The Implementations of GAAP and AFTF

By Humphrey Nash

In the February issue of Future Accounting News we explored the basic purposes of GAAP and rated the GAAP and the AFTF models for their effectiveness.   In this month's issue we will look critically at some basic accounting principles associated with GAAP.   These include concepts such as: the entity, accounting period, materiality, dual aspect, monetary measure, going concern, consistency, objectivity, matching, disclosure, conservatism, cost, and realization.   Many of these concepts also apply to prospective accounting, although their interpretation and implementations differ somewhat from GAAP.   The AFTF implementations are not inferior to GAAP.


Entity Concept:  Each entity should be accounted for on a separate basis (as distinguished from persons associated with the entity).   Under GAAP this is taken to mean that accounting should be independent of the management, owners, accountants, and the company's environment.   For example, under GAAP the price the shareholder pays for the company's existing stock does not affect the GAAP accounting; management assumptions, plans, and decisions have little or no affect on GAAP financial statements.¹   If we step outside the confines of GAAP accounting then we realize immediately how dependent an entity and its value are upon management, owners, accountants, and the entity's environment.   There is no hope for GAAP accounting to furnish relevant values unless it takes into account relevant factors outside of the narrowly defined entity.

AFTF is based on the present value of expected cash flows.   It is designed to capture all relevant factors.   We mention two important examples.   First, expected cash flows are based on management expectations.   This captures the assumptions, plans, and decisions that, in large part, determine future and present values.   Second, AFTF financial statements depend on the capital markets.   The dual validation uses capital market share prices to determine the cost of capital used in discounting the expected cash flows.   This makes the accounting relevant and reliable.   With AFTF the entity concept is recognized, but it is also recognized that an entity does not exist in a vacuum and that external factors affect value and have a legitimate role in financial reporting.


Accounting Period Concept: Accounting reports are for a specific period, showing the status at the beginning and end of the period (the balance sheet) and the financial progress made during the period (income statement).   This concept is fundamentally flawed.   Accountants routinely make some adjustments to the books to shift past or future cash flows out of or into the current period.    These include accrual adjustments, reserving, depreciation, and capitalized expenses.   These shifts are designed to better represent the financial progress made during the year, compared with the cash flows recorded during the year.

AFTF goes one step further by shifting² all future cash flows into the current period (producing the company valuation).   The progress of the company (value added) is the period change in the valuations, adjusted for interest.   In a sense, AFTF is pure accrual accounting since it ignores the results of the period just completed³ and is based only on future cash flows.   AFTF reports on the true economic progress achieved by the company during the period and does not limit the measure of that achievement to the current period cash flows.


Materiality Concept: This concept applies to financial reporting and disclosure and to areas where accounting judgments are made and not, for example, to the bookkeeping of cash flows which must be exact.   Hence, an estimate of future cash flows as a GAAP accrual adjustment or an estimated future liability meets a lower standard of materiality.   Often, however, absolutely or relatively large amounts fall through the crack of GAAP accounting immateriality.   Part of the reason for this is the highly judgmental nature of GAAP.   This results from the need to consider an uncertain future and to decide what part of the future to consider in the first place, e.g., the cost of stock options or post-retirement benefits.   It also results from the crudeness or whimsy with which accounting adjustments are made.   For example, few adjustments are based on a careful consideration of the contingencies involved or use interest to take into account the time value of money.   Retrospective accounting has murky purposes which makes it difficult to judge materiality, among other things.

With AFTF, all expected cash flows are included with due consideration for the contingencies involved and taking into account the time value of money.   Many judgments are involved but they are very careful judgments based on detailed and sophisticated models.   With AFTF the models should be reasonably accurate because of the cash flow validations, but this is not critical because the dual validation offsets possible distortions.   Even though AFTF is prospective the concept of materiality will not be stretched any more that it already is.   Under AFTF there is a bright light to illuminate materiality, namely, it is material if it would affect the shareholder's or management's decisions.


Dual Aspect Concept: This concept applies to bookkeeping (debits and credits) and to the balance sheet (assets and equities).   It applies to GAAP and AFTF.   All cash flows arise from an identified source and must go to some identified destination.   All assets must be allocated to creditors or to the shareholders.   With AFTF there are additional dualities not present with GAAP,

1.  reported shareholders equity is shareholder (capital market) value⁴
2.  the change in valuations (adjusted for interest) is directly the progress (value added)
3.  AFTF assets represent the means of productions and give rise to the production⁵
4.  the dual validation combines management and capital market information at the financial reporting interface
5.  unreliability is a feature both of our models of the future and of the future itself⁶.

