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    Judgment and Decision Making Research in Auditing: A Task,...
    research summary posted April 13, 2012 by The Auditing Section, last edited May 25, 2012, tagged 09.0 Auditor Judgment, 09.01 Audit Scope and Materiality Judgments, 09.10 Prior Dispositions/Biases/Auditor state of mind 
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    Judgment and Decision Making Research in Auditing: A Task, Person, and Interpersonal Interaction Perspective
    Practical Implications:

    The last 25 years has been an exciting and very productive period for judgment and decision making research in auditing.  The author of the discussion believes this review study will help stimulate important audit judgment and decision making research.  This line of
    research is important because it has potential to make important contributis to the audit practice.


    Nelson, M.W. and H. Tan. 2005. Judgment and Decision Making Research in Auditing: A Task, Person, and Interpersonal Perspective. Auditing: A Journal of Practice & Theory 24 (Supplement): 41-71.

    Trotman, K. T. 2005. Discussion of Judgment and Decision Making Research in Auditing: A Task, Person, and Interpersonal Perspective. Auditing: A Journal of Practice & Theory 24 (Supplement): 73-87.

    Auditing, Judgment and decision making, Literature review
    Purpose of the Study:

    The purpose of the study is to review and discuss research in auditing specifically related to auditor judgment and decision making.  This line of research uses a psychological lens to understand, evaluate, and improve auditors’ judgments and decisions.  The authors
    classify the research into three broad areas: (1) the audit task, (2) the auditor and his/her attributes, and (3) the interaction between auditor and other stakeholders in task performance.  The authors synthesize the prior research and identify gaps and opportunities for future research. 

    The objective of the discussion paper is to build on the study by providing additional insights into areas of productive future research for judgment and decision making in auditing. 

    Design/Method/ Approach:

    The authors review judgment and decision making research in auditing conducted over the past 25 years.  Much of the research uses the laboratory experimental approach, but they also include some survey and field study approaches.  The review primarily considers papers published in major accounting journals such as The Accounting Review; Journal of Accounting Research; Contemporary Accounting Research; Accounting, Organization and Society; and Auditing: A Journal of Practice & Theory, as well as some selected working papers. 


    The Audit Task:  

    • The authors of the study find that much of the research related to audit tasks is grounded by the practice and professional standards.  The audit tasks most recently studied include (1) risk assessments, including the audit-risk model and related audit planning decisions, (2) analytical procedures and evidence evaluation, (3) auditors’ correction decisions regarding whether to require clients to book proposed adjustments, and (4) going concern judgments.  The authors stress the need for more research examining how auditing tasks are adapting to the current post-SOX reporting and regulatory environments. 
    • The author of the discussion feels there has been a lack of attention to audit task effects in prior research.  Prior research has not allowed us to make many general statements about the state of knowledge for each of the audit tasks.  The author
      stresses the importance of researchers to place more emphasis on audit tasks and to consider how specific audit tasks are different from the generic judgment and decision making (i.e., psychology-based) tasks.  

    Auditor Attributes: 

    • The authors of the study explain how auditors’ individual characteristics such as knowledge, ability, and personality, as well as their cognitive limitations, leave them susceptible to biases in audit judgments.  The authors focus their review of the related literature on four topics: (1) auditor knowledge and expertise, (2) other individual characteristics including aspects of personality, (3) cognitive limitations, and (4) decision aids designed to improve auditor judgments.  The authors stress the need for more research to examine how auditors’ affect or emotions also influence audit performance. 
    • The author of the discussion encourages future research to examine “why” biases in judgment occur in order to identify remedies for reducing the biases.

    Interpersonal Interactions: 

    • The authors of the study stress that because auditors do not work in isolation it is imperative to understand how people, tasks, and the environment that auditors interact with influence auditors’ performance.  The authors specifically examine interpersonal interactions between (1) auditors and other auditors, (2) auditors and their clients, and (3) auditors and other participants in the financial reporting process (e.g., jurors, judges, investors, analysts, etc.).  The authors call for more
      research related to interactions between auditors and audit committees as well as to strategic interactions between auditors and important stakeholders.  
    • The author of the discussion provides several insightful areas for future research, such as interactions between auditors and other auditors, auditors and clients, and auditors and users of audit reports. 
    Auditor Judgment
    Audit Scope & Materiality Judgements, Prior Dispositions/Biases/Auditor state of mind, Materiality & Scope Decisions
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    • Robert E Jensen

