A C C O U N T I N G & A U D I T I N G
financial reporting
Professional Judgment: A Model for Accounting
and Auditing Decisions
By James Schmutte and
James R. Duncan
T
he transition of U.S. compa-
nies from U.S. GAAP to
IFRS, along with the related
discu.ssion of rules-based versus prin-
ciples-based standards, is a hot topic
in accounting circles. Both sets of
standards derive from conceptual
frameworks of accounting princi-
ples. The differences exist in the
extent to which authoritative standards
provide guidance in implementing
those principles. The common ele-
ment—regardless of the standards
used^—is the need to exercise profes-
sional judgment in determining and
applying an appropriate approach to
account for and report a transaction
or event.
Similarly, professional judgment is
an increasingly important aspect of
the independent audit function.
Recently issued audit risk standards
reflect this emphasis; they describe a
broad process and the general types
of information the auditor should
acquire. The auditor must employ
judgment in using that information to iden-
tify the risks of material misstatements and
develop an appropriate audit response.
Professional judgment synthesizes the
collection of information and the resulting
conclusions.
This article presents a framework for
making accounting and auditing judgments
as recommended in the recently issued
report by the SEC's Advisory Committee
on Improvements to Financial Reporting
(CIFiR). The report's recommendations
focus on accountants and auditors of pub-
lic companies; however, the suggested
judgment prtxess, factors to consider, and
tniil of documentation equally apply to all
practitioners for both nonpublic and pub-
32
licly traded companies. Public Company
Accounting Oversight Board (PCAOB)
inspections and the A l C P A ' s peer
reviews reveal that documentation defi-
ciencies are common audit findings. This
article also provides an example for
preparers and auditors oï the profes-
sional judgment model to illustrate how
it can be applied to accounting and audit-
ing issues.
Background
In July 20Ü7. the SEC chartered the 17-
member CIFiR. whose mandate was to
examine the U.S. financial repiirting .system;
make recommendations to improve the
usefulness of fmancial information; and
reduce the complexity of the finan-
cial reporting system for investors,
prepaiers. and auditors. The final
report, issued in August 2008,
included recommendations in
live areas:
• Increasing the usefulness of
infonnation in SEC reports,
• Enhancing the accounting stan-
dards-setting prtx;ess,
• Improving the substantive design
of new accounting standards,
I Delineating authoritative inter-
À pretive guidance, and
' f •(Clarifying guidance on finan-
* cial restatements and accounting
: judgments.
Regarding accounting judg-
ments, the report specifically rec-
ommended that the SEC and
PCAOB issue statements of poli-
cy articulating how they would
evaluate the reasonableness of
accounting judgments, including
factors they would consider in
making their evaluations. The
AICPA subsequently encour-
aged the SEC to implement the
professional judgment recom-
mendations as an initial step in the
move to IFRS, In addition, the SEC's
study on mark-to-market accounting
issued in late 2008 echoed the CIFiR's
recommendations.
Areas of Professional Judgment
The CIFiR report cites several categories
of accounting and auditing judgments.
Judgment is often nece.ssitated not only in
the selection of an accounting standard but
also in its implementation. For example,
determining whether SFAS 144,
Accounting for the Impainnenl or Di.spo.sal
of Long-Lived Assets, is the applicable stan-
dard to address a potential asset impair-
ment is only the first step. Complying with
SEPTEMBER 2009 / THE CPA JOURNAL
ihe standiird requii-es a series of judgments
as to the amount, timing, and uncertainty
of the pnijected cash flows that are criti-
cal to its application.
All transactions and events, however,
do not neatly fall within the scope of
existing standards. In such situations, prac-
titioners need to apply judgment to iden-
tify the applicable underlying accounting
principle or, by analogy, extrapolate an
existing standard to address the reporting
situation. For example, an entity faced
with an Occupational Safety and Health
Administration (OSHA) violation may
look to the A I C P A ' s SOP 9 6 - 1 ,
Environmental Remediation Liabilities, as
addressing an analogous reporting and
iiccounting situation.