Monetary Measure Concept: This concept assumes that the relevant unit of measure is the monetary unit.   Under the GAAP implementation it is further assumed that only information actually expressed in current nominal monetary terms is recorded or reported in financial statements.   It is impossible to express non-monetary or intangible values in current monetary terms.   This means than intangible values, perhaps the dominant values today, cannot be measured by GAAP.   Another problem with the monetary concept under GAAP is that the time value of money is ignored.   FASB made an effort at partially correcting this deficiency with FASB Statement Number 89: Financial Reporting and Changing Prices, but this effort fizzled.   The GAAP implementation is inadequate.

Under AFTF all intangibles that have future monetary consequences are expressed in the present value of future nominal cash flows so that the monetary measure concept is not a handicap.   With AFTF the time value of money is taken into account using the shareholders cost of capital.   This rate implicitly provides for a changing monetary unit (inflation).   The AFTF implementation adheres strictly to the monetary measure concept since only cash flows are recognized.   AFTF monetary measures are more complete and more meaningful than GAAP.


Going Concern Concept: A company is assumed to operate indefinitely barring strong evidence to the contrary.   One problem with a retrospective accounting model like GAAP is that a company can soon become bankrupt yet financial reports won't presage the problem.   More common, but worse than the rare sudden demise of a company, is the insidious cancer of not meeting the shareholder's cost of capital.   Shareholder value is gradually eaten away.   The shareholders are better off liquidating the company, yet management and the shareholder will continue to suffer because GAAP financial reports are not value based and can't reveal the loss of value.   The going concern assumption under GAAP accounting is dangerous.

Under a prospective accounting model, such as AFTF, future cash flow deficiencies are revealed early so that the markets are informed and bankruptcy possibly forestalled.   If a company is consuming shareholder value then it will show clearly as negative value added.   Value added is defined as the current valuation less the prior valuation increased at the shareholder's cost of capital so that the demand for positive value added is a demand for progress above a positive level.   The bar is raised.   AFTF does not assume a going concern; it actively encourages it


Consistency Concept: This concept states that accounting practices should remain the same from period to period and that, if they are changed, the change and its effects should be disclosed.   Consistency is a necessary ingredient for comparability between periods.   Strict consistency of practice can backfire if events or situations are inconsistent, especially if they are not disclosed.   GAAP is generally very consistent, although new or rescinded FASB statements may create discontinuities.⁷

AFTF is less consistent.   For example, the cost of capital changes somewhat⁸ from year to year.   This cost of capital is the discount rate applied to future cash flows.   Another example may be changing economic or competitive conditions which significantly change the company's outlook (cash flow expectations) and hence its value.   Hence, with AFTF consistency takes a backseat to relevance.


Objectivity Concept: This concept requires that accounting entries be based on objective evidence.   The concept is extended to require that financial reporting be based on objective evidence.   This confines accounting to the past, with some exceptions like accruals or capitalized costs which involve partial judgments about the future.   If objectivity were the only criterion or a necessary criterion then GAAP would be preferred over a prospective model.⁹   Objectivity is one of several competing accounting goals and may not be the most important, c.f., relevance.   Objectivity may not even be desirable if it blinds us to the future.

Not all statements about the future lack objectivity.   We may for example state that a coin flip will come up heads, on average, half the time.   This is a correct, objective (free of distortion, bias, or conflicts of interest), and decision-useful statement.   The fact that outcomes vary is another qualitative dimension.   Outcome reliability depends on diversification, an important point that we won't pursue here.   The models we construct, whether of a coin or of a company, can be objective without having to be retrospective.   The question for accounting to face is which is the more useful statement: "the coin came up heads" or "the coin will come up heads, on average, half the time."   If we are talking about decision utility, the answer is clear.

AFTF has many disciplines that create or encourage objectivity.   I will mention just one: the dual validation procedure.   This procedure requires that any cash flow model fit actual cash flows over a five-year period and requires that resulting company valuations match capital market valuations over the same five-year period.   This procedure is objective and scales the company valuation in a unique and unequivocal manner.   Nevertheless, AFTF involves basic judgments about the future.  With the division of labor proposed for AFTF, management has the responsibility for such judgments.   The cash flow modeler has the responsibility for the accuracy and completeness of cash flow projections.   The accountant's role, on the other hand, is objective.


