In the wake of Enron, Worldcom, Global Crossing et al, a recent article by two accountants challenges the fundamentals of accounting.The article, in Europe’s leading journal of asset, liability and risk management, questions the way in which auditors and accountants do their work: Balancing the Odds: Stochastic Accounting, Balance Sheet, Volume 10, Issue 2, MCB University Press (2002).
Michael Mainelli (FCCA) and Ian Harris (ACA), Directors of Z/Yen Limited, pulled no punches. “If auditors practise risk-based auditing, then why can we not see the odds they face?” The article recommends a root-and-branch reform of the mechanics of accounting and auditing using distribution functions where possible, rather than discrete numbers. The implications of this approach are:
While Mainelli and Harris do not claim that this stochastic accounting approach would have prevented some of the recent, high profile scandals, they do believe that investors would have been better informed of the risks. The authors put forward a case for preparing corporate accounts that show directly to finance directors, analysts and investors the ranges of potential profits, inventory, executive share options, etc. The authors believe that a move from traditional methods to stochastic accounting would take time, particularly in the specification of standards for the representation of the ‘odds’, e.g. how histograms should be shown. The authors recognise the need for commitment from the accounting establishment, restructuring of accounting training and communication of the approach to financial information users.
Michael Mainelli, Z/Yen’s Chairman, states: “Investors need to understand ranges, not have a self-serving, single number plucked by accountants from a distribution of numbers. We hope this paper starts a debate about the need to examine the bottom-up fundamentals of accounting.”