Professor Michael Mainelli, Z/Yen Group Limited
[An edited version of this article appeared as "Why Spurious Financial Precision May Be Killing Our Markets And Our Fish", City A.M., 15 September 2014.]
Why Spurious Financial Precision May Be Killing Our Markets And Our Fish
The way we handle uncertainty determines our future. Many of mankind’s self-created problems, from financial crises to environmental devastation, arise from poor analysis of future risks and rewards. We lack confidence in our tools for handling uncertainty. Within the financial sector we’ve been partially burned by derivatives, mark-to-market, or value-at-risk. Scottish devolution may be the latest reassessment of future scenarios, but there will be many more. We need to improve our toolkits. We need to improve our data.
‘Wicked problems’ is a phrase popularized in the 1970s to describe messy, circular, and aggressive problems. According to Laurence J Peter of The Peter Principle fame, “Some problems are so complex that you have to be highly intelligent and well informed just to be undecided about them.” In our book, The Price of Fish: A New Approach To Wicked Economics And Better Decisions, Ian Harris and I explore how we can meld four streams in any complex scenario, choice, economics, systems and evolution, to make better decisions about wicked problems. We also make suggestions. One such proposal is Confidence Accounting.
Confidence Accounting encourages companies and audit firms to use ranges, rather than discrete numbers, for major accounting entries. In a world of Confidence Accounting, the end results of audits would be presentations of distributions for major entries in financial statements. Ranges provide a fairer representation of results and valuations, mitigate mark-to-market effects, reduce the number of footnotes, and aid measuring audit quality over time.
One way to understand the importance of Confidence Accounting is to talk about fish. Back in the early 1900’s, on rumours that sardines had disappeared from their traditional waters in Monterey, California, commodity traders started to bid up the price of tinned sardines; a vibrant market ensued and the price of a tin of sardines soared. A classic bubble. One day after some successful trades a buyer chose to treat himself to an expensive snack; he actually opened a tin and ate the sardines. They tasted awful and made him feel ill, so the buyer called the seller and told him the sardines were no good. The seller said, “You don’t understand. Those are not eating sardines, they are trading sardines.” Ultimately, sardines off California were fished out by the 1950s. Had markets worked well on their own, and people really known the price of fish over space and time, we wouldn’t have overfished the North Sea, the Grand Banks of Newfoundland or Monterey.
Virtually all accounting entries require judgement, meaning that a range of values might apply. Accounting practices exclude the truth in a range behind overly-precise specific values. Over-precision forces companies to value assets, such as fish or fossil fuels, at higher or lower values than they might think they are worth in the longer-term, to the detriment of other natural resources or fossil fuels. A good example recently has been the stranded fossil fuel assets argument that if perhaps four-fifths of the fossil fuels on balance sheets are unburnable in the long-term, why are they calculated at full current prices. Using specific values when ranges are needed exacerbates volatility in markets and fish stocks.
There are numerous ‘judgement calls’ in financial statements - revenue recognition, tax liabilities, goodwill & intangibles, asset valuations, share-based payments, and management & performance fees. Confidence Accounting would have these judgement calls represented as ranges. There are indeed complicated ways of expressing ranges, such as errors bars on a chart, candlestick diagrams common amongst traders, time-based fan charts for economists, and box & whisper diagrams for scientists. There are simple ways. Simply state the bottom value, the expected value, and the top value, with a judgement on the likelihood that the value is in that range – a BET%.
Confidence Accounting may be started as easily as having audit committees to ask their auditors to discuss the accounts using ranges. A simple approach to ranges can go a long way in helping to incorporate knowledge and experience in discussions between audit committees and their auditors. Andy Haldane at the Bank of England, remarked, “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.” Much of the tension for accountants has been generated by single historic cost numbers colliding with the need for judgement about the future. More tension has been generated when historic and current accounts collide with future-looking risk scenarios. Much of the tension is released when ranges are recognised as fundamental to any discussion about financial reporting. Perhaps when we relax a little bit about precision we can gain some confidence about our decisions on markets and fish.
Michael Mainelli is Emeritus Professor of Commerce at Gresham College (founded 1597), Executive Chairman of Z/Yen Group, and Principal Advisor to Long Finance. His latest book, The Price of Fish: A New Approach to Wicked Economics and Better Decisions, written with Ian Harris, won the 2012 Independent Publisher Book Awards Finance, Investment & Economics Gold Prize.