Matching Concept: This concept requires that costs be reported as expenses in the period in which the associated revenues are reported.   Under GAAP matching is usually achieved by postponing (time shifting) a current expense to a future period.   Many difficult judgments are needed in attempting to match expenses with revenues.   The result of these judgments is generally arbitrary, incomplete, distortive, and not decision-useful.   First, the recognition and reporting of revenue is problematic; it must be decided which expenditures qualify to match that revenue; a matching or amortization period must be selected; some method for spreading expenses must be chosen.   Second, the application of the concept is restricted to tangibles, which are increasingly less important.   Third, the time value of money is usually neglected, distorting economic values in accounting statements.   Fourth, delaying expenses does not provide current decision-useful measures (as opposed to PVECF).

Under AFTF all expected cash inflows (revenues) and all expected cash outflows (expenses) are recognized.   Cash flows are recognized as occurring when they are expected to occur with no time shifting.   These cash flows are measured as present values taking the time value of money into account.   The result of these two steps is the recognition of value.   With AFTF revenues are reported in the period in which the associated expense occurs.   Hence, under AFTF matching is usually achieved by anticipating (time shifting) a future benefit.   Admittedly such matching is based on judgments (expectations) but the result is disciplined, complete, undistorted, and decision useful.

Since a shareholder cost of capital is used as the discount rate the values recognized match shareholder (capital market) values.


Full Disclosure Concept: This concept requires the disclosure of all information needed to appraise the reporting entity.   This has resulted in ever increasing amounts of financial statement data, but the appetite for data will always be insatiable because data is of the wrong type of information.   The right type of information is high level information that processes and condenses subsidiary information and data.   The clue to the type of information needed is in the word "appraise".   If we take this to mean appraisal or valuation then it is clear that reporting values, especially the company valuation, must be part of full disclosure.

GAAP financial statements make no attempt to appraise the company (in shareholder or capital market terms).   There is, however, a demand for the reporting of data and information that would, theoretically, allow others to do so.   Hence, for example, full disclosure for the financial analyst would be all information that would permit him to project cash flows and produce a company valuation, in essence to undo and redo what the accountant has done.   However, there is simply no way to provide enough data in a readable financial report to produce a meaningful company valuation.   There is no general capacity for the capital markets (shareholder or financial analyst¹⁰) to do this.   The answer is that full disclosure must include values.   Accounting and the accountant can add value to financial reporting by processing data and producing relevant high level information.

AFTF provides high level information in several forms,

1.  the company valuation (in shareholder terms)
2.  value added (in shareholder terms)
3.  actual to expected cash flows
4.  disclosure of management decisions
5.  historic cost of capital for the company
6.  the company estimated yield on shareholder equity (value)
7.  sensitivity of company valuation (for risk assessment)
8.  other discussions, analyses, opinions, exhibits, etc.

Conservatism Concept: This concept states that, in light of uncertainties, income and assets should be recognized only if reasonably certain and expenses and liabilities should be recognized if reasonably possible.   Conservatism introduces a deliberate bias, which is only acceptable if it is negligible, in which case it doesn't have to be employed.   The problem is that material amounts of conservatism are often present.

Since GAAP lacks relevance and is not forward-looking GAAP conservatism may be prudent.   For example, conservatism may forestall some failures from underestimated liabilities by underestimating assets.   One might ask whether conservatism is bad if it provides a margin of safety.   First, conservatism leads to less than optimal results.   Second, conservatism in one area doesn't always overcome or offset deficient accounting measures in another area.   Third, conservatism is unnecessary if a more relevant and anticipatory accounting model is employed.

A prospective model, such as AFTF, does not require conservatism to make up for lack of foresight or lack of relevance.   However, within a prospective model there are uncertainties, which might suggest conservatism.   But these uncertainties are better addressed directly.   For example, outcome uncertainty can be effectively addressed by diversification (more trials, different trials).   This may be a good time to stress another aspect of the expected cash flows used in prospective accounting; in any particular instance, they are just as likely to underestimate as overestimate cash inflows or assets.   Depending on the diversification, estimates may be very reliable overall.

AFTF is not neutral in preserving value and actively encourages value creation (see Going Concern Concept).   The company is buffered against bankruptcy thus decreasing the need for conservative margins.


Cost Concept: The cost concept permeates GAAP accounting.   This concept means that an asset is carried on the books initially at its cost and later at some modified cost.   Cost is reliable and easy to determine.   Unfortunately, for decision purposes, we need to know the relevant value not the cost.   Unfortunately, the easy answer is not the best answer.   Decisions are complex, difficult, and uncertain.   It should not surprise that accounting, for decision purposes, requires more than the easy answer.

