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July 29, 2012 5:24 am
Politicians assert that a lack of confidence impairs economic recovery, but over-confidence still abounds in one area despite decades of debacles: financial statements. Auditing and accounting have been much criticised over the past two decades, for market concentration, lack of independence, principal-agent problems, lack of indemnity, relationships with regulators, and mark-to-market rules.
Rarely, if at all, do critics question the basis of audit and accounting in terms of measurement science. For any significant asset, we expect seven not-so-precise pieces of evidence: cost, ownership, disclosure, value, existence, responsibility and benefit. Despite the uncertainties, especially around value, accountants and auditors report a single, definite number, not a range.
“Long Finance”, an initiative of several thousand financial services professionals, proposes a different approach, using ranges rather than discrete values to represent key items on the profit & loss and balance sheet.
This method, called “Confidence Accounting” seeks to move accountancy from a book-keeping paradigm towards scientific measurement. Scientists view measurement as a process that produces a range. They express a measurement as X, with a surrounding interval. There is a big difference between point estimation and interval estimation. Auditors provide point estimates, scientists intervals. For example, physical scientists report X measure ± Y interval. Social scientists report interval estimates for an election poll and state how confident they are that the actual value resides in the interval. Statistical terms, such as mean, mode, median, deviation, or skew, are common terms to describe a measurement distribution’s “look and feel”. The key point is that scientists are trying to express characteristics of a distribution, not a single point from it.
Auditors do not practice measurement science. Scientific measurement specifies accuracy and precision. Accuracy is how closely a stated value is to the actual value. Precision is how likely repeated measurements will produce the same results.
In a world of Confidence Accounting, auditors would present distributions for major entries in the profit & loss, balance sheet and cashflow statements. The value of freehold land in a balance sheet might be stated as an interval, £150,000,000 ± 45,000,000, perhaps recognising a wide range of properties and the illiquidity of property holdings. Next to each value would be confirmation of the confidence level, eg, 95 per cent – confidence that another audit would have produced a value within that range. Finally, there would be a picture, a histogram of the distribution, so people can see the shape of things. The proposed benefits of Confidence Accounting include a fairer representation of financial results, reduced footnotes, measurable audit quality and a mitigation of mark-to-market perturbations.
Such an approach has implications for providers of financial information. A discussion is needed, aimed at understanding the implications for management behaviour. Deep training is also required to move financial professionals from additive and subtractive book-keeping to more statistical approaches. Using ranges rather than numbers will strain information systems, which will need to encompass richer presentations as a matter of course. And Confidence Accounting provides a way to evaluate internal and external audits: were stated results within the confidence intervals over time.
ACCA, (Association of Chartered Certified Accountants) CISI (Chartered Institute for Securities and Investment) and Long Finance have issued “Confidence Accounting: A Proposal” as a consultation document, which closes for comment at the end of 2012. Andy Haldane, executive director, financial stability at the Bank of England, writes in the foreword: “My hope is that this proposal moves our thinking a step closer towards a set of accounting standards for major entities that put systemic stability centre stage. In the light of the crisis, anything less than a radical rethink would be negligent.”
How uncertain can you be that this proposal is right?
Michael Mainelli is executive chairman of Z/Yen Group and co-author with Ian Harris of ‘The Price of Fish: A New Approach to Wicked Economics and Better Decisions’
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