Confident accounting

THE FACT IT WAS ANDY HALDANE, executive director for financial stability at the Bank of England (and my preferred nominee for governor), who wrote the foreword to the Long Finance/ACCA/CISI paper on confidence accounting was enough to make me pay attention.

It is a proposal for using distributions, rather than discrete values, in auditing and accounting statements. The paper envisages audits resulting in distributions for profit and loss, balance sheet and cashflow statements to portray risks in the discrete values in financial statements. Haldane hopes confidence accounting will help put systemic stability centre stage in accounting – “in the light of the crisis, anything less than a radical re-think would be negligent”.

The proposal foresees companies presenting, for example, “the balance sheet showing net assets of £Y, plus or minus £Z, and we are [95]% confident that it falls within this range”. This probabilistic approach is similar to that of most measurement sciences, which rely not on one but many independent measurements. The authors focus heavily on banks and other large entities capable of systemic meltdown as we saw in 2007. Confidence accounting could have helped then if it had highlighted the extreme ranges of outcomes of, for example, various credit derivatives. An alternative interpretation is that, if the senior management of the banks did have this information, they either misused it or, even worse, negligently chose to ignore it.

There is a lot of detail in the paper and a couple of worked examples for a large bank and a professional services firm. The authors claim the proposals are not an attack on the foundations of the existing accounting framework but a change in perspective that resolves inconsistencies. But will it catch on? Could this idea have legs?

There is a lot of work and experimentation to do before this idea is anywhere near ready for the attention of the standards setters. For me, the most fruitful areas for taking the idea further are the audit committee and the audit itself. Management, auditors and audit committees frequently debate “quality of earnings”. This is often reduced to asking, “Are we more or less prudent than last year?”

Auditors sometimes present audit committees with a picture of the key balance sheet and profit and loss items in terms of where they sit on a range between optimistic and pessimistic or prudent and aggressive. I have found these useful in addressing the quality of earnings issue, but I am aware that I am looking at judgements or “gut feel”, not measurement. Such judgements can always be trumped by claiming that even if you are at the edge of the ranges, what you are doing is legal. If an audit firm were able to take the confidence accounting proposal and develop a measurement-based presentation of how prudent a company’s estimate is, this might be of considerable help to audit committees whose raison d’être is to address this matter. And it might be a competitive advantage for that firm.

If confidence accounting were to be picked up in this way, its first effect on financial reporting could be better reporting on risk. The single-point numbers in the financial statements might not change but the audit committee could want different words about those numbers where the confidence distributions are wider or skewed from situations where the distributions are more normal. Over time, the distributions might lead companies to change their numbers as they come to understand the implications of the confidence graphs at their single-point estimates.

In time, the distribution may come to be published, and regulators and shareholders alike could engage with the companies (and auditors) to discuss quality of earnings or quality of audits, on the basis of measurements, rather than feeling or assertion.

Eric Tracey is a consulting partner at Governance for Owners and a former FD