Proposal for accounting
Proposal for
Name : ABBAS JUMAAL JAYED
Country : Iraq
Email : abbasjoumach6@gmail.com
Contents
Abstract
Foreword......................................................................................................................4
Executive
summary.......................................................................................................................5
1.Origins........................................................................................................................6
2.Concept........................................................................................................................9
3.Models........................................................................................................................12
4.Benefits......................................................................................................................14
5.Worked examples..................................................................................................... 15
6.DiscussionMarket value, going concern, valuation uncertaint.....................................17
7.Further research........................................................................................................
21
8.Questions for discussion and comment
Bibliography
Abstract
Confidence
Accounting is a novel proposal for using distributions, rather than discrete
values, in auditing and accounting statements . previous efforts to
demonstrate the value of confidence interval financial statements for credit
evaluation and investment decisions have met with limited success. The present
study examined the impact of nonfinancial confidence interval reports on
predecisional behavior. A Bayesian revision task was used to investigate the
impact of report type, information system uncertainty and decision problem
uncertainty on the accuracy of probability judgements. All three variables
influenced task performance. Moreover, subjects given confidence interval
reports outperformed those who were given single-figure reports when
significant information system and decision problem uncertainties were present.
The results obtained here suggest several facets of the decision setting which
may influence the value of confidence interval financial statements.
Foreword
Confidence Accounting is a novel proposal for
using distributions, rather than discrete values, in auditing and accounting
statements. In a world of Confidence Accounting, the end results of audits
would be distributions for the profit and loss, balance sheet and cash flow
statements of major entities. The proposed benefits of Confidence Accounting
include a fairer representation of risks around financial results. That is an
essential prerequisite for the effective pricing of risk by end-investors. I
welcome this consultation document, which ACCA, CISI and Long Finance have
issued. Confidence Accounting is a big idea. As such, it will benefit from
debates and suggestions from the communities of account users, account
providers and regulators. I look forward to that discussion. 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.
Executive
summary
The use of a single number for accounting
terms such as profit or balance sheet value is clear and simple, but wrong.
’Confidence Accounting’ is a term for a proposal to use distributions rather
than discrete values in accounting and auditing. The term was coined by Long
Finance proponents as part of a shift from using specific values in accounts to
the use of interval estimates and confidence levels, making accounting and
auditing practices 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 and loss, balance sheet and cash flow statements.
Accountants would present uncertainties as ranges to investors and managers,
rather than as discrete numbers: ‘the balance sheet of Company X is worth £Y,
plus or minus £Z, and we are 95% confident that it falls within this range’.
Auditors would verify these ranges. This would move auditing towards
‘measurement science’, in line with the way most laboratories report
measurements.
Audited accounts would be presented in a
probabilistic manner, showing ranges. Over time, investors could evaluate an
audit firm on the basis of how closely historic accounts fell within the stated
ranges. Such evaluations might conclude that firms were too lax or too strict.
Clients would be able to make their own decisions about audit quality on the
basis of historic evidence rather than having to rely on assertions of quality.
In 2011, ACCA (the Association of Chartered
Certified Accountants) and the Chartered Institute of Securities &
Investment (CISI) commissioned the Long Finance community, led by Z/Yen Group
Limited (Z/Yen), to provide a proposal setting out the arguments for Confidence
Accounting and two worked examples of how audited accounts prepared under
Confidence Accounting for two hypothetical firms might look, one for a bank
(BancoUK Plc) and one for a professional services firm (Pro-Co UK Ltd). The two
worked examples are presented in the first two appendices.
The proposed benefits of
Confidence Accounting include a fairer representation of financial results,
shorter and fewer footnotes, measurable audit quality and a mitigation of
mark-to-market perturbations.
The
worked examples show that Confidence Accounting:
-Is
workable and can be applied to banks and professional services firms,
and probably
most major firms in other industries
-Does
result in a fairer representation of financial results
- could
reduce the size and complexity of annual reports, in the case of Royal Bank of
Scotland, for instance, by between 29 and 99 pages out of 446 pages (2010) -probably provides a sound basis for measuring
audit quality
-probably
provides a basis for beginning to reconcile balance sheet valuation and market
value, and
-
Certainly highlights the need for clarity between uncertainties over valuation
during the period of going concern versus risk about changes in the state of
the economic climate.
