Just as proverbial “beholders” have been left to define beauty through the generations, business executives have been left to little more than their own wits to determine how best to exercise professional judgments—especially ones that will hold up to litigation or regulatory scrutiny. So the Committee of Sponsoring Organizations has stepped forward to help out.
COSO—best known for providing leadership to public companies on risk, internal controls, and fraud—explores unchartered territory in its latest “thought paper,” Enhancing Board Oversight: Avoiding Judgment Traps and Biases. It leverages the work of academics who have studied the use of judgment in business and the more recent interest by at least one Big 4 firm to integrate those research findings into its training for accountants and auditors.
The use of judgment in business broadly, and in accounting and auditing specifically, is nothing new. But scrutiny of the use of judgment has escalated in recent years, says George Herrmann, national partner for KPMG, which contributed to the COSO paper. “Clearly, over our recent history, board members, audit committee members, auditors, and management have experienced an increasing degree of complexity in the transactions that are entering into,” he says.
There's more fair-value measurement, more oversight responsibility, and more scrutiny by regulators, not to mention U.S. movement toward International Financial Reporting Standards, which are steeped in judgments. “When you look at all the different dynamics in the marketplace, there's significantly more judgment involved, and the need to make consistently sound judgments is becoming increasingly important,” says Herrmann.
In its final report in 2008, the Securities and Exchange Commission's Advisory Committee on Improvements to Financial Reporting said the SEC and the Public Company Accounting Oversight Board should consider giving some guidance to the capital markets to explain how they assess the reasonableness of business judgments when they review filings or pursue enforcement actions. The PCAOB has discussed the idea with its Standing Advisory Group, but neither regulator has committed to developing such guidance.
Meanwhile, two accounting professors at Brigham Young University, Douglas Prawitt and Steven Glover, have been focusing their research and professional publishing on how business professionals make decisions and judgment calls. They began working with KPMG a few years ago to develop a judgment framework that KPMG would use in its own practice, says Prawitt, mapping out the rough outlines of a decision-making process that would lead to optimal judgments. The professors have been teaching judgment in their master's-level business courses, and COSO showed some interest in making the ideas available more broadly.
“People have been told by the regulators to use good judgment, or be skeptical, but they haven't been able to articulate what that would look like or sound like,” says Glover. Calls for guidance from regulators have focused in large part on providing executives with a “safe harbor,” he says, or criteria that could demonstrate a particular judgment call was based on a sound process even if hindsight shows the judgment missed the intended mark. That's not the objective of the COSO paper, however. “This initiative is more about good corporate governance,” he says. “This is a chance to step back and say we have a responsibility to exercise good judgment, so how can we improve the quality of the process?”
“When you look at all the different dynamics in the marketplace, there's significantly more judgment involved, and the need to make consistently sound judgments is becoming increasingly important.”
—George Herrmann,
National Partner,
KPMG
The resulting COSO paper is based on research findings that suggest professionals in virtually any area get pretty good with experience at making judgments, but even the best decision-makers can fall into common traps and biases that skew judgments, says Prawitt. “We're certainly not saying that business professionals are not good at exercising professional judgment, but we're saying there are insights from cognitive psychology that can help make them even better,” he says.
Don't Rely on Your Gut
For example, the paper says some executives want to appear decisive by making quick judgments or gaining quick consensus in group settings, or they are led astray from examining the real problem by getting fixated on a specific alternative. Some executives become overconfident in their ability to make good judgments, and then fail to examine a situation fully before reaching a conclusion, or they tend to focus on information that confirms their hunch before fully considering other evidence that goes against their intuition. The paper provides strategies for mitigating such tendencies or biases, and it outlines a five-step process to reach sound judgments.
Sandra Richtermeyer, accounting professor at Xavier University and the representative of the Institute of Management Accountants on the COSO board, says she often sees cases where directors or executives make hasty judgments without fully considering all the alternatives or possible consequences. “Management teams can spend weeks putting together information, but then maybe because of timing or a difficult decision earlier in a meeting, the board will zoom right by it and rush to solve a problem or approve an initiative,” she says. She sees significant benefit in giving executives and board members a process to follow to reach critical judgments. “Once you get used to doing it and realize the benefits of developing a process for critical decisions, you eliminate some of the risks of rushing to judgment,” she says.
PROFESSIONAL JUDGMENT PROCESS
Below are COSO's five steps to a professional judgment process:
(1)Define Problem and Identify Fundamental Objectives
(2)Consider Alternatives
(3)Gather and Evaluate Information
(4)Reach a Conclusion
(5)Articulate and Document Rationale
Defining the problem and identifying fundamental objectives
(step 1) is crucial in setting the stage for high-quality
judgments. Skipping this step can result in time wasted
solving the wrong problem, and it can severely limit the set
of alternatives available for consideration. It is important
to consider alternatives (step 2) because our judgment
can only be as good as the best alternative considered.
As we discuss subsequently, decision makers often skip
step 1 and consider an artificially constrained set of
alternatives because they are influenced by a judgment
trigger, which masquerades as a valid problem definition.
Gathering and evaluating appropriate amounts and types
of information, as indicated in step 3, is a critical step in
coming to an informed conclusion, which is step 4. Finally,
step 5 involves articulating and documenting the rationale
for the conclusion, which provides the decision maker(s)
an important opportunity to reflect on the rationale for a
judgment and on whether a sound professional judgment
process was followed. The inability to adequately articulate
the rationale for a conclusion often will reveal that a
decision may have been based on insufficient information or
may not have resulted from a good judgment process.
Source: COSO.
Susan Lister, national director of auditing for BDO USA, says she often sees decisions reached quickly as a result of overconfidence, described in the COSO paper as one of the obstacles to good judgments. “If you have someone in a position where they are making a decision time after time, they become confident they are in the best position to make the judgment, so they fall into a trap of not considering alternatives,” she says. Many corporations have developed a mantra that they want decisions to fall within a small circle of people to keep decision-making nimble. “I hear that all the time, but you may not have all the expertise in that small circle to make that judgment,” she says.
From an accounting perspective, she cites fair-value measurements and goodwill impairments as situations where perhaps the circle of decision makers should be a little larger than some companies would like to arrive at a good judgment. “It takes a lot of knowledge of the business, a particular product line, how the company operates, so many factors,” she says. “People who are used to making snap judgments really need to get more people involved on those challenging judgments.”
John Brackett, a partner with McGladrey & Pullen, says he sees plenty of the biases and traps described in the COSO paper at work. One that particularly resonated for him is the confirmation bias—the tendency for professionals to focus more on evidence that confirms what they already believe or want to believe. Not only do professionals gather more confirming evidence than disconfirming evidence, they place more confidence in it, he says. “We tend to weight the confirming information more heavily,” he says. “It is a deeply embedded, powerful human bias.”
Bill Watts, a partner with Crowe Horwath, says he sees some great potential for COSO's paper to pave a path to better decisions. “It's always helpful to give boards and audit committees more insight into what's in the minds of accountants and auditors,” he says.
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