The Flaw of Averages: Why We Underestimate Risk in the Face of Uncertainty

CHAPTER 31

Some Gratuitous Inflammatory Remarks on the Accounting Industry

The Enron debacle reminded me of an old joke. Three accountants interview for a job. When asked to evaluate 2 plus 2, the first responds, “Four.” The second, thinking it’s a trick question, says, “Five.” But the third, whom they hire on the spot, says, “What do you want it to be?”

I wasn’t laughing, however, when Marc Van Allen, a partner at the Chicago law firm of Jenner & Block, informed me in 2001 that generally accepted accounting principles (GAAP) might be guilty of the Flaw of Averages. Marc and I had worked together on a case the year before, and with degrees in both economics and law, he had a good understanding of probability and statistics. Marc explained that a statement on accounting for contingencies by the Financial Accounting Standards Board (FASB) might give a green light to the behavior of job applicant number three.

“I can’t believe that,” I told him. “I’m calling Roman Weil.” Roman, a prominent professor of accounting at the University of Chicago and former colleague, as well as an expert witness in accounting cases, confirmed Marc’s suspicion. Furthermore, he had coauthored an article on rules for recording uncertain numbers in financial statements in 1993 in the journal Accounting Horizons.¹ The piece exposes a smoking arsenal of FASB-sanctioned accounting ambiguities and inconsistencies, raising important questions about how accounting deals with uncertainty. I want to make clear ...