The worked examples raised issues of
defining ’going concern’, mark-to-market valuation and identifying
discontinuous environmental change. Those involved in future Confidence
Accounting discussions may find that this approach helps to reconcile some of
these problems. The authors feel that Confidence Accounting would enhance
existing financial reporting. They envisage that Confidence Accounting would be
presented alongside traditional accounts, either as part of the notes or as a
set of preform accounts.
1.
Origins
This report argues that the use of a
deterministic numeric paradigm in accounting and auditing may well be the root
cause of many current problems. Accounting methods could use probabilistic
inputs and show resultant outputs as distributions of numbers. Accounting and
auditing have been subject to much criticism over the past two decades.
During
the dot.com era, some accountants subjected themselves to needless criticism by
putting forward business plans based on deterministic numbers that were
incapable of showing the all-too-frequent reality: a small chance of making
lots of money and a large chance of losing money. Had accountants submitted
plans that showed the distributions, they might well have served investors
better, reduced unreasonable expectations and minimised criticism of the
accountants’ role. Instead, they presented single numbers or played with high,
medium or low forecasts to calculate ’average’ forecasts, none of which
contained the possibility of winding up the business or conversely of wild
success.
Criticism perhaps reached a peak in the
early 2000s after a series of telecommunications and Internet company failures,
coupled with Enron’s collapse. More criticism has followed the financial crises
since 2007. These crises have been systemic failures, where interactions among
banks, rating agencies, regulators, governments, financial instruments, and
auditors mattered more than the specific behaviour of a particular actor.
Still, as important actors, it is incumbent on accounting professionals to
explore how auditing and accounting could be improved.
Something akin to Confidence Accounting was
raised in 1977 in a letter to the New York Times by Professor Joshua Ronen of
New York University’s Stern School: ‘The myth of certainty, with its accounting
for the past, holds the accounting profession to a single number’. In the 1990s
and early 2000s, Mainelli and Harris used the term ’Stochastic Accounting’
(Mainelli and Harris 2002). In the mid 2000s the term ’Confidence Accounting’
was coined by Long Finance (www.longfinance.net) proponents as part of a shift
to interval estimates and confidence levels, making accounting and auditing
more closely resemble other measurement sciences. In 2006 Gresham College held
a symposium in conjunction with New York University, ‘Reforming Auditing –
Incremental Change or Radical Action?’, with Professor Ronen, where the
connection to Ronen’s earlier thoughts was made.
As Paul Moxey of ACCA observes, ‘If
auditors practise 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. ‘Balancing the odds’
might well give a truer and fairer picture of accounting than traditional ways
of ‘balancing the books’. Chenoweth notes that News Corporation reported its
profits for 1987 as Aus$364.364 million, 1988 as Aus$464.464 million, 1989 as
Aus$496.496 million, 1990 as Aus$282.282 million, 1991 as Aus$391.391 million,
and 1992 as Aus$530.530 million, after which it moved to rounded millions. As
he queries, ‘If this accounting team is so confident that they can make the
minor numbers in a profit report say anything they want, then what does this
say about the big numbers the company was reporting?’ (Chenoweth 2002: 302)
2.
Concept
Confidence Accounting is a term that covers
the use of distributions rather than discrete values 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 and
loss, balance sheet and cash flow 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, eg, 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, fewer and
shorter footnotes, measurable audit quality and a mitigation of mark-to-market
perturbations.
The
banker and financial researcher, John Abbink, relates a story about a banking
analyst who had an interview with the CFO of a large European bank. As they
were chatting about the accuracy of the financial results, the CFO picked up a
copy of the bank’s annual report and opened it to the P&L.
The CFO ran his finger down the accounts till
he reached the bottom and said, ‘Ah, yes, Dividends Paid. This number is true’.
Perhaps it is, but there are numerous accounting, and thus audit, issues where
a range reflects the true situation:
-capitalisation of research and development,
where assessments need to be made on the likelihood of a future revenue stream
-intangible assets whose future value may
fluctuate markedly, such as long-term contracts, patents, trademarks and
licensing agreements, must be recognised, valued, and amortised, yet this may
not include all intangible assets – only intangible assets that meet certain
criteria according to SFAS 141
-administering pensions and health-care
obligations, where actuarial assumptions become crucial .
PRESENTATION
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, ie balance sheet, income statement
(profit and loss) and statement of cash flows. The accountant would, however,
present three distributions as histograms for net assets, profit and cash.
