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Confidence Accounting: A Proposal Explained

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Confidence Accounting: A Proposal

Ian Harris FCA FBCS, Z/Yen Group Limited

Professor Michael Mainelli FCCA FCSI FBCS, Z/Yen Group Limited

Jan-Peter Onstwedder MBA, Z/Yen Group Limited

Confidence Accounting: A Proposal – Executive summary

The use of a single number for accounting terms such as profit or balance sheet value is clear and simple, but wrong. ’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.

In a world of Confidence Accounting, the end results of audits would be presentations of distributions for major entries in the profit and loss, balance sheet and cash flow statements. 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’. Auditors would verify these ranges. This would move auditing towards ‘measurement science’, in line with the way most laboratories report measurements. Audited accounts would be presented in a probabilistic manner, showing ranges. Over time, investors could evaluate an audit firm on the basis of how closely historic accounts fell within the stated ranges.

Such evaluations might conclude that firms were too lax or too strict. Clients would be able to make their own decisions about audit quality on the basis of historic evidence rather than having to rely on assertions of quality. In 2011, ACCA (the Association of Chartered Certified Accountants) and the Chartered Institute of Securities & Investment (CISI) commissioned the Long Finance community, led by Z/Yen Group Limited (Z/Yen), to provide a proposal setting out the arguments for Confidence Accounting and two worked examples of how audited accounts prepared under Confidence Accounting for two hypothetical firms might look, one for a bank (Banco Santander, S.A. (ADR) (NYSE:SAN) (BME:SAN)) and one for a professional services firm (Pro-Co UK Ltd). The two worked examples are presented in the first two appendices.

The proposed benefits of Confidence Accounting include a fairer representation of financial results, shorter and fewer footnotes, measurable audit quality and a mitigation of mark-to-market perturbations. The worked examples show that Confidence Accounting:

  • is workable and can be applied to banks and professional services firms, and probably most major firms in other industries
  • does result in a fairer representation of financial results
  • could reduce the size and complexity of annual reports, in the case of Royal Bank of Scotland Group PLC (NYSE:RBS) (LON:RBS), for instance, by between 29 and 99 pages out of 446 pages (2010)
  • probably provides a sound basis for measuring audit quality probably provides a basis for beginning to reconcile balance sheet valuation and market value, and
  • certainly highlights the need for clarity between uncertainty over valuation during the period of going concern versus risk about changes in the state of the economic climate.

The worked examples raised issues of defining ’going concern’, mark-to-market valuation and identifying discontinuous environmental change. Those involved in future Confidence Accounting discussions may find that this approach helps to reconcile some of these problems. The authors feel that Confidence Accounting would enhance existing financial reporting. They envisage that Confidence Accounting would be presented alongside traditional accounts, either as part of the notes or as a set of proforma accounts.

Confidence Accounting: Origins

This report argues that the use of a deterministic numeric paradigm in accounting and auditing may well be the root cause of many current problems. Accounting methods could use probabilistic inputs and show resultant outputs as distributions of numbers. Accounting and auditing have been subject to much criticism over the past two decades. During the dot.com era, some accountants subjected themselves to needless criticism by putting forward business plans based on deterministic numbers that were incapable of showing the all-too-frequent reality: a small chance of making lots of money and a large chance of losing money. Had accountants submitted plans that showed the distributions, they might well have served investors better, reduced unreasonable expectations and minimised criticism of the accountants’ role. Instead, they presented single numbers or played with high, medium or low forecasts to calculate ’average’ forecasts, none of which contained the possibility of winding up the business or conversely of wild success.

See full PDF here.

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