Investor advocates are skeptical about suggestions to establish frameworks around accounting and auditing judgments, worried that it is a veiled movement toward liability protections for auditors and preparers of financial statements.
The topic flared up at a Feb. 27 meeting of the Public Company Accounting Oversight Board’s Standing Advisory Group. The body met to review a proposal to establish separate frameworks for how accounting and auditing judgments should be reached and documented. The idea came from the Securities and Exchange Commission’s blue-ribbon Committee to Improve Financial Reporting, which the SEC established in 2007 to tackle the vexing questions of how to carve out unnecessary complexity in financial reporting.
The PCAOB asked its advisory panel to comment on the recommendation, looking for views on whether a framework such as the one suggested by CIFR would improve auditing of financial statements. Some members of the advisory group saw potential for judgment frameworks to enhance the process by which judgments are reached, which theoretically would improve financial reporting and increase investor confidence. Others wondered if it would become a safe harbor for auditors and preparers—establishing a protection from liability when errors or frauds are detected—not to mention a cause for more regulatory burden and cost.
Jonas
Greg Jonas, managing director at Moody’s Investors Service and a member of the CIFR committee who helped establish the framework recommendation, told the panel a judgment framework would improve the quality and reliability of reporting-related judgments. “Some misjudgments have been at the heart of important failures,” he said.
Frameworks would establish criteria for what constitutes a sound judgment, and it would give preparers and auditors more confidence that regulators will respect well-reasoned judgments, Jonas said. Judgment frameworks also would facilitate a movement toward a more principles-based approach to accounting rules, which rely more heavily on professional judgment, he added.
Arnold Hanish, chief accounting officer at Eli Lilly, said a framework as suggested by CIFR would represent “common sense,” facilitating but not eliminating debate over accounting judgments. “It clearly provides auditors with sufficient substance to suggest there has been a thorough enough review,” he said. “This certainly encourages or reinforces the need for the thoroughness of a memo that documents the thought process we as preparers go through.”
Nusbaum
Ed Nusbaum, CEO of Grant Thornton and a member of the CIFR, said he was skeptical of the idea when the committee first began discussing it, as were some senior members of his firm, and he conceded it will require more work and more documentation for prepares and auditors. “I became a major supporter when I saw that it would improve the judgments of preparers and improve the audit,” he said.
PASSING JUDGMENT
The following excerpt from the Advisory Committee’s Progress Report on Financial Reporting discusses what issues a framework would help to address.
Goals of a Framework
A. Investors’ lack of confidence in the use of judgment–A professional judgment framework may provide investors with greater comfort that there is an acceptable rigor that companies follow in exercising reasonable professional judgment.
B. Preparers’ and auditors’ concern regarding whether reasonable judgments are respected–In the current environment, preparers and auditors may be afraid to
exercise judgment for fear of having their judgments overruled, after the fact, by auditors, regulators and legal claimants.
C. Lack of agreement in principle on the criteria for evaluating judgments–The criteria for evaluating reasonable judgment, including the appropriate role of hindsight in the
evaluation, may not be clearly defined and thus may lead to increased uncertainty.
D. Concern over increased use of “principles-based” standards–Companies, auditors and investors may be less comfortable in their ability to implement more “principles-based” standards if there is a concern over how reasonable judgments are reached and how they will be assessed.
Categories of Judgments That Are Made in Preparing Financial Statements
1. Selection of accounting standard
2. Implementation of an accounting standard
3. Lack of applicable accounting standards
4. Financial Statement Presentation
5. Estimating the actual amount to record
6. Evaluating the sufficiency of evidence
Source
Securities and Exchange Commission (Feb. 14, 2008).
Others weren’t so sure. Cynthia Richson, director of corporate governance for the Employees Retirement System of Texas, questioned the real motivation for a judgment framework. “Why are we focused on this issue?” she asked. “All the data I’ve seen says that basically the post-Enron reforms are working pretty much as intended. Restatements are down in 2007. Why are we giving [auditors] a safe harbor?”
Jonas countered that the proposal does not recommend that a judgment framework would serve as a safe harbor, although he acknowledged the committee’s report discusses the safe harbor potential only to “decouple” the issues.
Still harsher words came from Barbara Roper, director of investor protection for the Consumer Federation of America. She called the framework proposal “hopelessly naive,” and said companies making good faith judgments will continue to do so while companies trying to game the reporting process to management’s benefit will use the framework for protection. “This will give them a whole new set of tools to use to argue that the approach they want is acceptable,” she said. “It will make it that much more difficult for auditors to challenge them.”
Conversely, Vincent Colman, an assurance partner with PricewaterhouseCoopers, said an appropriately applied framework would make it more difficult “to have a judgment that is out of bounds.” Further, Colman said, the increased movement toward a more principles-based approach to accounting, especially the movement toward International Financial Reporting Standards, demands more guidance around judgment. “A process of behavioral change could be extremely healthy and beneficial to the whole system and to investors,” he said.
David Becker, a partner with the law firm Cleary Gottlieb Steen & Hamilton, said he sees a need for more guidance around judgment that can establish a good process for decision making without necessarily providing a safe harbor. He cautioned, however, that a “litigation trap” could develop. “By proceduralizing decision making, you have grounds for enhanced liability,” he said. “Even if the judgment is defensible, but the documentation is crappy, you may find yourself with more complicated legal proceedings.”
Turner
Some members of the SAG listed elements of the proposal and mapped them to existing rules in accounting and auditing literature, leading them to wonder if a framework is necessary or would perhaps be redundant. “There’s nothing in here that isn’t already out there” in existing accounting and auditing rules, said Lynn Turner, a former chief accountant for the SEC. “Does the profession need a rule to say go look at GAAP, make sure you’ve got all the facts and analyze them? This doesn’t add anything.”
Instead, Turner and others advocated that CIFR should focus on mandating more disclosure around significant judgments, and then allow market forces to work. “That’s what investors want,” Turner said. “Give us the ranges of those estimates. Give us the key data and assumptions that go into those. Let’s get those disclosures out there and let the market discipline. The market and analysts can get their hands around it and they’ll take it from there.”
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