Accounting standards provide the gen-
eral framework for the structure of the
financial statements. The classification and
leporting of specific transactions, events,
or amounts within the financial statements,
however, often require elements of judg-
ment. This could include determining the
level of detail to provide within the state-
ments, the level of disclosure, or the clas-
sification of unusual or iionroutine trans-
actions or events.
Although sufficiency of evidence is typ-
ically considered an auditing issue, the pré-
parer of the fmanciai statements must also
exercise judgment in detennining whether
adequate support exists for the measure-
ment and reporting of transactions and
events. More complex transactions or more
subjectivity involved in the accounting
treatment or estimate increase the need
for evidential support for the judgments
made. For example, determining fair value
measurements under SFAS 157, Fair
Value Measurements, to situations where
Level 1 and Level 2 inputs are not avail-
able certainly presents both preparers and
their auditors with situations where sig-
nificant judgment is required in determin-
ing the adequacy of evidence to support
tlie estimates and reach a conclusion on the
actual valuation amount.
Levels of Judgment
In developing its guidance on judgment,
the CIFiR recognized that there are two
participants in the judgment process: I )
those who make the initial judgments;
and 2) those who may eventually evalu-
ate or challenge those judgments. The
SEPTEMBER 2009 / THE CPA JOURNAL
report's recommendations intend to pro- should consider guidance in the auditing
vide guidance to those who make the ini- standards, which describes an "experienced
tial judgments by encouraging the incor- auditor" as a benchmark. An interpretation
poration of factors that may be consid- of the auditing definition would indicate an
ered by those who subsequently determine experienced practitioner who possesses the
the appropriateness of those judgments. competencies and skills to understand the
Judgments in accounting and auditing are accounting and reporting issues relevant to
made at a point in time based on known the industry. The documentation should
relevant facts and circumstances. CíFiR notes provide such an evaluator with a com-
that using "hindsight" to evaluate earlier plete record of the judgment process and
judgments is not appmpriate. Subsequent the factors considered.
evaluations of the initial decision may be tar
removed from the time the initial decision Differences in Judgment
was made; accordingly, facts unavailable at The CIFiR report acknowledges that
the time of the initial judgment should gen- judgments could differ between experi-
erally not be considered. For this reason, con- enced, knowledgeable, and objective indi-
temporaneous documentation of the profes- viduals. The report stresses that those
sional judgment process establishes the infor- who subsequently evaluate the judgments
mation and inputs available at the time the of others should not consider such differ-
judgment was made. ences to imply that one judgment is cor-
Determining the fonn and extent of the rect and the other wrong, A clear record
documentation is yet another judgment of the judgment process and the factors
required of the accounting practitioner. In con.sidered can help reduce the possibility
making that decision, the practitioner of significant difference.
EXHIBIT 1
Factors Applicable to Making Accounting Judgments
1. The preparer's analysis of the transaction, including the substance and business
purpose of tiie transaction.
2. The material facts reasonably available at the time that the financial statements
are issued.
3. The preparer's review and analysis of relevant literature, including the relevant
underlying principles.
4. The preparer's analysis of alternative views or estimates, including pros and
cons for reasonable alternatives.
5. The preparer's consideration of known diversity in practice regarding the alter-
natives or estimates.
6. The level of input from people with an appropriate level of professional expertise.
7. The preparer's rationale for the choice selected, including reasons for the alter-
native or estimate selected, atid linkage of the rationale to investors' information
needs and the judgments of competent external parties.
8. The appropriateness and reliability of the assumptions and data used.
9. Linkage of the alternative or estimate selected to the substance and business
purpose of the transaction or issue being evaluated.
10. The preparer's consistency of application of alternatives or estimates to similar
transactions.
11. The adequacy of the amount of time and effort spent to consider the judgment.
Source: SEC Advisory Committee on Improvements to Financial Reporting (CIRR),
August 2008.
33

The CEO of a medí um-sized, privately held corporation informs the controller that she has just agreed with a shareholder to
repurchase the shareholder's stock at a fixed price over a four-year period. The CEO states that she does not want the agree-
ment to negatively affect the company's financial position due to the company's debt covenants, Below are the proper factors
the controller must consider in making a sound judgment.
