Painting by Numbers

Accounting is something that people do, and understanding accounting helps to understand people in their social context, writes Professor Paul Dunmore.

This is an edited version of Professor Dunmore’s inaugural lecture, delivered 26 July 2006

In July, Auckland International Airport Ltd announced that its assets had been revalued as at 30 June 2006. This more than doubled the reported value of the assets and the owners’ investment. Nothing changed on the ground; only the description changed.

Auckland Airport’s profit has been close to 8 percent of assets for several years. To preserve that reasonable return on a more-than-doubled investment, Auckland Airport must more than double its profits in future. If expenses stay the same, revenues must increase by two-thirds to achieve that. Airlines fear1 that Auckland Airport will use this accounting change as an excuse to justify higher charges.

Auckland Airport can increase its charges because of its near-monopoly power; other airports in a weaker position would find it harder to increase their charges whether their assets are revalued or not. But the airport’s accounting choice provides a story to justify the increase. It would be hard for the Commerce Commission to insist that the airport’s shareholders should not receive an 8 percent return on their investment when they could get 7 percent from a bank deposit.

New Zealand accounting standards encourage, but do not require, organisations to revalue their assets. Revaluation is most commonly used by public sector bodies such as universities, and by infrastructure companies with a near-monopoly position. Companies in highly competitive markets do not revalue their assets because they cannot raise prices, so revaluing would simply reduce their reported profitability. In non-competitive markets, however, revaluation provides an argument to raise prices.2 Because people regard accounting as arcane and unchallengeable, such decisions tend to pre-empt effective debate about prices.

Many people find this astonishing and vaguely corrupt. Surely accounting is a practical, rule-based profession, focused on trustworthy recording of facts? The reality is far more interesting: accounting is something that people do, and understanding accounting helps to understand people in their social context.

People employ accountants because what accountants do is useful, providing information for accountability, for economic decision-making, and for sharing resources.

Over time, practices have evolved that have been found useful for these purposes. Various principles and concepts have then been inferred from these practices. However, the principles are justified only because they lead to useful practices. Regulators ignore the principles when they get in the way: for example, when the International Accounting Standards Board decided that they did not want internally-generated brand names to be recorded as assets, they simply changed the definition of assets to achieve this.

Undergraduate accounting education focuses on learning to do all this well: graduates should be able to use well-established techniques, to understand applicable standards, and to be familiar with the underlying theories, all backed with the beginnings of sound judgement. Academic research, however, contributes little to improvement of accounting practice; at most, academics research and disseminate information on approaches that have been developed by practitioners.3

Practical accounting procedures have sometimes had extraordinary intellectual power, by the way. Both the idea of writing and the idea of pure number (“three” as distinct from “three sheep”) emerged from accounting techniques in Mesopotamia around 3500BC.4 And the debit and credit convention of bookkeeping, which was clearly in wide use when Pacioli described it in 1494, provided a way of working with negative numbers centuries before mathematicians accepted the idea that numbers could be less than nothing.

The profession of accounting thus resembles other useful professions such as engineering. But engineering must cope with an unforgiving physical world: if a bridge is not strong enough, it will fall down. If Auckland Airport’s profit is wrong by $10 million, however, it is unlikely that anyone will ever find out. Indeed, there is no “real” profit figure against which the reported number can be tested.

So accounting is less like engineering than it is like the arts of biography or portraiture. It is not just that there is room for judgement and interpretation: they are essential features of the activity. The cash which Auckland Airport holds is objectively measurable, but very little else in the accounts is. Some part of the value of the buildings and equipment was used up in the year’s activities, for example, but nobody can know how much because nobody can yet know how long those assets will actually last. Different reasonable estimates lead to different reasonable figures for the firm’s profit.

The decisions needed to prepare the financial statements begin with what facts are correct, of course; but beyond that, what judgements must be made, what should be emphasised, what downplayed, and what omitted? Broadly, what artistic conventions should be followed? Good accountants make a serious effort to produce an honest portrait (“a true and fair view” in the legal phrase). But there is no single correct portrait.

The accounting portrait concentrates on resources and the use made of them during a period. Auckland Airport’s balance sheet lists the resources controlled at 30 June, and the claims on those resources by creditors and by owners. The income statement shows the resources generated and used by the company during the year ending on that date. The firm generated more resources (by providing valuable services to its customers) than it consumed (in employees’ time, in the consumption of services of its buildings and runways, and so forth). The difference is the profit (EBIT) of the enterprise, the increase in wealth of society resulting from the airport’s operations. In the most recent financial year that was $201 million, which was divided between the lenders, Inland Revenue, and the shareholders. The net social benefit of Auckland Airport’s activities is even greater than this, because many customers would have been willing to pay more, and many suppliers and employees willing to accept less, than the actual transaction prices.

But much is missing from the portrait. First, there is nothing about risk. What risks Auckland Airport bears, what have been offloaded on to others, and how these changed during the year are all unmeasured. Further, there is no mention of the externalities of the operations, such as noise pollution, greenhouse gas emissions, and road traffic directed through city neighbourhoods. These costs do not fall on Auckland Airport, or they would be recorded in its accounts, but fall on society more generally.

