Judgment Sustained

The preparation and audit of financial statements have always required the exercise of judgment. The trend entails a move away from prescriptive guidance toward greater use of judgment – for example, fair value involves estimates that may be less objectively determined than historical cost measures. Similarly, auditing standards on internal control over financial reporting emphasize the need for professional judgment in taking a risk-based approach to internal control audits. Moreover, International Financial Reporting Standards (IFRS) rely on general principles.

Poor judgment in accounting can be costly. Despite the use of rules-based standards, poor judgment is one of the leading reasons for failed financial reporting. A 2006 study suggests that poor judgment is the second-leading contributing factor for restatements (refer to Stephen Taub, “Study Points Restatement Blame Back at Cos.,” Compliance Week, March 25, 2008). Flawed financial reporting is a serious outcome in itself, but many other aspects of business performance, such as financial planning, brand and reputation, are also exposed to significant risk through poor judgment.

Broadly speaking, there are two ways of reasoning (Stanovich and West, “Individual differences in reasoning: Implications for the rationality debate,” Behavioral & Brain Sciences, 23, 2000, 645–665). The first is an intuitive “gut feeling” about situations. This method of decision processing works quickly and instinctively, but it is sometimes an emotional reaction. The second is a more analytic, holistic, thoughtful approach to making decisions, perhaps using a framework. Clearly, a judgment framework is not a silver bullet, but research shows that it can work in various contexts, particularly ethics. While everyone has biases, there are some explicit strategies that can ameliorate some of the most common ones.

According to the US Securities and Exchange Commission (SEC) Committee on the Improvement of Financial Reporting (“CiFR”), a judgment framework is a critical and good faith thought process (see Final Report, pages 88-96). It is important to remember, however, that professional judgment is not formulaic. No judgment framework will result in consistently correct and effective decisions, but using a judgment framework could lead to greater consistency in decision making and practice.

To learn more, read “Judgment Sustained” in Deloitte Review online. This web article offers a view on using a judgment framework. It was prepared by: Shelley Barrows, partner, Assurance Services, Deloitte & Touche LLP and a fellow with Deloitte Idea Labs; Vikram Mahidhar, senior research manager and director of operations for Deloitte Research, Deloitte Services LP; and Ajit Kambil, global research director for the CFO Services, Deloitte Services LP.