Judgment Documentation Factor
1. Does ttie transaction make sense?
2. Do we have all the facts?
3. What does the literature say?
4. Are there any alternative treatments?
5. Are there any alternative or unique
industry practices?
6. Did we consult With any experts?
7. Why was this alternative selected?
8. Have we made all the relevant
assumptions and how reliable
are they?
9. Does it ail make sense?
ID. Is the proposed treatment
consistent with similar past
transactions?
11. Have we put enough time into
this issue?
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EXHIBIT 2
Illustrative Exampie
Case Example
The motivation behind the transaction is the shareholder's desire to convert his invest-
ments into more liquid assets for estate planning purposes and the CEO's desire to limit
new shareholders.
Obtain a copy of the agreement to determine the specifics related to the planned trans-
action, and ascertain from the CEO whether there are any "side agreements" related to
the transaction. Determine the planned subsequent treatment of the reacquired shares
(i.e., is the intent to retire the stock or hold it as treasury stock?).
Review authoritative literature such as:
SFAS 150—debt/equity,
ARB 43—treasury stock,
SFAS 47—disclosure of long-term obligations, and
FASB Concepts Statement 5,
Use the search capabilities of the FASB Accounting Standards Codification.
Consider possible accounting treatments such as: 1) a treasury stock transaction; 2) a
forward purchase agreement; 3) a stock retirement; 4) a reverse stock subscription; or
5) no financial statement recognition, but disclosure as a commitment
There do not appear to be any alternative or unique industry practices.
As the legality of stock repurchase and treasury stock transactions varies across juris-
dictions, the agreement should be reviewed by legal counsel. In addition, the company's
auditors may be consulted after preliminary research.
The agreement appears to fall under the guidance of SFAS 150 (as amended by FSP 150-3).
A liability is required to be recorded with an offsetting charge to stockholder's equity.
As the proposed treatment requires measuring the liability at the present value of the
future cash flows, the rate of interest needs to ba assumed. Propose using the
corporation's incremental borrowing rate.
Regardless of the desired reporting impact, the corporation has, in fact, incurred a
liability. The primary users (creditors) have an interest in the corporation's obligations.
The equity account charged must be consistent on both an accounting and legal basis.
There have been no similar prior transactions between the corporation and rts shareholders.
All of the previous steps likely employ significant time and effort The documentation
reflects the time and analysis devoted to the issue.
SEPTEMBER 2009 / THE CPA JOURNAL
 The CIFiR report cautions thaf adher-
ence to the recommended judgment pro-
cess does not preclude a preparer's judg-
ment from being questioned. A flawed
decision may not be supported, even if
appropriate factors were considered and
documented. Similarly, preparers who do
not make good faith attempts in the deci-
sion process can expect their judgments
to be challenged.
Factors Affecting the Judgment
Process
The CIFiR recommendations suggest a
structure for the judgment process in order
to improve the quality of ptx)fessional judg-
ments. The factors applicable to account-
ing (and auditing) judgments are listed in
Exhibit I. An illustrative example of their
application is provided in Exhibit 2. A brief
discussion of each factor follows.
Does the transaction make sense?
Many recent accounting scandals involved
transactions that lacked commercial sub-
stance or profit motive, or were structured
to achieve a desired financial reporting out-
come. The complexity of transactions can
range from the straightforward to the
obtuse. Accordingly, professional judgment
documentation should include an expla-
nation of the transaction's underlying busi-
ness ptirpose and the motivation or ratio-
nale for its structuring.
Do we have all the facts? The underly-
ing facts and circumstances should ulti-
mately drive the accounting and reporting
for a transaction or event. The dynamics
of the business environment, however, may
cause a change in the fact set between the
initial recording of a transaction and its ulti-
mate reporting in the financial statements.
Proper documentation should include not
only the material facts at the date of the
initial recording of the transaction but
also a consideration of the impact of any
subsequent changes through the release of
the financial statements.