These distributions would be built up in turn from underlying distributions, eg
in the case of assets – current assets, property, plant, equipment,
investments, etc.
A standardised reporting format might specify
the presentation of the distribution and conventions on representing confidence
levels, quartiles or standard deviations. Standard representations of
distribution histograms will have to be specified. Standards for distribution
function measures will have to be specified as well, to ensure accurate
presentation. Graphical disclosure is important for Confidence Accounting.
By
showing the four most relevant data elements (previous year’s actual loss,
current year’s expected loss, current year’s 90th percentile, and the worst
loss over the previous 10 years) most users will be able to make informed judgments
about the degree of prudence used in the preparation of the accounts.
Assumptions can be easily compared across a sector and with external views, eg
those of economic forecasters, rating agencies and equity analysts.
Hu
(2011) points out that there could be benefits from more comparable practices
among auditors and credit rating agencies, allowing each to benefit. Although
there would be a substantial volume of disclosures, the format is simple and
can be applied consistently.
3.
Models
One objective of published accounts must be to
allow comparisons between different companies in the same business, and for the
same company over time. That means there must be a high degree of consistency
in methodology and a relatively high degree of consistency in the way key
inputs are determined in pursuit of an objective of informing stakeholders
about the uncertainty in the values of assets and liabilities at the reporting
date. The only way to ensure that everyone aims at the same objective with a useful
degree of consistency is to use a model (in a relatively loose sense of the
word ‘model’).
Models are very useful but they come with
limitations and shortcomings since they have to simplify reality. For the kind
of model implied by Confidence Accounting, the critical shortcomings are that
inputs have to be estimated by a wide range of practitioners in a way that the
results, for a given firm, are not unduly dependent on the individual
accountant but are overwhelmingly the consequence of data and rules. In turn,
inputs must be derived from reliable data sources using more or less standard
methods.
The obvious consequence is
that the accounts are limited to informing the reader about ‘known unknowns’.
The only way to incorporate ‘unknown unknowns’ is to imagine them (eg stress
testing), but that will always be subjective and should be kept out of
accounting.
Confidence Accounting addresses the
‘known knowns’, current uncertainty, but not the ‘known unknowns’ of risk lore
or the ‘unknown unknowns’ of which people are inherently ignorant. Edward Nell
distinguishes current uncertainty from natural and market uncertainty: At least
two senses of ’uncertainty’ can usefully be distinguished – ‘natural
uncertainty’ meaning that the world is nonergodic (the law of large numbers
does not apply in a particular situation; the situation is unique) and that in
general the future cannot be predicted from study of the past, and ‘market
uncertainty’ which arises from the fact that agents do not know each other’s
intentions, and/or how the various strategies will work out when played.
Neither can be reduced to calculable risk. (Nell 1998: 68)
4.
Benefits
The
central role assigned to decision making leads straight to the overriding
criterion by which all accounting choices must be judged. The better choice is
the one that, subject to considerations of cost, produces from among the
available alternatives information that is most useful for decision making.
(Financial Accounting Standards Board 1980: 1) Financial information is
evaluated by its usefulness and comprehensibility for making financial
decisions. Moving to Confidence Accounting improves a number of characteristics
of accounting information as.
5.
Worked
examples
To move discussion further
along it would help to be able to show worked examples, ie pro forma sets of
accounts based on Confidence Accounting.
So,
in 2011 the Association of Chartered Certified Accountants (ACCA) commissioned
Z/Yen Group Limited (Z/Yen) to provide two short worked examples of how a
bank’s and a small professional firm’s audited accounts might look as prepared
under Confidence Accounting. The first example, Banco-UK Plc takes the form of
a presentation by the finance director of a hypothetical UK bank, loosely based
on an actual major institution.
The Chartered Institute for Securities &
Investment (CISI) was pleased to support this work, and ran an afternoon
seminar to discuss the draft worked example. The example concentrates on the
key line items in the balance sheet and income statement, and draws on
disclosures in the annual reports over a five-year period. The example attempts
to illustrate the key assumptions that are required to produce a pro forma set
of accounts based on Confidence Accounting including a graphical presentation
of the results.
6. Discussion – market value, going concern, valuation
uncertainty
WHAT IS A
‘GOING CONCERN’? UNCERTAINTY VERSUS RISK
In the worked example on bank equity, the finance
director points out that the mean value of equity at the balance sheet date is £36 billion, with a minimum of £6.5
billion and a maximum of £65 billion, with 95% confidence the value of equity is at least £24 billion.
