Consequences of Poor Judgment: Why It Matters
Exercising professional judgment is not just an academic exercise – it has real consequences for companies, investors, and markets. Poor judgment or misjudgment in applying accounting standards can lead to a host of negative outcomes, both for those making the decisions and for stakeholders relying on the financial statements. Understanding these risks underscores why developing good judgment is so critical. Here, we discuss a few key consequences: regulatory scrutiny and sanctions, financial restatements and associated costs, erosion of investor and public trust, and internal business impacts.
- Regulatory Scrutiny and Enforcement: Companies that make aggressive or unjustifiable accounting judgments can draw the ire of regulators like the SEC (in the U.S.), FRC (in the U.K.), ESMA and national enforcers (in Europe), or other securities commissions around the world. These bodies review financial reports and, if they find that judgments deviate from standards or from economic reality, they can demand revisions, impose fines, or in severe cases pursue legal action for securities fraud. For example, the U.S. SEC often issues comment letters to companies, challenging revenue recognition methods or impairment conclusions that seem questionable, essentially asking the company to defend its judgment. If the explanation isn’t satisfactory, companies may be forced to change their accounting or provide more disclosure. A notable case was the early 2000s when several tech companies were sanctioned for their judgment in recognizing revenue on software contracts – the SEC found they had too eagerly booked revenue without sufficient evidence of delivery or collectability. In recent years under principles-based standards, we see regulators focusing on areas like IFRS 15 and IFRS 16 judgments in their reviews. ESMA, for instance, issued a public statement urging consistency and adequate disclosure in applying judgment under IFRS 9 during COVID. If a bank was too slow to recognize credit deterioration, regulators could step in (some did pressure banks to be more forward-looking, effectively adjusting their judgment approach). For companies, being under regulatory spotlight can damage reputation and consume significant management time. And if enforcement finds a material misstatement, the consequences escalate to restatement and possibly penalties. Regulatory findings often become public (through enforcement releases), which can be embarrassing – essentially highlighting that the company’s judgment was flawed or biased. This is a strong incentive for boards and audit committees to ensure judgments are solid: none want their company to be the example in an enforcement case of “how not to apply IFRS.” In extreme cases, poor judgment can be construed as fraudulent if it appears there was intent to mislead. For instance, judgment that consistently falls on the most favorable extreme of a reasonable range might be viewed as crossing into earnings management. While judgment by nature allows a range, always picking the rosier end without basis could be seen as deliberate bias. Enforcement can then involve individual accountability for CFOs or others (fines, bans). In short, regulators serve as a backstop to overly poor judgment – and facing them is a costly affair.
- Restatements and Financial Corrections: Poor judgment often eventually reveals itself through errors that require correction. If a company’s interpretation of a standard or estimate proves wrong to the point of material misstatement, a restatement of prior financials may be necessary. Restatements are serious: they often cause stock price declines, increase the cost of capital, and can trigger lawsuits. For example, if a company aggressively recognized revenue (through flawed judgment on performance obligations or principal/agent status) and later under pressure re-evaluates and reverses some of that revenue, it will have to restate those prior results lower. Not only does this directly hit retained earnings, but investors lose confidence in management’s credibility. Restatements can lead to management shake-ups; CFOs or CEOs sometimes resign in their wake. Even if personnel remain, their attention gets diverted to remediation – improving controls, getting audits of restated periods, etc. The process can be extremely costly, both in fees (auditors, lawyers) and in opportunity cost. A study by the U.S. GAO in the mid-2000s found that restatement announcements led to an average stock price drop of several percent and often permanently lower market valuations. And these were often due to accounting judgments or choices that were later deemed mistakes. For instance, many companies had to restate around lease accounting in the mid-2000s (for lease term and renewal option misjudgments under the old rules) and more recently, a few have restated after IFRS 15 adoption because they realized their initial judgments on something like agent vs principal were not tenable. Beyond the direct impact, restatements can put a company at risk of breaching debt covenants (if earnings or equity are revised down). They also attract plaintiff lawyers – shareholders may sue claiming the company misled them (even if it was “just” a judgment error, in hindsight it appears as misrepresentation). Thus, consistent high-quality judgment is a first line of defense against restatements. We should note, not every change in judgment leads to restatement; companies can change estimates prospectively without restating (like revising useful life or credit loss estimates as conditions change). That’s normal and expected. Restatements occur when the prior judgment is deemed not in accordance with GAAP/IFRS – essentially an error. So, staying on the right side of the principle (and documenting well) can be the difference between a defensible estimate change vs. a correction of an error.