What does the literature say? The ini-
tial source for financial reporting guid-
ance should be the relevant standards, such
as U.S. GAAP. IFRS, or SEC regula-
tions. Where possible, the relevant
authoritative standards should be eited. In
situations not directly addressed in the stan-
dards, the préparer should consider alter-
native guidance by adopting a principles-
based approach or applying, by analogy.
SEPTEMBER 2009 / THE CPA JOURNAL
an existing standard. In any case, the doc-
umentation should provide a clear record
of the logic and underlying literature uti-
lized to support the accounting and
reporting decisions.
Are there any alternative treatments?
Not every analysis of the accounting or
reporting for a transaction or event will
necessarily lead to a single treatment. In
cases without a clear conclusion, the
altematives should be evaluated, citing their
strengths and weaknesses. The altematives,
however, should be evaluated based on
their theoretical merits rather than a desired
financial reporting outcome.
Are there any altematm or umpie indus-
try practices? in cases where the accounting
treatment selected is but one of several
altematives used in practice, the rationale
for the superiority of the selected reporting
should be demonstrated. This documentation
could be incorporated with the evaluation of
altemative treatments cited earlier.
Did we consult with any experts? In
many instances, it may be necessary to
consult with or obtain input from other
individuals with expertise in areas other
than accounting (e.g., attorneys or valua-
tion professionals). In such instances, the
documentation should include the rele-
vant input identified by its source and the
credentials of the expert.
Why was this altemative selected? Once
the analysis is completed and the solution
identified, the documentation should con-
nect the dots by providing the logical trail
that leads to the conclusion. Included in the
documentation should be the consideration
that the ultimate goal of financial report-
ing is meeting the informational needs of
the anticipated extemal users of the finan-
cial statements. An understanding of the
primary user and the application of the
financial statements is an important con-
sideration throughout the process.
Have we made all the relevant assump-
tions and how reliable are they? By its
nature, the accounting process is based on
assumptions and estimates. In cases
where assumptions represent a critical
element in the accounting treatment, the
documentation should include a determi-
nation of all relevant assumptions and their
reliability, as well as an analysis of their
sensitivity on the accounting treatment.
Does it all make sense? The documen-
tation should close the loop by tying
together the substance of the original trans-
action or event and its ultimate account-
ing treatment. At this point, the relevant
questions to be answered are 1) does the
accounting still make sense: and 2) has the
economic substance of the transaction been
reflected in the accounting and reporting?
/$ the proposed treatment consistent with
similar past transactions? If the entity has
experienced similar transactions or events in
the past, the préparer should determine
whether the current proposed treatment is
consistent with that utilized in prior peri-
ods. If the treatments vaiy, the two ^proach-
es should be reconciled, and, if necessaiy,
consideration should be given to revising or
comxdng the earlier application.
Have we put enough time into this
issue? All accounting judgments are not equal
in complexity, materiality, or uncertainty.
Some are of a recurring nature, while others
are nonroutine. Transactions and reporting
issues out of the ordinary, complex in their
structure, or material to the financial state-
ments can be expected to require greater time
and energy in determining the appropriate
accounting treatment. TTie associated docu-
mentation will likely vary acrossreportingsit-
uations. Contemporaneously prepared docu-
mentation should reflect the time and energy
invested in making the judgment. The
underlying purpase of the documentaticm is
to substantiate not only the accounting or
reporting decision but al.so the process of
applying pofessional judgment
Making Sound Judgments
Professional judgment has always been
a critical element in accounting and audit-
ing. The trend in professional standards set-
ting is to provide less specific guidance and
a requirement for greater use of profes-
sional judgment. Accordingly, accounting
practitioners can expect to find their judg-
ments subsequently questioned or chal-
lenged. Adherence to an adequate judg-
ment provides a framework for improv-
ing the quality of judgments in general and
can be instrumental in helping to make
judgments more defensible. Ü
James Schmutte, DBA, CPA, is a profes-
sor and James R. Duncan, PhD, CPA, is
an associate professor, both in the
department of accounting at Ball State
University, Muncie, Ind
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