Select Commitees Will Push for Auditor Professional Judgment Rule

There is a growing consensus that independent auditors of corporate financial statements need a professional judgment rule to protect them in the age of principles-based regulation. Two important committees formed by the Treasury Department and the SEC are coming to the conclusion that the adoption of a professional judgment framework or rule may be necessary for the success of principles-based standards, such as the PCAOB’s Auditing Standard No. 5 for internal controls.

Recent testimony before the Treasury’s Advisory Committee on the Audit Profession revealed a growing need for a professional judgment rule.Cynthia Fornelli, Executive Director of the Center for Audit Quality, urged the committee to ask the SEC and PCAOB for a rule or a framework for the exercise of auditor professional judgment. The Treasury committee is co-chaired by former SEC Chair Arthur Levitt and former SEC Chief Accountant Don Nicolaisen.

She cautioned that a professional judgment rule can only work if preparers and auditors trust that well-reasoned, good-faith judgments will be evaluated in an environment of professional respect. In that spirit, the professional judgment rule should be carefully crafted to reflect real-world audit experiences and be clear enough to avoid the need for interpretation.

The rule should take into account the fact that the judgments made during the financial reporting and audit processes can only reflect the information available at the time, not information that becomes available after the audit is concluded. If done properly, emphasized the executive director, a professional judgment rule will benefit all stakeholders by providing an environment where investors know that preparers, auditors and regulators act in good faith and have rational bases for their decisions.

Barry Salzberg, Deloitte CEO, also urged the Advisory Committee to ask the SEC to adopt a rule recognizing the essential role of good faith professional judgment in financial audits. The importance of auditors using professional judgment is recognized in PCAOB auditing standards, he noted, but professional judgment is not always accepted by either regulators or civil litigants. In his opinion, the fear of being second-guessed impacts the quality of financial accounting and auditing. He also observed that auditor exercise of professional judgment becomes even more important in an age of principles-based standards and IFRS.

At the same time, the SEC’s Advisory Committee on Improvements to Financial Reporting is also moving toward a professional judgment framework as a main theme of its work. The SEC committee believes that a framework should be consistent with principles to cover judgments made by auditors based on the application of PCAOB auditing standards. Thus, the committee proposes that the PCAOB develop a professional judgment framework for the application and evaluations of judgments made based on PCAOB auditing standards.

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 a number of factors, including an analysis of the transaction, the substance and business purpose of the transaction, as well as the material facts reasonably available at the time that the financial statements are issued.