Framework for Professional Judgment Recommended by SEC CIFR
January 11, 2008
FEI Summary
Following is the “Framework for Professional Judgment in Accounting” recommended by the U.S. Securities and Exchange Commission (SEC) Advisory Committee on Improvements to Financial Reporting (CIFR) in its the Draft Decision Memo (DDM) dated January 11, 2008.
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 forms 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 auditors and regulators will accept the judgment. Conversely, not following the framework would not imply that the judgment is unreasonable.
This framework also acknowledges that generally accepted accounting principles 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. Therefore, 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 and level of effort in making a professional judgment would vary based on the complexity, nature (routine vs. non-routine) and materiality of a transaction or issue requiring judgment.
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:
a. Analysis of the transaction, including the substance and business purpose of the transaction;
b. The facts reasonably available at the time that the financial statements are issued;
c. A thorough review and analysis of relevant literature, including the relevant principles;
d. Alternative views or estimates, including pros and cons for reasonable alternatives;
e. Rationale for the choice selected, including reasons for alternative or estimate selected and linkage of rationale to investor’s information needs and the judgments of competent external parties;
f. Linkage of the alternative or estimate selected to the substance and business purpose of the transaction or issue being evaluated;
g. Diversity in practice regarding the alternatives or estimates;22
h. Consistency of application of alternatives or estimates to similar transactions; and
i. 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 sufficiently transparent to inform the user of the financial statements about the substance of the transaction, including the relevant rights, obligations, risks and rewards, the relevant accounting principles, and the key assumptions that went into 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 make it more difficult to support an assertion as to the nature and propriety of a judgment made at the time of the release of the financial statements.
Prepared January 11, 2008 by Edith Orenstein, Director, Technical Policy Analysis, Financial Executives International (FEI). This summary does not represent FEI opinion unless specifically stated above.