Argumentation as it applies to principles-based accounting and fair presentation

Reasoning from principles is like reasoning using the Barnes (1991)/Toulmin (1958) argumentation framework. A hierarchy of major premises might start with a general moral theory or some assumption about the social norms of financial reporting—such as a hierarchy of objectives of financial reporting. A recent objective in ISA is to detect and deter fraudulent financial reporting. An extension of this might be to detect any cheating (including fraud by management incompetence) via financial reporting. Fraud of management incompetence includes any false claim by management of its capabilities. An example of fraud of incompetence in a university setting is cheating by students on an exam and getting a higher mark than deserved, and as a result perhaps a better job than qualified for. If such cheating were uncontrollably rampant, it could undermine the credibility of university degrees and the broader economy. Another example is an auditor (or profession as a whole) claiming expertise in some aspect of auditee activities when invalid criteria are used such as in some areas of risk management (e.g., see Power 2009 or Savage 2009).

Similarly, detection and deterrence of all types of cheating by capital users against capital providers may be crucial for preserving the trust, and thus the functioning, of capital markets (e.g., see Smieliauskas 2006). Fraud of management incompetence includes such common problems as the inability to prepare fairly presented financial statements. Misstatements might be unintentional yet arise because of management incompetence or the inability to deal with financial reporting issues. The auditor’s traditional role has been to detect such incompetence but it has not been treated as a form of fraud. However, if the concept of cheating were defined to include fraud by management incompetence, cheating would incorporate poor economic performance due to mismanagement, and misleading reporting including all reporting that fails to reflect the economic substance of an entity’s activities. Thus detection of cheating via financial reporting can address the goal of reflecting the economic substance of principles-based standards (IASB 2010, 2) as well as the detection of fraudulent financial reporting. Savage and Van Allen (2002) give good illustrations of how management cheating can arise through conformity with traditional GAAP, indicating such GAAP criteria need improving.

Further down the hierarchy are theories such as utilitarianism, widely used in economics theory and business. Since it is unlikely that a monistic ethical theory such as utilitarianism would be sufficient to deal with all moral issues, other theories such as Kant’s universal imperatives (e.g., the biblical commandments) may be added as qualifiers. Such an approach results in “top-down” reasoning that is laid out in standard logical form following the Barnes (1991)/Toulmin (1958) approach explained earlier, with the major premises in hierarchical order, followed by minor premises that are explained by the major premises, followed by the conclusion.

A good example of top-down or principles-based reasoning in existing professional standards is IFAC’s Code of Ethics for public accountants. This code avoids preparing detailed rules or interpretations, as these will be influenced by national laws, culture, and the particular circumstances of the engagement. However, a detailed rule should not conflict with a basic principle. If it did, the system of ethical reasoning would be illogical (inconsistent). Instead, detailed rules should clarify the application of a principle, yet be consistent with it. The principle has conceptual primacy over a detailed rule. This means that if a rule conflicts with a principle, the principle overrides the rule. Principles-based reasoning has always been important in moral philosophy. Principles-based reasoning is also increasingly important in financial reporting and auditing, especially under IFRS.

Essentially, a conceptual framework and more detailed guidance in the form of rules such as accounting and auditing standards should work logically similar to components of a country’s written constitution (e.g., the U.S. Constitution) which specifies goals, assumptions, and principles under which institutions within the country, such as its legal system, should work within the constitutional framework. Laws and regulations cannot override constitutional rights. In summary, an audit conceptual framework should work toward an ideal equivalent to a constitutional framework.

Part A of the IFAC code provides general concepts and a conceptual framework. Part B illustrates how the framework is applied by public accountants in specific situations. IFAC feels that specific rules can be arbitrary and not represent the public interest in all cases, justifying a conceptual approach. The framework identifies threats against conformity to the general principles, evaluates their significance, and, if warranted, applies safeguards eliminating or reducing them to acceptable levels. Serving the public interest is viewed as the most important principle since the remaining principles and detailed rules are meant to support this objective. Thus, there can be a hierarchy of principles. As accounting and auditing further evolve, we can expect more clarification of the principles of financial reporting. For example, how much measurement uncertainty regarding future events should be acceptable in general-purpose financial reporting? Or, should there be a priority or hierarchy of user needs that have to be met in serving the goal of meeting the public interest? If the professional standards do not appropriately specify the principles, there may not be sufficient guidance by standard setters to appropriately implement principles-based financial reporting, thereby resulting in potentially worse accounting communications than the existing standards.

The reason top-down approaches to argumentation are so useful for auditors and accountants is that they help clarify what is involved in fairness of presentation of financial reporting as required by ISA 200 (Overall Objectives of the Independent Auditor). Top-down or principles-based argumentation clarifies when the accountant should go beyond more specific requirements of standards and when the accountant should deviate from the detailed standards. The accountant should deviate from detailed rules when they conflict with a general principle. Attempting to consistently implement a coherent, widely accepted system of primary principles (major premises) is a rational way to implement fairness of presentation of accounting communications. The standard setter’s task is to articulate such a set of primary principles, and the auditor’s and preparer’s tasks are to implement the application of the principles.

Below is an outline of a possible conceptual framework of audited financial reporting that incorporates principles-based accounting, and implicitly has embedded within it more detailed guidance consistent with the principles. The more detailed guidance is indicated by the indented material.

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Overall Objective: Serve the Public Interest (the social role of the auditor is to increase the confidence of users of financial statements such as investors (capital providers) by reducing the risk of inaccurate or misleading financial reporting). This objective is implicit in legislation and regulations that require audits because audited financial statements for public companies are viewed as a public good because of the above objective.

