Professor Michael Mainelli, Executive Chairman, The Z/Yen Group
[An edited version of this article first appeared as "Confidence Accounting: Putting Essential Uncertainty Back Into Auditing And Accounting", Journal of Risk Finance, Volume 10, Number 3, Emerald Group Publishing Limited (June 2009)]
Con Or Con-fidence?
“Guilty but not, yet, charged" would be a good summary of the accounting & audit profession’s status in the Credit Crunch at the beginning of 2009. Virtually all of the balance sheet and going concern statements for mainstream financial services firms over the past three years have been a complete and total waste of time and money, several billion $, £ and €. So let’s look at the charge sheet:
inaccurate: the typical financial audit presents information that is precisely wrong – it’s fairly obvious that, as things unwind, the probability that Global MegaCorp’s balance sheet last year is exactly £71 billion is darn close to zero, but we laugh that off, professionally, followed by surprise as valuations run down rapidly due to liquidity problems;
incomplete: the typical financial audit process is one of throwing information away as early as possible rather than using it – a typical annual report states an exact number, say £71 billion followed by three, six or nine digits, then adds 62 footnotes explaining why that single point was picked, yet readers could never be given just a simple range;
irrelevant: everyone now concedes that non-professional users can’t use the information for financial services firms, but moreover, as summarised by the House of Commons Treasury Committee Chairman, John McFall MP for HC 144-ix on 25 February 2008, "We had Brendan Nelson of KPMG before us, the Chief Auditor, and I asked him quite simply that if he had HSBC’s statement of accounts before him and he looked at them, could he understand it? He said he could not understand it.” Real users aren’t credulous, the effort involved in using accounts, particularly almost always out-of-date numbers, does not justify the contribution to investment decisions;
unreliable: auditors can’t be held to account, in two ways. First, it’s impossible to review their record and be statistically definitive about their performance. The numbers aren’t there to evaluate performance, i.e. have restatements exceeded the confidence levels they didn’t provide. Second, auditors don’t provide any indemnity (for more ideas on indemnity, see Mainelli & Ronen, 2006 on financial statements insurance);
late, to the point of useless: the typical financial audit environment hides information that others need to spend time wastefully recovering – look at the process that kick off after accounts are published. First, they question the management about the figures, desperately trying to get some idea of the ranges. Then, the analysts start comparing lots of figures with other companies and suppliers to try and set out some ranges, resulting in some distributions that then become the ranges they use to recommend buy, sell or hold.
In the past few years we have not so much put confidence back into accounting as much as we have put the ‘con’ into ‘con’-fidence game and corroded confidence in not just financial statements, but most numerical financial analysis. Annual reports and accounts, driven by audit standards, are incomprehensible, serving neither the specialist nor the lay user. As an example Goldman Sachs’ 2007 annual report is 154 pages (103 are just the financial report), Royal Bank of Scotland’s 252 pages, HSBC’s 477 pages. The public are sceptical of the state of financial information produced by auditors and accountants, and by implication the accounting techniques upon which their work is based. Accountants indulge in trendy ideas such as Triple Bottom Line reporting (corporate disclosure which integrates financial, environmental and social reporting) yet sudies of lay users show that they find the financial portions of annual reports incomprehensible. Other studies show that professional analysts ignore narrative reporting [Campbell and Slack, 2008].
Loss Of Competition Corrodes Confidence
Which is all a disgrace as good financial information is supposedly accurate, complete, relevant, reliable and timely. And this is not a ‘one off’. At the beginning of the millennium there were the high-profile failures of Enron, WorldCom, Qwest, Adelphia, Tyco, HealthSouth etc. What is going on? Why are audits less and relevant? Why does the accounting & audit profession seem not care? Problems with audit firms preceded these headline collapses, as bad diet precedes symptoms of illness. The decline in confidence in audit has been going apace for some while. Fairly evident by the mid-1980’s, the Dickensian practices of auditors inspired less and less confidence about their relevancy and their value. By the late 1980’s for a variety of reasons the industry was racing towards an oligopoly in the provision of audits. The coalescing of this oligopoly was due to a number of factors, such as regulation reducing new entrants, regulation reducing diversity, economies of scale and low differential added value. By 1970 the Big Ten were fusing to the Big 8 (1970s-1989), the Big 6 (1989-1998), the Big 5 (1998-2002) and the Big 4 (2002-present).
