Confidence Accounting: New Foundations For Old Practices

Politicians and regulators assert that a lack of confidence impairs economic recovery, but one area remains too confident after decades of debacles, financial statements. Auditing and accounting have been subject to much criticism over the past two decades. Criticism perhaps reached one peak in the early 2000’s after a series of telecommunications and internet failures, coupled with Enron’s collapse. Another peak of criticism has followed the financial crises since 2007 when financial statements have been far too optimistic for major financial institutions. Criticisms are many and varied – audit firm market concentration, lack of independence, principal-agent problems, lack of indemnity, relationships with regulators, 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 (a fishy COD-VERB). There is a surfeit of old jokes in which an accountant delivers the punchline, “What do you want the number to be?” Yet despite the uncertainties, especially around value, accountants and auditors report a single, definite number, not a range.

Long Finance (www.longfinance.net), an initiative of several thousand financial services professionals addressing the question, “when would we know our financial system is working?”, proposes a different approach, using ranges rather than discrete values to represent key items on the profit & loss and balance sheet, ‘Confidence Accounting’. Following an introduction to Confidence Accounting in the book “The Price of Fish: A New Approach to Wicked Economics and Better Decisions”, ACCA, CISI and Long Finance have published “Confidence Accounting: A Proposal”(Ian Harris, Michael Mainelli and Jan-Peter Onstwedder, “Confidence Accounting: A Proposal”, (Chartered Institute for Securities and Investment, Long Finance, Association of Chartered Certified Accountants (July 2012), 66 pages.)

Confidence Accounting seeks to move accountancy from a book-keeping paradigm towards scientific measurement. Scientists view measurement as a process that produces a range. Scientists 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 in 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.

People who move from science to accounting are stunned to find that auditors do not practice measurement science. Scientific measurement specifies accuracy and precision. Accuracy - how closely a stated value is to the actual value. Precision - how likely repeated measurements will produce the same results. A measurement system can be accurate but not precise, precise but not accurate, neither, or both. If your bathroom scale contains a systematic error, then increasing sample size by weighing yourself more often increases precision but not accuracy. If your bathroom scale is very accurate but your past and future weight fluctuate wildly, today’s spurious accuracy is not a good guide to your weight, e.g. for safety purposes.

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 interesting properties and the illiquidity of property holdings. Next to each value would be confirmation of the confidence level, e.g., 95% confidence that another audit would have produced a value within that range, or that a firm is a going concern. 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.

Confidence Accounting is gaining attention. Andy Haldane, Executive Director, Financial Stability at the Bank of England stated in December 2011, “For perhaps the first time, it [‘Proposed Regulatory Prudent Valuation Return’, published in December 2011] provides confidence intervals around banks’ balance sheets – what some have called “confidence accounting”. Such an approach has large implications for providers of financial information. First, a widespread discussion is needed, aimed at understanding the implications for management behaviour. Second, deep training is needed to move financial professionals from additive and subtractive book-keeping to more statistical approaches. Broader training is also needed among other users of accounts so they understand the new approaches. Third, using ranges rather than numbers will strain information systems, which will need to encompass Monte Carlo modelling and richer presentations as a matter of course. Fourth, Confidence Accounting provides a comprehensive way to evaluate internal and external audits – were your stated results within the confidence intervals over time. Users of accounts shall be able to evaluate the quality of the audit industry over time.

A book on the subject would have examined in detail Bayesian versus frequentist thinking, developed more types of distributions, had more case studies, explored the implications of discrete versus continuous distributions, and commented more on account users' utility functions; but from the proposal all we seek are critiques between now and the end of 2012. As Andy Haldane, 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 re-think would be negligent.” How uncertain can you be that this proposal is right?

About the author Professor Michael Mainelli FCCA FCSI FBCS, Executive Chairman, Z/Yen Group, is a scientist and accountant. Michael’s third book, based on his Gresham College lecture series from 2005 to 2009 and co-authored with Ian Harris, “The Price of Fish: A New Approach to Wicked Economics and Better Decisions”, introduces Confidence Accounting and won the 2012 Independent Publisher Book Awards Finance, Investment & Economics Gold Prize.

[An edited version of this article appeared as “The Battle For Accountancy Has Begun” in Financial Times, FTfm Pearson PLC (29 July 2012), page 6.]