory committee worry that a new framework would introduce more audit costs to companies, because it could require additional documentation. They consider CIFR recommendations too basic and simplistic, for example, when they say that judgment should be derived after a transaction and its substance have been analyzed. The questioning members express doubt that such guidance is even needed, because some of the PCAOB standards already discuss the way judgment is used in auditing.

Grant Thornton CEO and CIFR member Ed Nusbaum defended the approach, saying that investors “are better off with more transparency and better information about the judgments that are made.”

However, Barbara Roper, director of investor protection for the Consumer Federation of America, called one proposal “hopelessly naïve” in its attempt to aid investors, while at the same time it would likely discourage auditors from challenging their clients’ judgments when warranted. “I want issuers and auditors to sweat it out if they’re getting it right or not…(and) this recommendation will make it less likely that will happen,” she said.