Slide 1

Professor Michael Mainelli, Executive Chairman, The Z/Yen Group
Jan-Peter Onstwedder, Senior Risk Manager

[An edited version of this article appeared as "Buried Treasure" , The CA, Institute of Chartered Accountants of Scotland (December 2012), pages 84-85.]

Accounting supports decisions, both internal to an organisation and external for investors, lenders, customers and other stakeholders. Current accounts have a major shortcoming: they have little to say about the uncertainty surrounding values of assets and liabilities, or expenses and revenues. Yet, almost every decision worth thinking about hinges on uncertainty.

Confidence Accounting is a proposal to use distributions, rather than discrete values, where appropriate in auditing and accounting. 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 proposed benefits of Confidence Accounting include a fairer representation of financial results, reduced footnotes, more measurable audit quality and a mitigation of mark-to-market perturbations. In July 2012, the Association of Chartered Certified Accountants, the Chartered Institute for Securities & Investment, and Long Finance published a landmark, free-to-download report - “Confidence Accounting: A Proposal” [http://www.zyen.com/activities/836-confidence-accounting.html, 63 pages].

Andy Haldane, Executive Director for Financial Stability at the Bank of England, welcomed the proposal and wrote in the foreword, “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.”

The report introduces Confidence Accounting and contains two examples, how it could be implemented for the accounts of a bank and how it could be implemented by a small professional services firm. But those are hardly the only types of company where major uncertainties should be more transparent in the accounts, not buried in the management discussion or footnotes. For example, natural resource companies hold a significant part of their value in physical reserves. Reserve valuation is a combination of art and science. Exploration and production companies, as well as their lenders and investors and potential merger or takeover targets, spend a lot of effort understanding the physical reserves. But they cannot look to the financial accounts for much help: those give a ‘conservative’ value based on guidelines generally set to assure lenders about the minimum amounts that can be extracted using today’s technology and brought to market economically at today’s prices.

So what’s wrong with that number? Everything. Even lenders barely use it: they use industry standard methods to assess recoverable reserves that are different, combined with their own price forecasts, and crucially, their own estimates of those values in a base case, in various downside cases, and generally in upside cases as well. Why? Before lending, lenders need to understand the range of possible outcomes, what might go wrong, and what might go well. After lending, lenders need to refresh those assessments periodically, and find management or published accounts of little help. Such assessments allow better individual credit decisions, but also meaningful comparisons across a portfolio through an understanding of which risks are unique to each firm, and which are common to an entire sector.

And equity investors certainly don’t use the accounting valuations as anything other than a starting point for their own analysis. They, too, want to understand how values might change in future, and that means understanding price sensitivities, the range of recoverable amounts not just with current technology but with emerging technologies (think of shale gas to understand how new technology can rapidly affect valuations!), and numerous other environmental factors.

Consider climate change. In “Unburnable Carbon – Are the World’s Financial Markets Carrying A Carbon Bubble?”, published in July 2011 by Carbon Tracker [http://www.longfinance.net/la-reports/index.php?option=com_content&view=article&id=470&Itemid=157, 33 pages], author James Leaton writes in the Executive Summary:

“Research by the Potsdam Institute calculates that to reduce the chance of exceeding 2°C warming to 20%, the global carbon budget for 2000-2050 is 886 GtCO2. Minus emissions from the first decade of this century, this leaves a budget of 565 GtCO2 for the remaining 40 years to 2050. The total carbon potential of the Earth’s known fossil fuel reserves comes to 2795 GtCO2. 65% of this is from coal, with oil providing 22% and gas 13%. This means that governments and global markets are currently treating as assets, reserves equivalent to nearly 5 times the carbon budget for the next 40 years. The investment consequences of using only 20% of these reserves have not yet been assessed.”

In other words, if the world will actually restrict the use of fossil fuels to limit global warming to approximately 2 degrees Centigrade, only a fraction of reserves currently on companies’ balance sheets can actually be used. But all those reserves are valued confidently at today’s prices, for the total amount technically recoverable. We accept uncertainty about technical recovery in the accounts, but not uncertainty about the economic ability to recover. Now people can, and do, argue about the likelihood of political will to implement regulations or other measures that will restrict greenhouse gas emissions consistent with the recommendations of climate scientists. Depending on your political persuasion and your level of scepticism or confidence in complex and emerging science, you may disregard this factor as a triviality, or you may put it front and centre in your analysis of a company’s value.

But in neither of those cases do the accounts give you much insight about the uncertainty everyone knows is there. Confidence Accounting proposes that the accounts show ranges of values, with a clear and concise explanation of the assumptions used to generate the expected value. This could be a full-blown distribution range, a bit like the Bank of England’s inflation ‘fan’ charts. It could also be some simple downside and upside ranges at, say, the 5% and 95% confidence ranges as assessed by management. Ranges could be expressed using something graphical in-between, think candlestick diagrams.

Too difficult? As we noted before, equity analysts, corporate financiers and lenders already do this analysis today, just with their own estimates, which no doubt are worse than those of management. Company managers should have the best views on technology and resource recovery prospects. It seems reasonable that as these views constitute a major part of the valuation the inherent uncertainties of management should be shared. This kind of analysis is conducted before committing billions to new exploration projects, so sharing it is not that difficult a step.

The current bias in accounting itowards ‘conservative values’ leads, like any systematic bias, to a misallocation of resources. In the case of natural reserves accounting, the lack of information on the potential upside could lead lenders and equity investors to lend or invest less than is actually warranted - and therefore lend and invest more in other companies and projects. This distortion can be reduced by incorporating the potential upside in a clear and consistent manner through confidence accounting.

Ranges should help outside parties to evaluate not only the best estimate of reserve values (instead of the conservatively biased estimate they currently get), but also the views and beliefs management holds. And the views and beliefs would not be muffled in the woolly marketing phrases of the management discussion, but in quantitative charts and tables complete with assumptions and methodologies. Further, these management opinions can be tested over time to see how their views of uncertainties evolve.

Bertrand Russell wrote: “The whole problem with the world is that fools and fanatics are always so certain of themselves, but wiser men so full of doubts.” Uncertainty is everywhere. Dealing with uncertainty is what analysis is all about. Uncertainty is part of every decent financial analysis today. Shouldn’t it be part of accounting, too?

About the authors:
Jan-Peter Onstwedder is a senior risk manager at an international bank. Jan-Peter was co-author of “Confidence Accounting: A Proposal”. The opinions in this article are his strictly his own. Professor Michael Mainelli is Executive Chairman of Z/Yen Group. Michael’s third book, based on his Gresham College lecture series from 2005 to 2009 and co-authored with Ian Harris, “The Price of Fish: A New Approach to Wicked Economics and Better Decisions”, introduces Confidence Accounting to a lay audience and won the 2012 Independent Publisher Book Awards Finance, Investment & Economics Gold Prize.