So we cannot be sure that Auckland Airport’s activities actually produced $201 million of net social benefits. But there are no good practices for dealing with these problems. Accountants fall back on writing pages of descriptive notes, but that is only a clumsy second-best.

Another important problem is that the portrait is painted by the management of the company itself. A major theme of accounting research over the past few decades has been to understand the effects of the self-interest of various parties in both biasing the self-portrait and in misusing the results.

For example, there is evidence that managers try to ensure that their firm will meet profit targets (at a minimum, will avoid reporting losses). The picture above5 suggests that firms are less likely than one would expect to report small losses, and more likely to report small profits. Perhaps managers tend to airbrush the portrait or even take actions that may cause real damage to the firm, such as delaying maintenance, advertising, staff training, or research, to ensure that the reported profit will look good.

But perhaps the most interesting function of accounting is its role in creating the social relationships in which we live. Homo sapiens evolved in society: our ancestors were social before they were human. But the emergence of large social structures required people to interact with each other by conceptualising relationships with their social institutions, not just with each other.

To put this simply, Massey University exists because we all agree to act as though it does. Students turn up to courses expecting that lecturers whom they have not met will come to teach them, and will be competent to do so. Lecturers turn up to teach expecting that some payroll administrator will ensure they get paid. We speak of Massey University as though it were real; and legally, it exists because an Act of Parliament says it does. But at bottom it is individuals that interact with each other, often without knowing each other; their shared idea of Massey University mediates that interaction.

Accounting plays an essential role in making this possible. Partly it coordinates the actions of many individuals so that they can work together for a common goal. But beyond that, accounting systems structure organisations in particular ways by making us think about them in particular ways.

An early example is the development of the concept of a business enterprise itself.6 One cannot create an enterprise distinct from the family until one can conceive of such a thing. The double-entry bookkeeping system was developed among the merchant families of the early Renaissance, originally as a technology for checking clerical accuracy. Fundamental to the system was the balance sheet, listing the resources and the claims on the resources. For these to be equal, one of the claims had to be the owners’ equity in the business.

This technology led the merchants to think about the enterprise as a thing which the family owned, rather than as an activity of the family, and then to think of the enterprise as having its own financial status and prospects, as being something which one could invest in, could lend to, or could buy. Without the accounting system, that idea might never have emerged.

Today, if one wishes to create a company, one of the few formal requirements of the Companies Act is to keep proper accounts. Before forming the company, decisions are needed on the accountability relationships: who are to be the owners, and who shall be directors to run the company on behalf of its owners and account to them for what has been done. These decisions can be postponed when creating an informal club or unincorporated business, but they must be resolved before the club grows to the size where its members can no longer interact informally. Any large organisation needs an accountability system, which can be implemented only through some system of accounting.

The more recent emergence of large-scale capital markets has given accounting new kinds of reality-creating roles, such as the rating of companies’ ability to pay their debts. Major banks now use accounting-based models to rate their borrowers: a firm scored as being too risky will not be extended further credit, which itself is likely to cause it to collapse. So an accounting portrait showing that a firm is in difficulty is likely to precipitate that difficulty by affecting the behaviour of lenders.

And so we come back to Auckland Airport, and the portrait which creates an argument for raising prices. Accounting is a sophisticated social invention, used in sophisticated ways. It is an agent of cooperation, of conflict, and of creativity. As a practical technology, it aims for a fair but not unique portrait of an organisation, unit, or activity. Inevitably, the portrait is rough and ready – it is painting by numbers, not by Vermeer. Precisely because the portrait is not unique, there are opportunities for people to present it or to use it in ways that benefit them, by creating a particular reality to which others in society respond. Research into this seemingly uncomplicated technology leads to some remarkably interesting insights into how humans organise themselves in a complex society.

1 Hembry, O. (2006). Airport boost stirs fears of higher charges. New Zealand Herald (July 25).

2 A rough calculation suggests that about $2.5 million of Massey University’s reported expenses comprise the depreciation of revalued fixed assets. (For some other universities, the figure is much greater.) To achieve a given surplus target, Massey must raise an extra $2.5 million of annual revenue to offset this voluntary expense. Historically, universities justified fee increases by the need to cover their expenses; although domestic fees are now capped, the same arguments are used to lobby for increased Government funding.

3 Two significant exceptions are the invention of dollar-unit sampling techniques to assist auditors, and the invention of bankruptcy prediction models. But such exceptions are rare, and even in these cases practitioners had begun developing the techniques that academic researchers perfected.

4 Schmandt-Besserat, D. (1986). An ancient token system: The precursor to numerals and writing. Archaeology 39: 32-39. A step along the way to writing was the storage of clay tokens inside baked clay envelopes, on which impressions were made to indicate what tokens were inside. I confidently expect that archaeologists will eventually discover an envelope bearing impressions of ten tokens, but with only five tokens inside: the first accounting fraud.

5 Dechow, P.M., Richardson, S.A, & Tuna, I. (2003). Why Are Earnings Kinky? An Examination of the Earnings Management Explanation. Review of Accounting Studies 8: 355–384.

6 Rosenberg, N. & Birdzell, L.E. (1986) How the West grew rich: the economic transformation of the industrial world. NY: Basic Books.