Auditors Hesitant to Use Judgment, Fear Challenges

Recent events have made auditors skittish about using their judgment in their work, as they fear challenges by lawyers, the media and regulators, Robert Herz, chairman of the Financial Accounting Standards Board (FASB) said in a statement reported by Financial Times.

This reluctance to use judgment is in spite of a Securities and Exchange Commission (SEC) call for a principles-based approach to accounting. To illustrate the current issue, Financial Times cited the recent accounting scandal at Fannie Mae, the mortgage finance company, centered on violations of FASB Statement 133 on derivatives, which runs to more than 200 pages, augmented by hundreds of pages of guidance notes.

Herz's statement shows the magnitude of the task ahead should the U.S. decide to change over to a financial reporting regime based on principles rather than rules, Financial Times reported, adding that the SEC called for such a change in a 2003 report.

The SEC's report was required by the Sarbanes-Oxley Act of 2002, which was passed in response to the Enron scandal's effect of undermining investor confidence in U.S. accounting rules.

The SEC, the chief U.S. financial regulator, published a report in 2003 that called on the U.S. to ditch its tradition of complex accounting rules and adopt financial reporting standards rooted in principles. The change to a principle-based reporting regime would require far-reaching judgments, exceeding that of whether financial statements comply with accounting standards.

Herz told the Financial Times he believed auditors would like to exercise more judgment but felt inhibited by regulators, the trial bar and the business media.

"There is clearly a fear-not only among auditors but among [companies] and audit committees-of being second guessed," he said. "There seems to be a reluctance to exercise more judgment. If anything, we have perceived people are requesting more rules because they want clarity and defenses against being second guessed."

Herz praised regulators such as the SEC and the Public Company Accounting Oversight Board and acknowledged the tough tasks before these bodies.

The 2003 SEC report recommended the FASB adopt a principles based approach to accounting that resulted in "objectives oriented" standards, Financial Times reported, meaning an outline of accounting objectives, and avoiding use of percentage tests that have in the past enabled aggressive managements to claim they adhered to the letter of standards even if they breached their spirit.

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