By using distributions, rather than discrete values in accounting and auditing, Confidence Accounting would aid in effective pricing of risk by end-investors, notes a joint paper from ACCA.

A joint paper from Associated of Chartered Certified Accountants (ACCA), the Chartered Institute for Securities & Investment and Long Finance titled: “Confidence accounting: a proposal” highlights an alternative approach to reporting assets and liabilities for consideration.

Confidence Accounting – A novel proposal

‘Confidence Accounting’ is a term for a proposal to use distributions rather than discrete values in accounting and auditing. The term was coined by Long Finance proponents as part of a shift from using specific values in accounts to the use of interval estimates and confidence levels, making accounting and auditing practices more closely resemble other measurement sciences.

Thus as a novel proposal, under Confidence Accounting, the end results of audits would be distributions for the profit and loss, balance sheet and cash flow statement of major entities.

For instance, accountants would present uncertainties as ranges to investors and managers, rather than as discrete numbers: “‘the balance sheet of Company X is worth £Y, plus or minus £Z, and we are 95% confident that it falls within this range’. These ranges would then be verified by auditors. Thus, audited accounts would be presented in a probabilistic manner, showing ranges.

Such an approach would present a sound basis for measuring audit quality, as over a period of time, investors could evaluate an audit firm on the basis of how closely historic accounts fell within the stated ranges. This would help in concluding whether the firms were too lax or too strict.

The joint paper highlights that the proposed benefits of Confidence Accounting include a fairer representation of financial results, fewer and shorter footnotes, measurable audit quality and a mitigation of mark-to-market perturbations.

Confidence Accounting – An example

To illustrate the concept of Confidence Accounting, the paper takes a hypothetical example of Banco Santander, S.A. (ADR) (NYSE:SAN) (BME:SAN), whose opening balance sheet might look like the one below in a traditional approach:

Traditional-opening-balance-sheet

Since the above set of accounts has only single value numbers, the authors note this particularly odd as there are significant uncertainties behind the bank’s assets and liabilities. The following presents a new set of accounts prepared under Confidence Accounting by using the past five years’ accounts to obtain estimates for the various sources of uncertainty:

Opening Balanace Sheet before applying Confidence Accounting

The following highlights the detailed Balance Sheet of the hypothetical UK bank:

Detailed Balance Sheet

The paper notes on the basis of reasonable and valid assumptions and modeling of previous years’ results of the bank, an income statement was prepared using Confidence Accounting. This revealed that there is only a 15% probability that this figure is correct to +–10%, ie between £6.0 billion and £7.4 billion, which has implications for dividend and bonus policies.

The paper points out that the usage of Confidence Accounting for the bank would result in a fairer representation of financial results. Moreover, it could reduce the size and complexity of annual reports as in the case of Royal Bank of Scotland, by between 29 and 99 pages out of 446 pages (2010).

The paper concludes that in order for accountants to move to a ‘range’ paradigm, further work needs to be done in areas such as commitment by the accounting establishment, restructuring of accounting training and communication to users of financial information.

The full paper could be found here tech-af-cap