I. First Major Premise: Overriding concepts are moral reasoning and ethical theories that apply to financial reporting. For example, we might start with a hierarchy of user needs. For another example, the major underlying objective should be to encourage trust in financial reporting by reducing the risk of unethical financial reporting to acceptable levels.

A. Moral Responsibilities from Social Norms: Auditors are hired to verify the acceptability of management-prepared financial statements consistent with objectives of generally accepted financial reporting.

B. Rules of Professional Ethics

• 1. Act in public interest (e.g., by effectively detecting misleading or fake value accounting).
• 2. Not be associated with misleading information.
• • Misleading to whom? In modern world accountability (see Chapter 1) capital providers should be the ones least likely to be misled by the accounting communication.
• • Accurately reflect economic substance: this is possible only if deception of capital providers via financial reporting is appropriately deterred, where the deception includes the fraud of incompetence in running the company or in preparing fairly presented financial statements.

II. Second Major Premise: Suitable Criteria for General-Purpose Financial Reporting (such as Acceptable Reporting Framework of ISA 200 and 210, consistent with a principles-based conceptual framework).

A. Fairness of Presentation Framework (= Principles-Based Accounting = True and Fair Override = Top-Down Reasoning)

Conceptual Framework (objectives, principles, and related concepts, including auditability) has the highest authority. An example of an important fairness of presentation principle is to account for uncertainties of future events in a way that keeps risks associated with measurement uncertainties at acceptable levels (otherwise the reporting may be deemed misleading to capital providers).

• 1. Allows disclosures beyond specific requirements (detailed rules).
• 2. Allows departures from specific requirements (detailed rules) when applicable.

B. Compliance Reporting Framework: Detailed accounting rules without reference to generally accepted guiding principles (e.g., cash basis accounting; or tax basis accounting which has no generally accepted principles—the government makes political decisions about who gets preferential treatment).

III. Third Major Premise: Assurance Framework (clarifies conditions of auditability). This premise can be characterized as reducing evidence risks to acceptable levels. The evidence relates to key assertions of accounting communications as reflected in Premises I and II. This means the relevance of the evidence is determined by the applicable reporting framework.

A. Generally Accepted Auditing Standards (ISAs)

• 1. Provide assurance for, and verify assertions used by, an acceptable financial reporting framework.
• • Compliance reporting framework (conformity with II B).
• • Fairness of presentation reporting framework (conformity with II A and reduction of measurement risks in accounting estimates to acceptable levels).

B. More detailed guidance via ISAs and audit guidelines (AuGs).

C. Other assurance engagements.

IV. Minor Premises: Obtain data (gather sufficient appropriate evidence).

A. Relevance of evidence (must relate to assertions as per III).

B. Hierarchy of reliability of audit evidence (see an introductory audit text such as Ch. 8 of Smieliauskas et al. 2019).

C. Sufficiency of appropriate evidence (reduce evidence risk to acceptable levels for those audit assertions requiring audit evidence).

D. Develop well-calibrated ranges to assess accounting estimates.

V. Evaluate data to give an opinion on the appropriateness of the application of an acceptable reporting framework (e.g., fairness of presentation in accordance with principles-based accounting standards).

• • This is the justified conclusion in audited financial reporting relying on the above four categories of premises in hierarchical order, and taking appropriate actions consistent with these premises).
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The above lays out the general reasoning of principles-based financial reporting and its audits. Principles should be more sophisticated for fairness of presentation reporting than for compliance reporting because of the added complexity associated with claims about fairness.

If the objectives of financial reporting are aligned with user needs, and concepts and principles are aligned with the objectives, then financial reporting should be meeting the public interest. Thus verification of meeting these concepts and principles of reporting should deter fraud of incompetence and fraud due to intentional misstatements by management (i.e., fraudulent financial reporting), and meet the objectives of financial reporting. That would mean a high inductive probability to the above argumentation.

But how do we know what is the epistemic probability of the audit opinion? True conclusions follow from true premises. So, this question is answered by looking at the epistemic probabilities of the premises above. If the objectives are widely accepted, the epistemic probability of the objectives is high. Social facts that accounting and auditing deal with depend on general acceptance for their epistemic probabilities—the more generally accepted, the higher the epistemic probability. Similarly, it is the relationship of the concepts and principles to such presumed epistemically high-probability objectives that determines the epistemic probabilities of the remaining premises. Thus if you believe that the conceptual frameworks of financial reporting and assurance will really help meet the objectives of financial reporting, then you are entitled to assume they have high epistemic probability. At least, that is the way legal reasoning works in the courts and we assume that this is a practical enough approach for auditing and financial reporting.

In conclusion, this chapter notes that argumentation theory aligns quite naturally with ICAS’s (2006) principles-based reasoning approach. However, new premises in the form of clarified concepts and principles such as for professional ethics and professional judgment are needed to achieve fairness of presentation when implementing a principles-based reporting framework. Specifically, new premises related to acceptability of uncertainties in accounting for future events are needed. Such premises relate to the fundamental measurement process of accounting theory and are necessary to make the theory more complete. In addition, premises related to clarification of responsibilities for protecting capital supplier interests in financial reporting are needed, specifically a hierarchy of needs, so that if there is a conflict auditors and preparers know whose needs should take precedence. With such a more complete set of premises, auditors and preparers would be in a better position to justify fairness of presentation in financial reporting using principles-based reasoning.