This article is the fifth in a series of articles that takes our readers on a journey through International Financial Reporting Standards (IFRS) with a special focus on the standards’ quintessential feature: they are principles-based. In this article, we explain how the exercise of judgment is not the result of obscure decisions but rather is intended to be the result of a thoughtful process that combines two major ingredients: knowledge of principles-based IFRS, and sound and professional business and accounting knowledge.
Perhaps the first thing that crosses one’s mind when comparing the word “principle” with the word “rule” is that a rule offers a higher degree of certainty, provided it is well formulated and detailed. A principle might initially be perceived as less prescriptive and subject to a higher degree of interpretation. In other words, when we move from an environment characterized by rules to an environment characterized by principles, we could say that we enter a sort of unknown territory dominated by a not-well-defined process called “exercising judgment.”
The Oxford English Dictionary defines “judgment” as: “The ability to make sensible decisions after carefully considering the best thing to do.” Interestingly, that dictionary gives the following exemplification, among others, for how the word “judgment” can be used: “It is not something I can give you rules for; you’ll have to use your judgment.” This example describes very well the idea behind a set of principles: principles extend where rules, by definition, cannot arrive.
Contrary to popular belief, the exercise of judgment is not the result of an uncontrollable obscure process. In fact, using the words of the Oxford English Dictionary, the exercise of judgment is more like a “sensible” and “careful” journey that can be undertaken only after carefully considering “the best thing to do” – i.e., by having a good knowledge and understanding of the core principles underpinning IFRS. The following steps might constitute some milestones along the journey of exercising judgment.
Preliminary Considerations
- Focus on the substance of the transaction from a business standpoint. Understanding the economic rationale of the transaction is a fundamental prerequisite.
- Forget about IFRS and U.S. generally accepted accounting principles. As an experienced accountant basing your analysis on the principle of substance over form, what would you consider to be the proper accounting treatment to be applied?
Analysis of IFRS
- Identify the possible accounting alternatives that can be used under IFRS.
- Consider all relevant IFRS literature, including IASB staff discussion papers that resulted in the issuance of the IFRS.
- Analyze what peers and competitors did in similar situations. What is the industry practice?
- Verify whether there are applicable regulatory enforcement decisions.
Build a Case
- Document the process that led to a final decision, explaining the reasons for the decision. That is, reply to the following questions: Why is alternative A preferable to alternative B? According to what IFRS literature does this make sense?
- Consult other views and share your opinion.
It is likely that at the end of this journey the exercise of judgment is not as obscure as we thought. However, this process takes time and effort, and there are no miraculous shortcuts that can be taken. Ultimately there is no better recipe than explaining why alterative A is preferred over alternative B and what the consequences are.
Readers of financial statements will have all the information they need to make informed decisions. Sometimes artificially reducing inherent uncertainty to a black and white situation does not add very much to transparency. In certain cases it is not a question of right vs. wrong, but rather a question of transparent information vs. lack of information. Possibly in such cases, what is meaningful is explaining why a certain decision has been made, rather than simply saying what the decision was. |