Question

What is the role of professional judgement in accounting and two implications on the users of accounting information if the professional judgment has not been made in the most appropriate approach.

Answer 1

A mathematical equation to define professional judgement in accounting would be:

Professional Judgement = Accumulated Knowledge + Experience (on the job or training)

Compliance with ethical standards is an integral fragment of professional judgement. The process of professional judgement should be logical, unbiased and consistent.

The need for professional judgement in accounting arises when there is a mis-match between different standards of accounting or there are a few alternatives to record a transaction.
We can reach different conclusions and thus, different interpretations for the same set of facts when using IRS/IFRS or IAS. Most importantly, it might not mean that one conclusion is correct while the other is false; both of them could fall into any of the categories.
How to support professional judgement?
Documentation is the key. A proper and reasonable argument should be made highlighting the procedure used, analysis of the circumstances and alternatives that were available.

Two implications on users where professional judgement is not made:

1. Measurement Basis: Choosing the right measurement basis for different elements of financial statements is critical. There are numerous basis: historical cost, present cost, fair value etc.
e.g: If historical cost is used, it acts as an impediment in estimating the true profits as the principle of conservatism and prudence does not allow recognition of potential rise in value of assets, but only that of potential decrease or losses.

2. Lease Contracts:  There are two types of lease usually: a) Financial Lease and b) Operating Lease.
In case of the financial lease, the lessee, even though he is not the owner but he is benefiting from most economic benefits provided by the asset and catering the risks associated and controls the asset and must report it in its financial statements.

In case of operating leases, payments made by the lessee are reflected as a decrease in profits (expense) in each
period. Erroneous classification of a financial lease as an operating lease causes the understatement of the
lessee’s assets and liabilities, thus professional judgement backed by supporting analysis plays an important role in such cases.