A more restricted list of audit firms created an increasing number of conflicts of interest as audit firms branched out into numerous business lines, most noticeably consulting and IT outsourcing, again very evident by the late 1980’s. Anglo-Saxon societies used litigation to solve the problems of poor audit quality and conflicts of interests, again very evident by the late 1980’s. Successful litigation exacerbated conflicts of interest and eased competition by reducing the number of firms further. Auditors and their firms attempted, predictably, to circumscribe liability, pretending to be one-stop international shops while collapsing nationally or threatening to collapse and create less so-called competition. Meanwhile, fees have soared, trebling in some cases in just a few years [Mainelli et al 2003] While much has been made of IFRS versus GAAP, the overall trend has been for more consolidation and less competition.
Theoretically, the trust that audits give to investors and other stakeholders such as employees, creditors, banks, governments and the general public is crucial to the functioning of modern commerce. If we believe that we have a true and fair view of our economic entities, then we can better understand them, better contract with them and better manage them. Yet we know that that trust is ebbing away. Audits are seen as a process ‘one goes through’ rather than a process that adds value. Public confidence in audits is low. The Public Company Accounting Oversight Board (PCAOB) is a private, nonprofit corporation established by the Sarbanes-Oxley Act of 2002 to oversee the auditors of public companies, an auditor of auditors. At a technical level, PCAOB assessments show that the loss of confidence has justification, but of much more concern is that the entire auditing profession is not working.
One issue is particularly troubling, mark-to-market, i.e. taking valuation from some third-party forum’s price. Why is this troubling?
relative value: different instruments have different values to different entities. A hedge fund that has been caught out on a long-term instrument in the short-term is different from a pension fund that may be holding the instrument to maturity where a short-term face value loss isn’t relevant. In fact, taken to extremes, if everyone arrived at the same value over any significant period, trading would be unnecessary – we trade because there are value differences;
specific timings: why does the valuation date dominate? We should, and do, make arguments about historic valuation over the period, volatility, etc. But this is all in aid of looking forward. Surely a range of potential future valuations, informed by historic prices, is key, not just marking-to-the-market price;
do you need an auditor: the value of the audit should be to agree that in many cases market values can differ from firm value, particularly on a portfolio basis. If this is not true, i.e. market values should be mandated, then who needs auditors? Market prices will do. Auditors are on a slippery slope here, but they can’t get off until they accept the need to present valuation information as ranges rather than discrete numbers.
If auditors practice risk-based auditing, then why can’t we see the odds they face? This simple question raises a number of concerns about the approach to financial statements and auditing by today’s accountants. Accountants and auditors throw away tremendous amounts of information as they use fixed numbers in almost all their calculations. The financial community knows that the annual report is subject to tremendous uncertainty, but will find little evidence therein. The key community for the annual report, investors, spend more of their time on reconstruction of the underlying ranges or guessing other investors’ sentiments than worrying about the annual reports singular guess at what might reality be. A lot of effort is wasted. Surely no theory of measurement has wasted so much effort ignoring the real world.
As in so many other areas of measurement, we should ask for four basic numbers – bottom, expected, top and the % of things being in that range, or BET% for the sake of an acronym. The obvious implication for auditors is that a specific number is the wrong measure. Too many things in profit, as in all accounting statements, are ranges, from the estimate of gains in freehold land value to the likely profit on individual contracts to the value of insurances, etc. To ensure total clarity, we litter the financial accounts with explanatory footnotes to the point that only highly sophisticated financial analysts can understand them. When the accounts are presented, these financial analysts tear them apart in order to try and re-build estimates based on ranges. Intriguingly, the auditors get off very, very lightly, practically skipping away. How do you hold an auditor to account? Is being off by £1 enough to claim the accounts are invalid? Certainly not. £2? Well, when? In fact auditors have cleverly avoided giving us anything substantive to go on, such as "we are 95% certain that profits were between £X and £Y”. Let’s think about forcing auditors to lay these ranges out clearly and pin down their estimates using BET%.
For want of a phrase for this theoretical framework, let’s call it "Confidence Accounting”. If every output is a probability distribution, we need to have statements of the confidence the accountant or auditor have of the range. A single number for accounting terms such as turnover is "clear and simple and wrong”. As long as accountants continue to indulge this false simplicity, they will leave themselves exposed to misunderstandings of what they said and consequent misunderstandings of their role.
Successful Confidence Accounting would be the presentation of audited accounts in a probabilistic manner. Beneath that evidence we would expect to see methods which established input distributions, determined their interactions (e.g. sensitivity analysis, Monte Carlo simulations and some statistical calculations) and presented their impact in meaningful statements. If outputs from Confidence Accounting are distributions, then they should materially affect the way financial statements look and feel. The structure of financial statements would remain similar to the three current, primary statements, viz.income statement (profit & loss), balance sheet and cashflow. However, the accountant would present three distributions as histograms for profit, net assets and cash. The auditor would ensure that the distribution functions presented are not materially misleading and would perform sensitivity analysis on the distributions to determine where greater investigation would narrow the range at the same confidence level.
