By Michael Mainelli
Published by Economia, "Institute of Chartered Accountants of England and Wales” (December 2014), pages 68-69.
Fishing for Confidence in Accounting
Professor Michael Mainelli FCCA FCSI FBCS
“Why Spurious Financial Precision Is Killing Our Markets And Our Planet – And What Accountants Can Do About It”
[an edited version of this article appeared as "What Has Accounting Got To Do With The Price Of Fish?”, Economia, Institute of Chartered Accountants of England and Wales” (December 2014), pages 68-69.]
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 aren't eating sardines, those are trading sardines.” Ultimately, sardines off California were fished out by the 1950s.
A few millennia of fish markets, and a decade of CDOs, demonstrate that markets aren’t perfect. Had fish markets worked well, 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. We ‘mine’ fish. We discover a source of fish and deplete it to destruction. It is a strange world where, after millennia of trading, we still don’t know the price of fish. If we knew the correct price of fish, one-third of the world’s fisheries wouldn’t have collapsed and we wouldn’t be projecting total global fisheries collapse within the next fifty years while the seas grow increasingly acidic.
What has all this got to do with accountants? Our profession is supposed to provide the valuations of all these stocks, yet somewhere the system is failing. Despite our best intentions, we seem to be making problems worse rather than better. Whether it’s valuing technology companies that bubble and burst, or financial services that do the same, or long-term natural resources, it’s clear that we need to improve our decision-making toolkits.
Virtually all accounting entries require judgement, meaning that a range of values might apply. Accounting practice frequently excludes the truth contained in a range behind overly-precise specific values. Uncertainties are relegated to textual footnotes indicating that precise numbers above may or may not be of much use, go make up your own mind. We are particularly poor at handling uncertainty.
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. A good example has been the stranded fossil fuel assets argument: if perhaps four-fifths of the fossil fuels on balance sheets are unburnable in the long term (like those fish were inedible), why are they calculated at full current prices? It is difficult to have discussions with shareholders about the uncertainties ahead in numerical terms as a single number won’t do. Over-precision leads to poorer decisions.
Over-precision forces companies to act on transient measures. During the financial crises, mark-to-market as opposed to mark-within-range forced companies to liquidate holdings in the near-term even though their long-term ranges might have been acceptable. This liquidation in turn reduced prices thus forcing other companies to liquidate. A similar problem occurs as investors mark too frequently to indices, thus providing a bias for holding over selling and leading to higher volatility. Systematic mispricing would be mathematically amusing, if it didn’t create a propensity for crashes, misallocate capital, and dislocate lives. Using specific values when ranges are needed misprices and perturbs both markets and our planet’s stocks.
‘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.” While the phrase emerged from aircraft design and urban planning, we are not short of other wicked problems such as overpopulation, poverty, inequality, environmental degradation, climate change, or corporate planning.
Wicked problems are characterised by high degrees of uncertainty, and multiple components of uncertainty. 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, particularly about tools to handle uncertainty. One such suggestion is Confidence Accounting.
Auditing and accounting have been subject to much criticism over the past two decades. Criticism perhaps reached a peak in the early 2000’s after a series of telecommunications and internet failures, coupled with Enron’s collapse. Another peak of criticism followed the financial crises of 2007 to 2008. These criticisms are many and varied – audit firm market concentration, lack of independence, principal-agent problems, lack of indemnity, relationships with regulators, mark-to-market rules. Rarely, if at all, does criticism seem to question the basis of audit and accounting in terms of measurement science.
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 laser range finder contains a systematic error, then increasing sample size by measuring a bridge’s height above the water more often increases precision but not accuracy. If your laser range finder is very accurate but your bridge’s height above the water fluctuates, perhaps due to rains or tide, today’s spurious accuracy may not be a good guide to height, e.g. for providing consistent guidance to mariners about safe clearance.
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.
Confidence Accounting is a term for using distributions rather than discrete values in auditing and accounting. The term was coined by Long Finance proponents as part of a shift to interval estimates and confidence levels, making auditing and accounting more closely resemble other measurement sciences. 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 patents in a balance sheet might be stated as an interval, £100,000,000 ± 95,000,000, perhaps recognising a wide range of interesting technologies and the inherent uncertainties in technology development. 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. The proposed benefits of Confidence Accounting include a fairer representation of financial results, reduced footnotes, measurable audit quality and a mitigation of mark-to-market fluctuations.
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 percentage (%) judgement on the likelihood that the value is in that range – a BET%.
While regulatory, institute, legislative, and audit standards might promote such a change, Confidence Accounting can begin immediately in the dialogues between audit committees and their auditors. A supplementary report, or just an illustration to the side of an annual report, would suffice. Quite sensibly, firms should probably test it out first. Such piloting is as easy as having the audit committee begin discussing the accounts with auditors 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. Perhaps just focus on the balance sheet for such a pilot.
Applying Confidence Accounting to a simple natural resources company balance sheet for a few entries might produce an example table like this:
|Entry||Bottom||Expected||Top||% Confidence In Range|
|Natural resource reserves||£15,000,000||£20,000,000||£50,000,000||85%|
The BET% table above suggests a simple agenda for audit committees and their auditors. Proceeding line by line, the following questions naturally arise:
The biggest complaint about the Confidence Accounting proposal is a presumed increase in complexity. There is clearly a risk that this approach might increase complexity. However, an analysis of the Royal Bank of Scotland’s 2010 annual report concluded the opposite - a Confidence Accounting approach would have reduced the annual report’s 446 pages by between 29 and 99 pages, largely by removing senseless verbiage. There are tricky areas, such as derivatives and pensions, and politically sensitive areas, such as tax liabilities. That said, quite a bit of most balance sheets can be discussed by audit committees and their auditors using the straightforward BET% approach.
Alongside many professions addressing risk management, the accountancy profession is moving towards better understanding and better handling of uncertainty. Much of the tension for accountants has been generated by the discord of a single historic cost number colliding with the need for judgement. Just think of the interminable debates about historic cost versus market value. 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.
In support of Confidence Accounting, Andy Haldane, Executive Director for Financial Stability at the Bank of England in 2012 welcomed the proposal, writing: “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.”
So what is the price of fish? Well, if you’re a pessimist and believe in long-term trends of population growth and resource scarcity, the price has been too low for too long and demand will shrink supply to extinction. If you’re an optimist, then you believe accountants using ranges might help supply and demand reach sustainability. If you’re a fish, be an optimist; pessimism is for better times. Chill - relax precision a little bit and gain more confidence in determining the price of fish.
Ian Harris, Michael Mainelli and Jan-Peter Onstwedder, “Confidence Accounting: A Proposal”, Chartered Institute for Securities and Investment, Long Finance, Association of Chartered Certified Accountants (July 2012), 66 pages.
Michael Mainelli is Emeritus Professor of Commerce at Gresham College, 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, [Nicholas Brealey Publishing £12.99] written with Ian Harris, won the 2012 Independent Publisher Book Awards Finance, Investment & Economics Gold Prize.