Natural Selection

By Humphrey Nash

GAAP financial reporting has evolved and continues to evolve in a controlled and unnatural environment.   This environment is a centralized bureaucracy of experts who decide for us what we want and need.   They are knowledgeable, well intentioned, and dedicated.   These experts are the best and the brightest.   Unfortunately, centralized direction and control is simply inferior to the free-market of ideas.   We need to look to the accounting systems that have evolved naturally and freely to see what best serves user needs.

The following four systems provide examples of accounting technologies that have freely evolved to fit user needs.

1. Pricing mechanisms
2. Capital budgeting processes
3. Merger and Acquisition valuations
4. Capital market stock analysis

These are important and successful accounting technologies that are all based on certain common principles, principles that financial reporting would be wise to follow.   All the above technologies are oriented toward decision making.   They are all value-based systems.   In fact, they are all shareholder value-based.   They are all prospective systems, which make use of expected future cash flows.   All of the above systems make use of a shareholder cost of capital as a discount rate.   They have all evolved in the unforgiving environment of capital efficiency.   They are all well motivated by self-interest, as is any freely evolving organism.

The draft proposal, Accounting For The Future, suggests that these principles be applied to financial reporting.   The draft proposal also provides specific technology that can be used to achieve this result.  This "specific technology" is not an entirely new invention.   It arises naturally and logically from what is available and from what is needed.

There is a need for financial reporting of relevant decision-useful information.   This information must be relevant and useful to shareholders.   Shareholders want to know the realizable value of their shares.  This may be the realizable selling price of their shares or may be the equivalent present value of dividends realizable in the future.   Shareholder values are capital market values; they are not traditional accounting values.   Financial reporting must be shareholder value-based.

How do we determine shareholder values?   The above four systems point the way.   Shareholder values, at all levels, are determined by the future cash flows discounted for the shareholder's cost of capital.


This presents some immediate difficulties.   How do we reliably estimate future cash flows?   How do we reliably determine a cost of capital?   Can we bridge the gap between plausible theory and reliable practice?   It seems impossible.   The cost of capital question alone seems to present insurmountable difficulties .

The answer is that we don't consider the cost of capital alone.   We don't consider the expected cash flows alone.   We consider the combination.   The reasoning is simple; it is the result of applying the cost of capital to the expected cash flows that is of interest.   The cost of capital must be coordinated with the expected cash flows since the cost of capital will be applied to expected cash flows.   The dual validation is a mechanism which does this.   It uses capital market pricing to determine a market cost of capital suitable to be applied to modeled cash flows.   Any determination of a cost of capital not taking capital market pricing into account would be unnatural and suspect.   Any determination of a cost of capital not taking into account the cash flows to which the cost of capital applies would be unreliable and suspect.

The models needed to produce expected cash flows should emerge naturally as a by-product of good management.   Management should anticipate the future, understand the interrelationships and dynamics, develop a plan of action, consider all significant contingencies, make appropriate assumptions, and factor in all significant costs and benefits.   If management does these things (for pricing, profit studies, cost benefits analyses, capital budgeting, etc.) then it has the basis for expected cash flows.   Conversely, good management should emerge naturally from the need to model and account for the future within a prospective accounting system.

Prospective accounting will create greater capital efficiency.   This is generally desirable from a macro standpoint, but it will accelerate the natural evolutionary process.   The birth and death rate of companies will increase.   Economic factors will dominate decisions and the part will be subservient to the whole.  Individual companies, lines of business, projects will have to survive in the unforgiving environment of capital efficiency.

Natural selection is a universal process affecting species, societies, professions, organizations and ideas.   Within financial reporting a slow evolution of thought is taking place.   This evolution is an adaptation to the changing needs and capabilities of the financial environment.   The question is whether financial reporting can adapt fast enough to survive and thrive.   I don't believe traditional financial reporting is thriving.   It is increasing viewed as quaint --- an evolutionary dead end which can only survive in captivity.   Financial reporting can adapt to the general needs of management and capital markets, but it must be freed from the shackles of the past.   If financial reporting is to have a future, financial reporting must look to the future.