Topic 10: Accounting policy, theory, and professional judgementTopic overview
Topic 10: Accounting policy, theory, and professional judgementTopic overview
As you have seen from your studies so far, maintaining accounting records, shaping accounting policies and generating financial statements is impacted by the professional judgement of decision makers. Whilst a range of accounting treatments are prescribed by the accounting standards, how they are applied often also involves a degree of decision making and therefore requires the application of professional judgement by the decision maker. These judgements shape the policies that organisations implement and how they recognise, measure and disclose items in the financial statements. These policies are also shaped by the accounting professions underlying body of theory The Conceptual Framework.
Topic rationale
By engaging in this learning you will be working towards the following learning outcomes:
be able to apply professional judgement in the preparation of financial statements for reporting entities in accordance with relevant professional and statutory reporting requirements;
be able to discuss and critique the statutory and professional requirements upon which published financial statements are based and their impact on practical situations and recent developments in accounting; and
be able to apply and analyse generally accepted accounting principles and specific financial reporting standards relating to concepts of recognition, measurement, disclosure, revaluation and impairment of key financial statement elements;
Accounting theories
The underlying theory of accounting, the conceptual framework can help guide the use of professional judgement. The conceptual framework outlines the objectives of financial accounting. Financial accounting should be useful for users such as investors and lenders in making resource allocation decisions. The conceptual framework also highlights the qualitative characteristics accounting should possess it should be relevant and provide a faithful representation of the underlying transactions and events. Therefore, when exercising professional judgement accountants need to ask questions such as:
What information is relevant to our key users?
What information will faithfully represent financial performance and position?
While the conceptual framework is a theory which tells accountantswhatthey should do, there are also accounting theories which can explainwhyaccountants (and their managers) exercise their professional judgement in particular ways, for example, through the choice of particular accounting methods or in relation to what additional information is disclosed to users. These theories, and the associated research, can be used to further inform standard setters when they update or write new standards.
What is the role of professional judgement in accounting theory?
Paragraph 11of The Conceptual Framework states:
To a large extent, financial reports are based on estimates, judgements and models rather than exact depictions. The Conceptual Framework establishes the concepts that underlie those estimates, judgements and models.
The judgement applied in the application of accounting standards determines and shapes an organisations accounting policies. You can see a summary version of this depicted in Note 1 of the annual report for reporting entities. These policies capture all of the key areas of the standards including how items are recognised, measured and disclosed in their financial statements.
What does this mean in the development of accounting standards, and therefore the preparation of financial statements? It indicates that the AASB (and the IASB) take a more principles based approach to the establishment of accounting standards. This means that Australian Accounting Standards tend to prescribe the principles that can be applied to a range of different situations, with the application of the standard involving subjective assessment in applying the principles to various situations (Loftus et al, page 43).
Reflect
Review an electronic copy of the conceptual framework (which can be downloaded from the AASB website) and search for the term judgement. Review each of these references as they provide an indication to you of the expectations of the AASB relating to the use of professional judgement by accountants in undertaking their role.
Hint: prepare a summary of the paragraphs where judgement is included and what this means for the role of the accountant.
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Professional judgement and the users of financial statements
Different users of financial statements have different information needs as reflected inparagraph 1.8of the Conceptual Framework
'Individual primary users have different, and possibly conflicting, information needs and desires.'
Accounting theories, developed through research, tell us that capital markets react when accounting results are released. These theories tell us that investors find accounting information useful and use it as a basis for resource allocation decisions, such as where they should (or should not) invest their money. These findings have also contributed to the identification of present and future investors as a key group of users within the conceptual framework. This is not the say that all users are exclusively interested in the share market, as others may use accounting to evaluate the performance of management. These two groups of users may be in conflict, because the former may want information about the future performance of the entity, while the later may be more interested the past performance of the entity.
Given the need to weigh up the different information needs of users, the AASB has developed the Conceptual Framework and accounting standards to achieve part of the boards mission in (the Conceptual Framework,SP1.5):
'...developing Standards that bring transparency, accountability and efficiency to financial markets in Australia. '
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The standard setting process
In prior weeks we have considered the role of the standard setters, including the Australian Accounting Standards Board (AASB) and the International Accounting Standards Board (IASB). The setting of standards is not a stagnant process and, as the world of business and accounting continues to evolve, so does on the role of our standard settings. As professionals of the future, you play a pivotal role in this process by being able to be involved in the standard setting process, providing commentary and assisting with the interpretation and application of standards.
ctivityUsing the table below as a starting point, summarise the use of professional judgement in the standards you have reviewed in ACG508. Consider the paragraphs in each standard that allow preparers of financial statements to choose from a number of options or requires estimation. How does the use of professional judgement in these scenarios impacts on the financial results presented in the financial statements of an entity?
Note:This summary is anessential outputfrom this topic and will be an essential resource in your study of Topic 11, Alternative methods of valuation.
Accounting standard Professional JudgementImpact on the financial statements
AASB 138 Intangible Assets Paragraphs 22 and 23 The probability of future economic benefits is assessed using reasonable and supporting assumptions with the standard acknowledging that the entity uses judgement to assess the degree of certainty attached Within the parameters of the standard, management assumptions and judgement will determine whether an intangible asset is recorded in the financial statements. If an intangible asset is recorded this will impact on the assets within the Statement of Financial Position as well as future amortisation, impairments or revaluations.
AASB 138 Intangible Assets Paragraphs 97 99 When amortising an intangible asset with a finite life, the organisation needs to use professional judgement in determining what is the useful like of the asset and which amortisation method they will apply. These decisions impact directly on the value of the asset in the statement of financial position and the amount of amortisation expense charged to the Profit and Loss.
As you prepare this summary, consider:
Are the points included in your summary above consistent with your notes relating to the Conceptual Framework?
How do these decisions potenially impact on the users of financial statements?
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Activity
During the session, we have reviewed the disclosures included in the financial statements of Woolworths. Select two standards from your summary above and review how professional judgement has been applied by Woolworths in the preparation of their Financial Statements. How has this professional judgement impacted on the financial results presented by Woolworths? How would this impact on your decision making if you were a user of these financial statements?
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Professional judgment and the profession
The importance and role of professional judgement in the accounting profession, is highlighted by the support offered by the professional bodies internationally including:
CPA AustraliaWe recognise that ethical dilemmas sometimes arise in business and we are here to help you make a sound professional judgement.
Institute of Chartered Accountants Australia New ZealandPerforming a quality audit in the current uncertain climate will require auditors to exercise heightened levels of professional judgement and professional scepticism in order to deal effectively with the range of challenges
Institute of Chartered Accountants of Scotland(ICAS) has developed a guide for preparers, auditors, regulators and standard setters titled a professional judgement framework for financial reporting
A professional judgement framework for financial reporting
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Activities to complete
This topic synthesises the content you have learned during this semester. To bring together your learning for this topic, you need toprepare your summary of all of the accounting standardsstudied this session, where professional judgement can be applied and how this impacts on the financial statements (as detailed above under the heading Using your professional judgement). You should then use your summary and apply what you have learned to a set of publicly available financial statements, such as Woolworths. Note that this summary is an essential resource for your next topic.