"One of the most common mistakes made by uninformed persons reading accounting reports is that of believing there is a close correspondence between the amount at which the asset appears on these reports and the actual value of the asset."¹¹

The mistake is not the report reader expecting the reporting of values, but the failure of accounting to provide them.   It is hypocrisy to suggest that readers of financial reports "must arrive at their own estimate of current value, partly by analyzing the information in the report and partly by using non-accounting information."¹²   If this can be done then accounting has the duty to do it, especially if it can be done in a relevant and reliable manner.   What is accounting for otherwise?   Is it for the convenience and ease of the accountant?   Quite the opposite, accounting must do the hard work that adds real value to the financial reporting process.¹³   The easy way out for the individual accountant is the easy way out of existence for the profession.   Financial reporting must be relevant and must deliver processed high-level value information.

AFTF provides a relevant and reliable method for measuring value.   The value of an asset is the shareholder value, so that, valuations are directly decision useful.   Historic cost is not directly¹⁴ used in a prospective model.    Past costs are sunk cost and are irrelevant; future costs are incorporated into cash flows.   Under AFTF, historic cost is replaced by present value.   AFTF is forward looking.


Realization Concept: Revenues are recognized in the period in which they are realized (through a past exchange of goods or services) in an amount that customers are reasonably certain to pay.  The GAAP implementation of this concept, for the most part, measures only the revenues realized in the current period.

Under AFTF expected cash flows are recognized when realized (through an expected exchange of goods or services) and measured as a present value.   If we consider value added as the counterpart of "net revenue" then such "net revenue" is recognized in the current period in which value is realized (through experience, changing conditions, actions, or decisions).   An expected amount is the future amount that customers are reasonably certain to pay; it is not higher or lower.   The expected amount will be essentially realized for a large or diversified company.


Conclusions: The GAAP and AFTF implementations of basic accounting concepts differ.   In some instances they differ so substantially that the concept itself is impacted.   For example, the cost concept is replaced by a value concept.   The AFTF implementations are designed to broaden the scope of accounting within a more relevant and more unified value-based financial model.


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¹ The importance of management assumptions, plans, and decision is well recognized and they are a vital component of financial reports, but they are not part of GAAP financial statements.
² With due consideration for the time value of cash flows and contingencies affecting the magnitude of expected cash flows.
³ Current period positive net cash flows are well represented in the present value of future cash flows. A dollar of cash has a present value of a dollar, a $1,000 bond acquired during the years has a present value equal to its coupons and maturity value discounted at the shareholder cost of capital, etc. In this way current shareholder values are represented (as opposed to, for example, the cost of the bond).
⁴ Roughly. The market valuation and company valuation can diverge, but this is just as likely to be capital market inefficiencies as it is to be reporting deficiencies. The two-way AFTF communication of AFTF will force convergence. If reported values fail to move the capital market then the capital market will soon move the reported values (via the cost of capital).
⁵ GAAP is massively incomplete so that production seems to arise spontaneously.
⁶ For example we may correctly expect a coin flip to be heads half the time, but the outcome of say 4 coin flips may differ. It is the actual not the expected which fails.
⁷ Recent examples include FASB 123: Accounting for Stock Based Compensation, FASB 115:Accounting for Certain Investments in Debt and Equity Securities, FASB 106: Employer's Accounting for Post-Retirement Benefits Other Than Pensions
⁸ The cost of capital is a trailing five year average so that the rate changes by roughly 1/5 of the difference between the latest year and the oldest year rates. If this rate changes by 1% then the discount rate changes by .2% A changing rate is needed so that the company valuations are scaled to the capital market valuations, i.e., shareholder relevance is maintained.
⁹ Current period cash flows would be preferred over both GAAP and AFTF.
¹⁰ See the paper The AIMR and AFTF, section A Line in the Sand, for a discussion of why an internal valuation can be superior to an external valuation.
¹¹ Anthony, R. N., and Reece, J. S., Accounting Principles, 4th Edition, Irwin, page 24.
¹² Anthony, R. N., and Reece, J. S., Accounting Principles, 4th Edition, Irwin, page 25.
¹³ I sense that the accountant, with the cooperation of management and the modeler, would be more than willing to tackle the hard job of measuring value. The professional organizations need to lead.
¹⁴ In the AFTF cost is used directly as a cash flow. Cash flows are the foundation of AFTF. Past cash flows enter into the dual validation and actual to expected ratios. They also are realized and measured as future cash flows.