- Erosion of Investor and Market Trust: Financial statements are a cornerstone of trust between a company and its stakeholders. If judgments embedded in those statements turn out to be consistently overly optimistic, self-serving, or volatile, investors’ trust can erode. For example, say a company always just meets earnings targets by using the maximum discretion possible (lowering provisions, stretching revenue, etc.). Investors and analysts may catch on – they might notice that the company’s working capital or other signals suggest earnings quality issues (e.g. revenue up but receivables way up too, indicating maybe aggressive revenue recognition). This can lead to a market “trust discount” on the stock. Conversely, companies known for conservative, transparent accounting often trade at a premium because investors feel more confident in the reliability of earnings. Warren Buffett has often emphasized the importance of candid financial reporting and not hiding bad news – precisely because trust is invaluable. If a company surprises the market with a big write-down that could have been anticipated, trust dips. Research has shown restatement companies face higher bid-ask spreads (a sign of perceived risk) and sometimes permanently higher cost of equity. It’s not just investors: lenders might become wary if they think a company’s judgments (say on asset values or covenants) are too rosy – they may restrict credit or demand more covenants. Credit rating agencies also pay attention to aggressive accounting as a risk factor. There’s also reputational trust: management’s standing in the business community can suffer if they’re seen as having “cooked” the numbers even subtly. The late 1990s and early 2000s provided stark examples – companies like Enron, WorldCom, etc., destroyed trust not only in themselves but shook trust in capital markets, leading to Sarbanes-Oxley Act reforms. Those were egregious cases, but even less extreme poor judgments chip away at the credibility of financial reporting, which is a public good. The entire principle-based system relies on users believing that management is applying standards in good faith. If too many instances of poor judgment come to light, it could increase calls for more rules (“if companies abuse principles, maybe we need bright lines again” – a debate that surfaces after every accounting scandal). Thus, there’s a broader consequence: patterns of poor judgment can influence standard-setting and regulation trends, perhaps in ways preparers wouldn’t like (like reintroducing prescriptive elements).
- Investor Decision-making and Valuation Impact: If investors suspect poor accounting judgment, they may adjust their analysis, often to the detriment of the company. For instance, if a company reports profits but investors think revenue recognition is aggressive or provisioning too light, analysts might “haircut” those profits in their valuation models (maybe using lower earnings or adding a risk premium). That can lead to lower stock prices or difficulty raising capital. So ironically, trying to make numbers look better through aggressive judgment can backfire by undermining confidence in those very numbers. Real-world example: some banks in the lead-up to the 2008 crisis were slow to recognize asset quality problems. The market, however, started heavily discounting their book values, essentially saying “we don’t believe your assets are worth what you say.” Eventually the write-downs happened, confirming market suspicions. It would have been better if they had been more upfront; in times of uncertainty, transparency can bolster confidence (even if the news is bad) because it reduces uncertainty. As another example, in 2020 some companies took big COVID-related impairments or provisions while others in similar straits did not. Investors often penalized those that didn’t take obvious write-offs, on the theory they were delaying the inevitable. In this way, market discipline sometimes punishes poor judgment in real time, even before regulators do.
- Operational and Internal Consequences: Within a company, poor accounting judgments can mislead management itself. Good internal decision-making relies on realistic assessments – for example, if expected credit losses are underestimated in accounting, that might lull management into a false sense of security about credit risk and they might extend too much credit. Or if revenue is pulled forward unsustainably, it might hide underlying sales problems until it’s too late to correct course. While one might argue management should know the “true” situation beyond the accounting, in practice accounting numbers feed into KPIs and can influence decisions and behavior (the term “management myopia” – chasing short-term accounting results at the expense of long-term health is a known phenomenon). Therefore, consistently unbiased judgment in financial reports also helps ensure management’s dashboards are telling the truth. Another internal consequence is morale and culture: accountants and finance staff who feel pressured to make dubious judgments (for example, being told to “find a way” to avoid an impairment) may become cynical or disengaged. It can create ethical conflicts and a toxic environment, leading to turnover or even whistleblower situations. On the flip side, a culture that supports quality judgment (even if results suffer sometimes) fosters integrity and pride among finance professionals, which in turn strengthens the organization. The development of judgment capabilities (addressed in the next section) is also easier in a culture that values doing the right thing over just the convenient thing.
In summary, poor judgment can set off a domino effect: misstated financials → regulatory intervention/restatements → loss of investor trust → higher capital costs or stock decline → possible legal issues and internal fallout. The cost far outweighs any short-term benefit that might have been gained by a rosy portrayal. That’s why most companies truly aim to get judgments right and err on the side of conservatism when in doubt. The adage “it’s not the crime, it’s the cover-up” applies in accounting too: often the attempt to fudge or overly delay recognition leads to worse outcomes than an earlier acknowledgment would have.
Principle-based standards give latitude, but they come with the expectation of responsibility. When that responsibility is not met – when judgment is exercised poorly – the system has corrective mechanisms, from auditors qualifying opinions (worst-case if disagreements on judgment are intractable), to regulators enforcing corrections, to investors pricing in their skepticism. All of these consequences underscore a vital point: sound professional judgment is not just a technical nicety; it is foundational to the integrity and smooth functioning of financial markets. Developing and maintaining that judgment is thus in everyone’s interest – companies, auditors, regulators, and investors alike.