      "FASB Will Propose New Credit Impairment Model," by Anne Rosivach, AccountingWeb, October 16, 2012 ---

      How to measure and disclose evidence that a loan or bond is not performing continues to be an issue in the ongoing deliberations of the Financial Accounting Standards Board (FASB) and the International Accounting Standards Board (IASB). The two boards have been working on a single, converged Accounting for Financial Instruments standard for years.
      FASB announced recently that it will separately issue an exposure draft, possibly by the end of 2012, of a new model for disclosing credit impairment. The draft of the new approach, which FASB calls the "Current Expected Credit Loss Model" (CECL Model), may be viewed in FASB Technical Plan and Project Updates. The CECL Model applies a single measurement approach for credit impairment. 
      FASB developed the CECL Model in response to feedback from US stakeholders on the "three-bucket" credit impairment approach, previously agreed upon by the FASB and the IASB. US constituents found the three-bucket approach hard to understand and suggested it might be difficult to audit. 
      The IASB continues to propose the three-bucket approach. 
      FASB board members agreed that the CECL Model would apply in all cases where expected credit losses are based on an expected shortfall in the cash flows that are specified in a contract, and where the expected credit loss is discounted using the interest rate in effect after the modification. This would include troubled debt restructurings. The board has provided additional guidance.
      The Technical Plan explains the CECL Model as follows:
      "At each reporting date, an entity reflects a credit impairment allowance for its current estimate of the expected credit losses on financial assets held. The estimate of expected credit losses is neither a 'worst case' scenario nor a 'best case' scenario, but rather reflects management's current estimate of the contractual cash flows that the entity does not expect to collect. . . . 
      "Under the CECL Model, the credit deterioration (or improvement) reflected in the income statement will include changes in the estimate of expected credit losses resulting from, but not limited to, changes in the credit risk of assets held by the entity, changes in historical loss experience for assets like those held at the reporting date, changes in conditions since the previous reporting date, and changes in reasonable and supportable forecasts about the future. As a result, the balance sheet reflects the current estimate of expected credit losses at the reporting date and the income statement reflects the effects of credit deterioration (or improvement) that has taken place during the period."
      The FASB has tentatively decided to require disclosure of the inputs and specific assumptions an entity factors into its calculations of expected credit loss and a description of the reasonable and supportable forecasts about the future that affected their estimate. The entity may be asked to disclose how the information is developed and utilized in measuring expected credit losses.
      In July, when the FASB decided to pursue a separate course from the IASB and develop a simpler Model, the FASB explained the three-bucket approach as follows: 
      "Previously, the Boards had agreed on a so-called 'expected loss' approach that would track the deterioration of the credit risk of loans and other financial assets in three 'buckets' of severity. Under this Model, organizations would assign to 'Bucket 1' financial assets that have not yet demonstrated deterioration in credit quality. 'Bucket 2' and 'Bucket 3' would be assigned financial assets that have demonstrated significant deterioration since their acquisition."
      FASB states in its Technical Plan that the key difference between the CECL Model and the previous three-bucket model is that "under the CECL Model, the basic estimation objective is consistent from period to period, so there is no need to describe a 'transfer notion' that determines the measurement objective in each period."

      Where Fair Value Market Accounting Fails:  Unique Items Not Traded (e.g., bank loans)

      In the above module it was stressed how fair value adjustments are troubled for unique assets such as each of 300+ Days Inn hotels where no single hotel is alike due in large part by affects different locations can have on fair value. Fair value adjustments are possible for bonds traded in public markets, but hundreds of millions of bank loans are not traded in public markets. Each borrower is unique, and each purpose of a loan from a bank is unique. Unless the government will buy up selected types of bank loans (e.g., residential mortgages) there are no trading markets for these bank loans. Typically banks hold these investments to maturity (HTM Held-To-Maturity).  Such loans may be adjusted for inflation and interest rate changes, but there are no markets for mark-to-market adjustments.

      Much more subjectivity in valuation becomes necessary for "granular factors" that take uniqueness of each loan into consideration. The typical valuation model is discounted cash flow (DCF economic value) adjusted by granular factors. In 1932, Bill Paton (in his Accountants Handbook), Bill Paton outlines thos "appraisal factors" in the following categories:

      1.      Length of time the account has run.

      2.      Customer's pract6ice with respect to discounts.

      3.      General character of dealings with the customer.

      4.      Credit ratings and similar data.

      5.      Special investigations and reports.

      Fair value advocates sometimes mislead students into thinking that there are markets or surrogate markets for everything to be marked to market, but the fact of the matter is that more often than not it is impossible to find reliable market values.