Confidence or Credulity?
Many firms have too little data to give any statistical validity to a distribution. However, much can be done to provide data through intra-firm comparisons, benchmarking or auditor input, e.g. what is a standard actuarial curve for bad debts in a given business sector. As directors must "prepare annual financial statements that give a true and fair view of the state of affairs”, in many cases they will have to provide a qualitative distribution curve (in fact, quite a bit of software supports homemade distribution curves). If this seems artificial, in fact it’s quite the opposite. Which is worse, forcing directors to a single number, such as a guess-timated mean, or asking them to specify their views of the likely range of outcomes?
Some organisations will want to provide extremely wide ranges in their distributions. Where this reflects reality, so be it. In other cases managers will hope that a wide range removes some responsibility of meeting target. However, markets will punish managers who have not invested enough in gathering information to reduce uncertainty. Expect phrases such as "Global MegaCorp was punished today on release of its results, with a range for ROA of over 15% in an industry where 5% is the norm, much of this attributed to overseas licence problems…" Further, managers will be forced to, in Baruch Lev’s terms, "true up”. If they are consistently providing silly future estimates, and these are now recorded in the financial accounts, they are there for investors to judge. There will also be a competitive force on auditors, both from an increased ability to compare their previous years’ approvals with outcomes, and also from being known to be prone to wild ranges. Markets will transparently price the value of tighter distribution ranges.
There are some obvious complications. Standard representations of distribution histograms will have to be specified. Distribution function measures will have to be specified as well, to ensure accurate presentation. Alongside existing numerical descriptions of shape such as kurtosis or skewness, people will seek single number measures for comparison, e.g. riskiness. Some of these measures may well help, particularly if they are calculated and presented in standardised forms.
Many people will claim that the mythical "Aunt Agatha" cannot understand all this. It’s too complicated - yet life is complicated. While I would support more research on how presentation of distributions could be improved, I would contend that Aunt Agatha cannot understand today all the footnotes that only help a sophisticated financial analyst partially reconstruct the probabilities.
If accountants are to move from a deterministic towards a stochastic paradigm, much work needs to be done, largely in three areas – commitment by the accounting establishment to reform, restructuring of accounting training, and better communication to users of financial information. The starting point is an open debate about extending the conceptual framework of accounting to include stochastic concepts. This debate ought to lead to commitment from the accounting establishment for Confidence Accounting and recognition that deterministic accounting is the root of many current problems. Evidence of that commitment would be more presentations incorporating distributions rather than single points, a review of accounting standards (GAAP and IAS) to see where replacing a single number with a distribution would simplify statements and a review of audit methodology to change risk-based auditing to a more rigorous method based on quantitative evidence of estimation.
Financial information is evaluated by its usefulness in making financial decisions. Moving to Confidence Accounting improves several characteristics of published financial information. Confidence Accounting is a change of perspective that resolves inconsistencies. So, let’s take the con out of accounting, put the uncertainty back in and help the confidence increase, oh, and reintroduce competition, get auditors to state their indemnity levels beforehand …, but those are other articles.
David Campbell and Richard Slack, "Narrative Reporting: Analysts’ Perceptions of its Value and Relevance”, ACCA Research Report 104 (2008).
Mark Stevens, The Big Eight: Inside America’s Largest Accounting Firms, Macmillan, 1984.
Michael Mainelli and Ian Harris, "Balancing the Odds: Stochastic Accounting”, Balance Sheet, Volume 10, Issue 2, pages 22-27, MCB University Press (2002).
Michael Mainelli and Joshua Ronen, "Put Your Money Where Your Audit Is: Financial Statement Insurance In The UK?”, Journal of Risk Finance, The Michael Mainelli Column, Volume 7, Number 4, pages 446-450, Emerald Group Publishing Limited (August 2006).
Michael Mainelli, Ian Harris and Alan Helmore-Simpson, "The Auditor’s Cross Subsidy" (statistical modelling of audit prices), Strategic Planning Society Newsletter (June 2003).
Uncorrected Transcript Of Oral Evidence To Be Published As Hc 144-Ix, House Of Commons, Minutes Of Evidence, Treasury Committee, Banking Crisis, 25 February 2009, Mr Hector Sants, Lord Turner Of Ecchinswell and Ms Loretta Minghella, Public Questions 2140 - 2319 - http://www.parliament.uk/parliamentary_committees/treasury_committee/bankingcrisis.cfm