Using Professional Judgment
By Guy Moore, Senior Advisory Partner for Professional Practice,
Deloitte & Touche LLP*
The meaning of professional judgment and its application in an audit environment continue to be subjects of interest and discussion by auditing and accounting faculty, students, standard setters, regulators and auditing professionals alike. As accounting frameworks continue to call for increased judgment by preparers of financial statements, the auditor assessing those judgments will in turn need to apply his or her professional judgment. What follows is one “view from the profession” about the meaning and importance of professional judgment, as well as one approach that may be employed when applying professional judgment.
The phrase “professional judgment” is not new to the accounting and auditing profession; however, there has been an increased emphasis on the importance of professional judgment as a result of regulation, standard setting, inspections, and a move toward more principles-based accounting and auditing standards. In its recent report**, the Advisory Committee on Improvements to Financial Reporting recognized the “need for a cultural shift towards the acceptance of more judgment” and recommended that both the SEC and PCAOB issue statements of policy articulating how the reasonableness of accounting and auditing judgments is evaluated. So while professional judgment may not be a new concept, its use is becoming increasingly more vital to the appropriate application of accounting and auditing standards.
Defining Professional Judgment
Professional judgment is a process used to reach a well-reasoned conclusion that is based on the relevant facts and circumstances available at the time of the conclusion. A fundamental part of the process is the involvement of individuals with sufficient knowledge and experience. Professional judgment involves the identification, without bias, of reasonable alternatives; therefore, careful and objective consideration of information that may seem contradictory to a conclusion is key to its application. In addition, both professional skepticism and objectivity are essential to the process and to reaching an appropriate conclusion.
Professional judgment is not an arbitrary decision, a substitute for professional skepticism, or a method to rationalize a particular result. Performing the process in “form” without focusing on the substance does not constitute well-reasoned professional judgment.
Professional judgment is critical to efficiently and effectively planning, performing, and concluding in an audit. Auditors use professional judgment to focus on the most important aspects of an audit; to determine the nature, timing, and extent of audit procedures; and to appropriately challenge the accounting, reporting, and other conclusions reached and financial statement assertions made by management.
Applying Professional Judgment
Because of the nature of the auditor’s professional responsibilities and the regulatory environment, the auditor’s judgments will most likely be challenged. Knowledgeable, experienced, and objective persons can reach different conclusions in applying professional standards despite similar facts and circumstances. This does not necessarily mean that one conclusion is right and the other is wrong. Appropriate questioning to understand the procedures performed and basis for conclusions reached is to be expected.
Contemporaneous documentation of professional judgments is important. Documentation demonstrates that a sound process was followed and helps the development of a well-reasoned conclusion. When professional judgment is challenged, contemporaneous documentation shows the analysis of the facts, circumstances, and alternatives considered as well as the basis for the conclusions reached. The extent of documentation and the effort expended in the process will vary with the significance and complexity of an issue.
When the professional judgment process is appropriately applied and contemporaneously documented, it is much easier to support and defend the conclusions reached. Conversely, decisions that appear to be arbitrary; not supported by the facts, evidence, or professional literature; or not well-reasoned or documented are difficult to support.
The sample framework that follows is an example of a common sense approach to reaching judgments based loosely on the work of the Advisory Committee on Improvements to Financial Reporting. It certainly is not the only approach to applying professional judgment, as there are multiple paths to reaching appropriate decisions and judgments.
Considerations When Applying Professional Judgment
IDENTIFY ISSUE: Identify the accounting or auditing issue requiring the use of professional judgment. Consider the following:
- Has the issue been sufficiently framed?
- Are there any related issues that need to be considered in the process?
GATHER THE FACTS: Objectively obtain a thorough understanding of the relevant facts and information available concerning the transaction, event, or situation. Consider the following:
- Have source documents and other materials been examined, knowledgeable client personnel interviewed, and other available sources of information considered?
- Were the appropriateness and reliability of the assumptions and data to be used in the analysis of the transaction or situation sufficiently assessed, tested, and objectively challenged by obtaining sufficient competent evidence?
REVIEW RELEVANT LITERATURE: Identify the accounting or auditing literature (or other standards and rules) relevant to the issue, keeping in mind the various authoritative pronouncements in the GAAP hierarchy and the different sources of professional auditing and attestation pronouncements. Consider the following:
- Has the relevant accounting or auditing standard been identified and reviewed, recognizing that reference to more than one authority may be appropriate to address the issue?
- Have the underlying principles in the relevant accounting or auditing literature been considered?
- To the extent that one particular authority does not address the issue directly, have other pronouncements or literature, by analogy, been considered as appropriate?
ANALYZE ISSUE: Apply the applicable accounting or auditing literature to the relevant facts and other information concerning the transaction, event, or situation and assess the most appropriate accounting treatment or auditing approach under the circumstances. Consider the following:
- Do the individuals addressing the issue have sufficient knowledge, experience, and objectivity for the matter being evaluated?
- Do additional resources need to be involved in addressing the issue?
- Have the reasonable alternatives been identified?
- Have the reasonable alternatives been analyzed, including the pros and cons of each alternative? For example, has all evidence been considered, including potentially contradictory evidence, and whether any negative evidence was outweighed by positive evidence?
- Has preferability or diversity in practice been considered?
- Has the business purpose and the form and substance of the transaction been analyzed?
- Have the audit risks and potential responses to those risks been analyzed? For example, if assessing the inherent risk of material misstatement of an account balance or assertion have the potential errors relevant to the account and the factors that could reasonably increase the likelihood of a material misstatement (by error or fraud) been analyzed?
- Has consideration been given as to whether the treatment that results from applying the relevant literature has been applied consistently to similar transactions, events, or situations?
Conclude and Document: Contemporaneously document the conclusion reached, with specific discussion of the issue; applicable facts and evidence gathered; relevant literature, policies, and guidance; individuals consulted; alternatives considered; analysis performed; and basis for the conclusion reached.
- Was the rationale for the alternative selected (including the reason why the selected alternative is preferred to other alternatives or reasons why the preferred alternative was not selected) documented?
- Has an assessment been made as to whether the effort spent in the process and the extent of documentation are consistent with the significance and complexity of the professional judgment reached?
**The Final Report of the Advisory Committee on Improvements to Financial Reporting to the United States Securities and Exchange Commission, issued on August 1, 2008, addressed the use of “reasonable judgments” in the accounting and auditing profession.
* This article contains general information only and Deloitte & Touche LLPis not, by means of this publication, rendering accounting, business, financial, investment, legal, tax, or other professional advice or services