The 95th percentile value supports a ’going concern’ assertion (assuming that £24 billion is sufficient for
regulatory requirements). If the state of the world does not change, the realised value of the balance
sheet should be no more than £(36–24) = £12 billion worse than the mean. If the net assets over a subsequent
period were to fall £12 billion short, and cannot be explained by a change in the fundamental business climate, or a very
substantial change in the business model and
exposures,or a very large intra-period event, then the
quality of the balance sheet (and audit) must be called into question.
7. Further research
A number of points arose in discussion among the authors,
commentators and workshop attenders. Following its application to banks, many people
believed that the next logical application would be for insurance companies. The
following issues are of particular note.
TO SOME
EXTENT, MANAGEMENT JUDGEMENT IS ALREADY INCLUDED IN REPORTED ACCOUNTS.
True, but current guidelines stress ’prudent’ reporting
that creates a systematic bias in values and does not give an indication of uncertainty over the
value. Many of the immediate reactions to the draft worked example assumed that the
distributions were ‘normal’, ‘Gaussian’ or ‘bell-shaped’ in all cases. After
discussion, people realised this was not the case. In the example, loan
losses are far from symmetrically distributed. Further, many items in today’s
banking accounts are at extreme values and not at expected values. Arguably,
Confidence Accounting provides a better framework for disclosing the
use of extreme values and a strong reason to support Confidence Accounting.
THIS LOOKS
LIKE A ‘FORWARD LOOKING VALUE AT RISK’ (VAR) COMPUTATION ON PROFITS
Confidence Accounting has similarities to VaR but is
different in its purpose. VaR is intended to incorporate changes in the state of the world over
a short time period, but does not include any uncertainty over value given a specific state
of the world (where ‘state of the world’ is a complete set of rates and prices
used to value trading positions). Confidence Accounting is intended to express
uncertainty over value in the state of the world as at the reporting date, with most of that
uncertainty arising from the need to make assumptions beyond observablerates
and prices in trading markets in order to value assets and liabilities.
8. Questions for discussion and comment
The authors and the publishers are keen for this paper to
stimulate discussion and invite comment on how financial accounts can better
recognise both uncertainty and confidence about valuations. Listed below are
three series of questions (1) general discussion questions, (2) questions
specifically for ACCA and CISI members and (3) authors’ questions, mainly of a
more detailed technical nature. Readers are invited to
submit comments and answers to any or all of the
questions, or make other general comments to michael_mainelli@zyen.com ACCA would be grateful if ACCA
members could also respond to Paul Moxey, head of corporate governance and risk
management (paul.moxey@accaglobal.com), at any time until 31 December 2012.
GENERAL DISCUSSION QUESTIONS
1. Is the degree of precision to which
figures in accounts are currently reported a problem? If so, to whomand why?
2. Do you think that ’Confidence Accounting’
is worth further consideration or would you suggest a different approach – if so, what?
3. Does this report contribute to the debate
about the future direction of financial reporting, even if the exact presentation of the idea has faults?
4. To what extent is there a desire from
analysts or investors to find a better way to report precision and uncertainty around valuations?
5. Should an approach such as Confidence
Accounting be a supplement to existing reporting requirements or a full or partial replacement.
6. Is corporate reporting suited to the use of
more scientific methods of presentation? In particular, how would these methods meet the needs of users
and preparers in terms of accuracy (given the limitations of the modelling) and understandability (in view
of the need for some knowledge of statistical methods and reporting)? Is there a danger that a more ‘scientific’
presentation might appear more accurate than it actually is?
7. This report uses frequency distribution
diagrams to represent uncertainty, but might other representations,such
as error bars or candlestick diagrams, be more easily understood?
9. Conclusion
If
accountants are to move to a ‘range’ paradigm, much work needs to be done,
largely in three areas:
commitment by the accounting establishment.
restructuring of accounting training, and
communication to users of financial information.
The
starting point is an open debate about extending the conceptual framework of
accounting to include probabilistic concepts. This debate
ought to lead to commitment from the accounting establishment by recognising that deterministic accounting is the root of
many current problems. Confidence Accounting is a change
of perspective that resolves inconsistencies, not an attack on the foundations.
Evidence of that commitment would be more
presentations incorporating distributions rather than single points, a review
of accounting standards (GAAP and IASC)
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, not qualitative, evidence of estimation
.
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