Applying Principles: Developing Judgment in Complex Accounting Standards

Strengthening the Judgment Process: Documentation and Substance over Form

Given the pivotal role of judgment, both preparers and auditors must approach ambiguous or complex transactions with a structured reasoning process. This involves several best practices: thorough documentation, consultation with others, consideration of alternatives, and an unwavering focus on substance over form. Below, we break down how accountants and auditors can structure their process to develop and support sound professional judgment:

1. Clearly Understand the Transaction’s Substance: The first step is gathering all facts and understanding the economic purpose of a transaction. Accountants should ask, “What is really happening here?” and “What is the business rationale?” For instance, if there’s a complex multi-party arrangement, what is each party actually giving and receiving? This may involve discussions with the business teams or legal department to fully grasp contractual terms. By understanding the substance, one can avoid being misled by form. A classic mantra is “substance over form” – if a transaction is structured legally as one thing but in substance achieves something else, the accounting should reflect the true substance. The IFRS Conceptual Framework emphasizes that substance over form must prevail for financial information to be faithful. For example, a company might sell receivables to a third party but guarantee to compensate for any losses (a factoring arrangement). Legally it’s a sale, but if the risks are largely retained, substance might be closer to a secured borrowing. Recognizing this requires digging into the agreement and economic motivations. Accountants should document their understanding of substance and use it as a guiding light in choosing accounting treatments.
2. Identify Applicable Guidance and Principles: Once the transaction is understood, the accountant identifies which accounting standards or principles could apply. Often multiple may seem relevant, or none directly on point. Here, they should consider the hierarchy: specific standards first, then conceptual framework guidance for gaps. They might write a brief white paper or memo summarizing the transaction and potential applicable literature. By laying out options (e.g., “Is this a lease under IFRS 16? Or a service under IFRS 15? Could IFRS 9 apply if there’s a financial component?”), they ensure no angle is overlooked. This is also the stage to consider if any IFRIC interpretations or agenda decisions exist on similar fact patterns – those can provide authoritative clarifications. It’s wise to consult accounting firm guides or examples to see how similar cases have been handled. This research phase grounds the judgment process in the relevant rules-of-the-road, while still leaving room for principle-based interpretation when exact precedents don’t exist.
3. Consultation and Collaboration: Complex judgments benefit from multiple viewpoints. Preparers should consult within their organization – for example, discussing with the corporate technical accounting team, the regional CFOs (who might have seen similar issues), or even reaching out to industry peers informally. Within audit firms, it’s common to have a consultation process: engagement teams discuss tough issues with national office experts who bring broader perspective. Consultation is not a sign of weakness; rather it is a mechanism to challenge biases and ensure all factors are considered. The FRC’s professional judgment guidance and experts like Sir Andrew Likierman highlight the value of diversity of thinking – having people with different perspectives weigh in can greatly improve judgment quality. For instance, an auditor facing an unusual revenue contract might call an internal expert who has seen how other clients approached IFRS 15 for something similar. The technical expert might raise questions or scenarios the team hadn’t thought of, preventing tunnel vision. Likewise, within a company, involving someone from risk management or tax or legal in the discussion can surface additional considerations (maybe a legal covenant or a tax treatment that signals something about the intent). These discussions should be documented: who was consulted, what were their views, and how it influenced the conclusion. This not only strengthens the judgment by showing it was well-vetted, but also provides evidence to regulators or reviewers that the decision was not taken lightly or unilaterally.
4. Consider Alternatives and Justify the Chosen Treatment: A robust judgment process explicitly evaluates the plausible alternative accounting treatments. Management should ask, “If not this approach, what else could we do and why isn’t that appropriate?” For example, say the question is whether to consolidate an investee. The obvious answers are yes (treat as subsidiary) or no (treat as investment). Management would evaluate both: if yes, how does that align with control criteria? If no, why might significant influence or lack of control be concluded? They might conclude that while they have 40% ownership, they actually control because the remaining shares are widely dispersed and they dominate votes (thus consolidate). In documenting judgment, they should write why the alternative (not consolidating) was rejected – perhaps noting that in substance they exercise control via key decision-making rights, so not consolidating would ignore economic reality. By demonstrating they thought through the options, the reasoning is clearer. In practice, this could be a short section in a memo: “Alternative view considered: We considered treating this as a sale of assets rather than a leaseback. However, because we retained significant rights to the asset’s use, this did not meet the criteria for sale accounting – a leaseback treatment better reflects the continued control of the asset.” Such articulation is invaluable for auditors (who often need to challenge and corroborate management’s judgments) and for any subsequent inspection or inquiry. It shows the decision wasn’t arbitrary but reached by elimination of less suitable approaches.