      Banks must also submit much more granular information, including dozens of details about individual loans.
      See article below.

      "Stress for Banks, as Tests Loom," by Victoria McGrane and Dan Fitzpatrick, The Wall Street Journal, October 8, 2012 ---

      U.S. banks and the Federal Reserve are battling over a new round of "stress tests" even before the annual exams get going later this fall.

      The clash centers on the math regulators are using to produce the results. Bankers want more detail on how the calculations are made, and the Fed thus far has resisted disclosing more than it has already.

      A senior Fed supervision official, Timothy Clark, irked some bankers last month when he said at a private conference they wouldn't get additional information about the methodology, according to people who attended the event in Boston. Wells Fargo WFC -0.78% & Co. Treasurer Paul Ackerman said at the same conference that he still doesn't understand why the Fed's estimates are so different from Wells's. His remarks drew applause from bankers in the audience, said the people who attended.

      The annual examinations in their fourth year have become a cornerstone of the revamped regulatory rule book—and a continuing source of tension between the nation's biggest banks and their overseers.

      Smaller banks will soon have to grapple with similar requirements. On Tuesday, the three U.S. banking regulators—the Fed, the Comptroller of the Currency and the Federal Deposit Insurance Corp.—plan to complete rules requiring smaller banks with more than $10 billion in assets to also run an internal stress test each year. That would widen the pool of test participants beyond the Fed's current requirement of $50 billion in assets, a group comprised of 30 banks.

      The stress tests, which started in 2009 as a way to convince investors that the largest banks could survive the financial crisis, now are an annual rite of passage that determines banks' ability to return cash to shareholders.

      The financial crisis taught regulators that they need to be able "to look around the corner more often than in the past," said Sabeth Siddique, a director at consulting firm Deloitte & Touche, who was part of the Fed team that ran the inaugural stress test in 2009.

      The Fed asks the big banks to submit reams of data and then publishes each bank's potential loan losses and how much capital each institution would need to absorb them. Banks also submit plans of how they would deploy capital, including any plans to raise dividends or buy back stock.

      After several institutions failed last year's tests and had their capital plans denied, executives at many of the big banks began challenging the Fed to explain why there were such large gaps between their numbers and the Fed's, according to people close to the banks.

      Fed officials say they have worked hard to help bankers better understand the math, convening the Boston symposium and multiple conference calls. But they don't want to hand over their models to the banks, in part because they don't want the banks to game the numbers, officials say.

      It isn't clear if smaller banks will have to start running their tests immediately, as regulators have issued guidance indicating that midsize banks will have at least another year until they have to run the tests.

      One new frustration for big banks is that the information requested by the Fed is changing. This year the Fed began requiring banks to submit data on a monthly and quarterly basis, in addition to the annual submission. Banks must also submit much more granular information, including dozens of details about individual loans.

      Fed officials say the new data gives them the information they need to build their stress-test models and to see banks' risk-taking over time. Banks say the Fed has asked them for too much, too fast. Some bankers, for instance, have complained the Fed now is demanding they include the physical address of properties backing loans on their books, not just the billing address for the borrower. Not all banks, it turns out, have that information readily available.

      Daryl Bible, the chief risk officer at BB&T Corp., BBT -0.77% a Winston-Salem, N.C.-based bank with $179 billion in assets, challenged the Fed's need for all of the data it is collecting, saying in a Sept. 4 comment letter to the regulator that "the reporting requirements appear to have advanced beyond the linkage of risk to capital and an organization's viability," burdening banks without adding any value to the stress test exercise. BB&T declined further comment.

      The Fed has backed off some of its original requests after banks protested. For example, the Fed announced Sept. 28 that it wouldn't require chief financial officers to attest to the accuracy of the data submitted after banks and their trade groups argued that the still-evolving process was too fresh and confusing for any CFO to be able to be sure his bank had gotten it right.

      Banks needed more time to build up the systems and controls to report data reliably, the Fed said. But the regulator also warned that it may require CFO sign-off in the future.

      Bob Jensen's threads on fair value accounting controversies ---