Auditor Judgment Frameworks; or Principles-Based versus Rules-Based Accounting Standards Part II
A recent paper by Backof, Bamber, and Carpenter (2011, International Financial Reporting Standards and Aggressive Reporting: An Investigation of Proposed Auditor Judgment Guidance) investigates auditors’ judgments under IFRS and US GAAP. The authors conduct an experiment where 200 auditors from a Big 4 accounting firm were asked whether they agree with management’s preferred accounting methods for two different transactions. The first transaction is revenue recognition where management wishes to aggressively recognize revenues in the current period. The authors characterize this transaction as one where it’s unclear whether the underlying economics justifies early or late recognition of revenue (high ambiguity). The second transaction is a lease contract where management desires to account for the lease off balance sheet. The authors characterize this transaction as one where the underlying economics clearly suggests recognizing the debt on balance sheet (low ambiguity). For both transactions, current US GAAP provides more bright lines guidance (i.e., rules-based) relative to IFRS that dictates how companies should account for the transactions. The study is enriched by the fact that the U.S. GAAP rules support the management preferred method under the lease accounting scenario, but does not support the aggressive revenue recognition. In contrast, the less precise IFRS could be used to support or refute management’s preferences for both transactions.
The experiment addresses two research questions. The first question is whether bright-line rules are more or less effective at curbing management’s aggressive reporting. As indicated in a prior post (here), arguments could be made either way on this issue. From this base case, the authors next examine how various auditor judgment frameworks affect the extent to which auditors curb aggressive reporting under both sets of standards.
Perhaps coincidentally, the study examines two transactions related to joint FASB/IASB convergence projects where the accounting differences are likely to disappear. Nevertheless, it has important implications for how auditors are likely to behave as standards move from being rules-based to more principles-based and the potential advantages from developing/employing an auditor judgment framework. As noted in the study, the Advisory Committee on Improvements to Financial Reporting (CIFiR) proposed judgment guidance, which would presumably yield higher quality auditor judgments (in addition, a judgment framework potentially could protect auditors from adverse legal judgments by providing explicit support for their decisions). This study directly tests this assertion.
The findings from the study can be summarized as follows. First, auditors are able to more effectively curb management’s aggressive reporting under less precise IFRS for the lease transaction (low ambiguity). This result reflects favorably on principles-based standards. In contrast, auditors were more likely to support management’s preferred revenue recognition approach under IFRS. The authors place a negative connotation on this latter result as corroborating concerns that less precise standards are unable to curb management’s aggressive reporting when the underlying economics are ambiguous. However, it’s not clear to me that the “aggressive reporting” under this highly ambiguous transaction is necessarily inappropriate. In other words, it’s possible that most auditors (and users) would believe that early recognition is appropriate even without knowing management’s preference. Therefore, while the paper seems to interpret this finding as an indictment against principles-based standards when the economics are ambiguous, I’m not sure we can definitively arrive at that conclusion.
With regard to the second research question, the study finds that employing a judgment framework is effective at further curbing management’s aggressive behavior, but only in cases when the underlying economics are not ambiguous (lease contract) and the standards are less precise (no bright-line rules). None of the frameworks seemed to have any effect on auditor’s judgments when bright-line rules are used in the standards (i.e., the frameworks can’t overcome the effects of the bright-line rules) or even under less precise standards when the economics of the transaction is ambiguous.
The results from this study should be of interest to the FASB and IASB as they deliberate and promulgate standards that are based on principles and the potential effects of bright-line rules on auditors. In addition, the PCAOB and the SEC should be interested in the evidence as it relates to developing auditor judgment frameworks.