5. Documentation of Judgments: High-quality documentation is both a process and a product. Writing down the thought process forces clarity. The documentation should include: the facts, the accounting question, summary of relevant guidance, discussion of judgments made (with emphasis on estimates, assumptions, and qualitative factors weighed), conclusion, and if applicable, how it aligns with the conceptual framework. For critical issues, companies often create an internal “accounting position paper.” Auditors likewise will document in their workpapers how they evaluated management’s judgment and whether they concur. Good documentation will explicitly reference evidence used. For instance, if management’s judgment on a warranty provision is based on historical defect rates, the memo might include a table of past rates and how they justify the percentage used going forward. Or for an expected credit loss overlay, documentation would include the macroeconomic scenarios considered and why certain weights were applied. This level of detail not only supports the number in the financial statements but also contributes to organizational learning – next time a similar issue arises, one can refer back to see what was done and why. Regulators increasingly expect clear disclosures of significant judgments in financial statements (which is an external form of documentation). Per IAS 1, companies must disclose the judgments (apart from estimates) that have the most significant effect. This could be, for example, that management judged it controlled a structured entity and consolidated it, or that revenue for long-term service contracts is recognized over time based on an output method because that best reflects performance. Such disclosures, often in the significant accounting policies or notes, give users insight into the key decisions made. They are an external byproduct of the internal documentation and analysis.
6. Apply Substance over Form and Ethical Oversight: Throughout the process, a mantra of “substance over form” should be maintained. This means if the strict legal form or literal wording of a standard would yield a result that doesn’t reflect the commercial reality, accountants should lean towards the treatment that does reflect reality (while still staying within the bounds of the standards). This principle is enshrined in IFRS as part of faithful representation. Auditors similarly look out for instances where management might technically follow a rule but undermine its substance. An ethical dimension is also present: professional accountants are bound by principles of integrity and objectivity. They should avoid biases (more on that in the training section) and not let pressure (e.g. to hit earnings targets) skew their judgment. One way organizations embed this is through tone at the top – leadership clearly communicating that transparent, principle-based reporting is valued over short-term expedients. When teams know that management and the audit committee will back a prudent judgment even if it’s unfavorable to short-term results, they are empowered to do the right thing. Conversely, if the culture rewards hitting numbers at all costs, there’s risk that judgments will be biased or rationalized incorrectly. Therefore, the process should include a “gut check”: does this conclusion align with the economic substance and would we be comfortable explaining it openly to stakeholders? If the answer is yes, it’s likely a sound judgment; if there’s discomfort or heavy reliance on formalisms (“the standard doesn’t forbid this explicitly”), that’s a red flag that the judgment might not be robust.
7. Review and Approval: Finally, for significant judgments, companies often have internal review mechanisms. This might be a technical accounting committee or the CFO’s review, and for auditors, significant issues go through partner review or a technical review committee especially if it’s a novel issue. Many audit firms require a second partner “concurring review” for filings to ensure no major judgment is overlooked. Similarly, an audit committee of the board often reviews management’s judgments on major accounting issues as part of their oversight role, asking management and auditors to explain the reasoning. This governance layer adds discipline: knowing that a judgment will be reviewed by knowledgeable others encourages thorough preparation and unbiased analysis. It also provides some protection to those making the judgment – if it’s vetted at high levels, there’s shared accountability that the company stands behind that decision.

By structuring the judgment process in this way – gather facts, consult standards, seek diverse input, evaluate alternatives, document thoroughly, focus on substance, and review/approve – preparers and auditors can greatly enhance the quality and consistency of professional judgments. In an environment of well-documented and well-considered judgments, even if two companies arrive at different conclusions under similar standards, each can be understood and rationalized by users. Moreover, such a process builds a knowledge base and a culture of thoughtful decision-making. It turns individual judgments into organizational assets: lessons that can be applied to future issues and training materials for new staff to learn how to approach gray areas.

In fact, regulators and professional bodies have been encouraging exactly this: for example, the UK FRC’s 2022 guidance on professional judgment for auditors sets out a structured framework to make auditors’ judgments more consistent and auditable, including steps like clarifying issues and objectives, considering alternatives, and avoiding traps. This mirrors the process we’ve outlined, demonstrating that the profession recognizes judgment can and should be approached with rigor, not gut feel alone. Solid judgment processes also reduce the likelihood of judgment traps – like groupthink or rush to solve – which can lead to errors. By slowing down, involving the right people, and systematically evaluating, accountants are more likely to reach a reasonable and defensible judgment that stands up to scrutiny.