Professor Michael Mainelli, Executive Chairman, The Z/Yen Group
A decade ago a series of failures embarrassed auditors. Large firms boasting successful-looking financial statements collapsed. Today, auditors boast punctured balance sheet and going concern statements of global financial institutions. Surely this is a good time to rethink auditing.
People who move from science to accounting are stunned to find that auditors do not practice measurement science. Scientific measurement specifies accuracy and precision. Accuracy - how closely a stated value is to the actual value. Precision - how likely repeated measurements will produce the same results. A measurement system can be accurate but not precise, precise but not accurate, neither, or both. If your bathroom scale contains a systematic error, then increasing sample size by weighing yourself more often increases precision but not accuracy. If your bathroom scale is very accurate but your past and future weight fluctuate wildly, today’s spurious accuracy is not a good guide to your weight, e.g. for safety purposes.
Scientists view measurement as a process that produces a range. Scientists express a measurement as X, with a surrounding interval. There is a big difference between point estimation and interval estimation. Auditors provide point estimates, scientists intervals. For example, physical scientists report X ± Y. Social scientists report interval estimates for an election poll and state how confident they are in that the actual value resides in the interval. Statistical terms, such as mean, mode, median, deviation, or skew, are common terms to describe a measurement distribution’s ‘look and feel’. The key point is that scientists are trying to express characteristics of a distribution, not a single point. Finance should be no different.
For want of a term that distinguishes the use of distributions from the use of points or discrete values, let’s use “Confidence Accounting”. This term was coined by Long Finance proponents of a shift to interval estimates and confidence levels. In a world of Confidence Accounting the end results of audits would be presentations of distributions for major entries in the profit & loss, balance sheet and cashflow statements. The value of freehold land in a balance sheet might be stated as an interval, £150,000,000 ± 45,000,000, perhaps recognising a wide range of interesting properties and the illiquidity of property holdings. Next to each value would be confirmation of the confidence level, e.g. 95% confidence that another audit would have produced a value within that range. Finally, there would be a picture, a histogram of the distribution, so people can see the shape of things.
Counter-charges to Confidence Accounting are complexity and ‘gaming’. But audit is complex and the profession needs to worry about members’ scientific measurement ignorance. Managers are already gaming a system that provides too many ‘get-outs’ based on the unfairness of reporting on single numbers. Under Confidence Accounting, difficult single numbers, such as exploration assets or environmental liabilities, become ranges. A range of potential future valuations better reflects reality than marked-to-the-market prices at a particular valuation date. For users, presentation would be easier to understand and many footnotes would be redundant.
Under Confidence Accounting, external assessors could evaluate managers and auditors performance. If managers consistently provide silly future estimates, the silly estimates remain there for investors to judge. Any audit firm will have a number of client failures over, say, a decade. If failures are within confidence levels, then we have a good, or even too prudent, auditor. If not, perhaps a sloppy, or statistically unusual, auditor. Markets will price the value of higher confidence levels, and quality auditors will be able to value work on better disclosure appropriately.
Work needs to be done, largely in three areas – commitment by the auditing establishment to reform, restructuring audit skills, and better communication to users of financial information. Auditors are taught that good financial information is accurate, complete, relevant, reliable and timely. Confidence Accounting more accurately reflects the situation, provides more complete information, is more relevant to users, allows reliability to be checked and takes better account of timing issues. Audit reform will come. Better that reform is based more on science than on more compliance.
Established in 02007 by Z/Yen Group in conjunction with Gresham College, the Long Finance initiative began with the conundrum - “when would we know our financial system is working?” Long Finance aims to “improve society’s understanding and use of finance over the long term”, in contrast to the short-termism that defines today’s financial and economic views. Long Finance is a community which can be explored and joined at www.longfinance.net – there you can also find "In Search of the Eternal Coin: A Long Finance View Of History".