Professional Judgment Framework In CIFiR’s Draft Progress Report
February 11, 2008
In its Draft Progress Report (DPR) dated Feb. 11, 2008, the U.S. Securities and Exchange Commission’s (SEC's) Advisory Committee on Improvements to Financial Reporting (CIFiR or the ‘Pozen Committee’ for its chair, Robert Pozen) made the following proposal ('developed proposal 3.4') relating to the use of a professional judgment framework (bulleted for empahsis, not bulleted in the original):
- The SEC or its staff should adopt a judgment framework for accounting judgments.
- The SEC or its staff should also encourage the PCAOB to consider similar action with respect to auditing judgments.
Careful consideration should be given in implementing any framework to ensure that the framework does not limit the ability of auditors and regulators to ask appropriate questions regarding judgments and take actions to require correction of unreasonable judgments.
The proposed framework applicable to accounting-related judgments would include the choice and application of accounting principles, as well as the estimates and evaluation of evidence related to the application of an accounting principle.
CIFiR is scheduled to vote at its February 11 meeting on whether to ‘publish’ its progress report. ‘Publication’ of the progress report likely refers to formal delivery of the report to the SEC Chairman, and posting of the report by the SEC for public comment, if the process follows that of an earlier SEC advisory committee on small business.
Below is the "Professional Judgment Framework" excerpted verbatim from CIFiR's February 11 DPR. Footnote references conform to numbering in CIFiR's DPR. The framework proposes nine components that exhibit professional judgement, and recommends related documentation requirements.
Framework for Professional Judgment in Accounting
The Concept of Professional Judgment
Professional judgment, with respect to accounting matters, should be the outcome of a process in which a person or persons with the appropriate level of knowledge, experience, and objectivity form an opinion based on the relevant facts and circumstances within the context provided by applicable accounting standards. Professional judgments could differ between knowledgeable, experienced, and objective persons. Such differences between reasonable professional judgments do not, in themselves, suggest that one judgment is wrong and the other is correct. Therefore, those who evaluate judgments should evaluate the reasonableness of the judgment, and should not base their evaluation on whether the judgment is different from the opinion that would have been reached by the evaluator.
This framework would serve as the primary, though not exclusive, approach to evaluating the process of making professional judgments. While regulators would strongly support the principles of this framework, the mere completion of the process outlined in the framework in making a judgment would not prevent an auditor and/or regulator from asking appropriate questions about the judgment or asking companies to correct unreasonable judgments. A judgment framework would not eliminate debate, nor should it attempt to do so. Rather, it organizes analysis and focuses preparers and others on areas to be addressed thereby improving the quality of the judgment and likelihood that auditors59 and regulators will accept the judgment. Conversely, not following the framework would not imply that the judgment is unreasonable.
This framework acknowledges that GAAP do not always reflect the economic substance of a transaction and that it may be difficult to determine how the accounting would meet the needs of investors. In addition, this framework would be applicable to accounting matters only to the extent that judgments were required in the choice or application of accounting principles, in estimating the amount to record, or in evaluating the sufficiency of the evidence.
In applying the components of the framework, it would be expected that the amount of documentation, disclosure, input from professional experts,60 and level of effort in making a professional judgment would vary based on the complexity, nature (routine versus non-routine) and materiality of a transaction or issue requiring judgment.
59 It should be noted that, while auditors should be using the framework to evaluate a client’s judgments and should respect reasonable judgments, they still have a requirement to follow PCAOB auditing standards, which would include expressing an opinion regarding whether the client’s financial statements are fairly presented, in all material respects, in accordance with GAAP. Therefore, this framework would not require auditors to issue an unqualified audit opinion when they disagree with a judgment.
60 In many cases, input from professional experts would include consultation with a preparer’s independent auditors.
[NOTE: Following are the “Components of a (Professional Judgment) Framework” (including a list of nine components that would exhibit a “Critical and Good Faith Thought Process,” and related requirements for “Documentation,” as excerpted directly from CIFiR’s DPR. Footnote references conform to numbering in the DPR.]
Components of a Framework
Critical and Good Faith Thought Process – Professional judgment should be based on a critical and reasoned evaluation made in good faith, prior to the exercise of the judgment, of an identified issue, including the nature and scope of the issue based on:
1. An analysis of the transaction, including the substance and business purpose of the transaction
2. The material facts reasonably available at the time that the financial statements are issued
3. A thorough review and analysis of relevant literature, including the relevant underlying principles
4. Alternative views or estimates, including pros and cons for reasonable alternatives
5. The rationale for the choice selected, including reasons for the alternative or estimate selected and linkage of the rationale to investors’ information needs and the judgments of competent external parties
6. Linkage of the alternative or estimate selected to the substance and business purpose of the transaction or issue being evaluated
7. Diversity in practice regarding the alternatives or estimates61
8. The consistency of application of alternatives or estimates to similar transactions
9. The appropriateness and reliability of the assumptions and data used.
The critical thought process should include input from personnel with an appropriate level of professional expertise and should include a sufficient amount of time and effort to properly consider the judgment.
Material issues or transactions that were analyzed pursuant to the application of the framework should be disclosed in accordance with existing disclosure requirements. This disclosure should be transparent and clear so that the investor understands the transaction and assumptions that were critical to the judgment. When evaluating professional judgment, auditors, and/or regulators should take into account the disclosure relevant to the judgment.
Documentation – The alternatives considered and the conclusions reached should be documented contemporaneously. The lack of contemporaneous documentation may not mean that a judgment was incorrect, but would complicate an explanation of the nature and propriety of a judgment made at the time of the release of the financial statements.
61 If there is not diversity in practice, it would be significantly harder to select a different alternative.
Prepared Feb. 11, 2008 by Edith Orenstein, Director, Technical Policy Analysis, Financial Executives International (FEI). The Professional Judgment Framework and Components of a Framework cited above are excerpted directly from the SEC Advisory Committee on Improvements to Financial Reporting (CIFiR) Draft Progress Report dated Feb. 11, 2008. This summary does not represent FEI opinion unless specifically stated above.