Prospective Accounting Initiative 

GAAP accounting is primarily retrospective whereas value is realized in the future.  Only to the extent that the past indicates the future will retrospective accounting measure value.  Often the past is a backwards indicator of the future, in the sense that expenditures have a current cost and a future benefit and that lack of current investment forestalls future benefits.  Some expenditures may be capitalized which is tantamount to recognizing future benefits up to the limit of the expenditure.  In that case the GAAP measure is at least non-negative, but it still doesn't measure positive value. We cannot expect to make decisions that add value if we do not measure value added by decisions.  In today's increasingly service oriented economy much of the value added is based on intangibles, such as research and development, which are seldom even capitalized. GAAP accounting measures are not suitable as a guide for management decisions.  In the same way and for the same reasons, GAAP financial reporting is not suitable for shareholder capital allocation decisions.  There is no reliable relationship between GAAP operating results and the financial progress of the company.  There is no reliable relationship between the market value of a company and its GAAP shareholder equity.  GAAP accounting does not provide relevant measures to shareholders and fails in its primary mission.

Prospective accounting is designed to measure shareholder value (and shareholder value added) in the same way the financial analyst would attempt to measure it, i.e., by taking the present value of expected cash flows.  Any management decision will have expected cash flow consequences.  These consequences must be evaluated before the decision is made; hence the prospective accounting measure is a byproduct of good management.  If the expected cash flows are discounted at the shareholders cost of capital then the decision will be positive if and only if the valuation is positive.  Furthermore, the value measured will approximate the shareholder value added as defined by the capital markets. Many, perhaps most, management decisions today involve intangibles, such as, personnel, technology, vision, skills and training, R&D, customer satisfaction, etc.  Management must be aware of the value of intangibles and must quantify its expectations for those intangibles (at least new decisions) in order to allocate capital effectively.  The value of intangibles can be captured in the expected future cash flows.  This makes prospective accounting generally suitable for internal capital allocation decisions by management.  In the same way and for the same reasons, prospective accounting is suitable for external capital allocation decisions by the shareholder.  This suitability creates financial reporting relevance.  Prospective accounting satisfies the intended mission of GAAP accounting.  It also satisfies many of the fundamental principles of GAAP accounting.  This will be explored in depth in a later issue of Future Accounting News.

Traditional retrospective (GAAP) accounting does not produce relevant data.  One result is that various measures and ratios are unreliable.  This makes analysis and comparison hazardous.  Two examples are cited. 1. The Price/Earnings (P/E) ratio is nearly useless.  The basic problem is that price embodies expectations about the future whereas GAAP earnings are retrospective.  Often future results are negatively correlated with past earnings since past expenditures are needed to produce future benefits.  Often companies with the brightest prospects have the highest P/E ratios.  Conversely low P/E ratios are often a sign of impending problems.  P/E ratios vary substantially by industry and as interest rates change.  It should be clear from this variability that the capital markets essentially ignore the P/E ratio.  It is not the numerator which is ignored. 2. The return on equity (ROE). There are two problems with this ratio.  One problem, as you might guess, is with the return which is retrospective.  The other problem is the definition of equity which doesn't include major value producing components.  Any meaningful ratio must have its numerator and denominator related. In this case the measure of production (earnings) must be related to the measure of the means of production (the assets).  For example, a high tech company's primary assets (means of production) may be its technologies, structures, and personnel, which are not valued under GAAP.

The solutions to these two problems, surprisingly, are the same.  With prospective accounting we look at the Present Value of expected Net Cash Flows (future earnings) rather than last year's GAAP accounting earnings. If we make that simple substitution the first ratio becomes the price to PVNCF ratio.  But PVNCF is the company valuation so that the P/E ratio becomes a Price/Value ratio.  This ratio is meaningful because the numerator and denominator both embody expectations about the future, i.e., they are related.  This ratio provides decision useful information.  This ratio is normalized in the sense that it will always be approximately unity (=1) regardless of the industry, interest rates, or the company's prospects, unless there is new information.  This is the point of prospective accounting; it communicates new information.  Hence the price/value ratio provides buy or sell signals if it differs from 1. If we make the same substitution into the ROE ratio, namely substitute a present value of earnings for GAAP earnings, then the ROE becomes a PVNCF/Equity ratio.  Under a prospective model like AFTF we define equity as the net excess of assets or liabilities where assets are the present values of cash inflows and liabilities are the present values of cash outflows.  This excess equals the present values of net cash flows.  Hence equity equals PVNCF and the ratio PVNCF/Equity is exactly 1! We can define a more useful ratio.  We take the return to be the value added during the year and the equity to be as of the start of the year. The ROE then becomes a value added to value ratio.  This ratio is the growth rate and is the excess (above the cost of capital) rate of return on equity. The reciprocal is close to a P/E ratio.

GAAP accounting matches costs with revenues.  Since revenues and costs are generally not simultaneous, this matching is accomplished by shifting some revenue, or some cost, or some of both, to a different time.  Time shifting, without taking the time value of money into account, does violence to that value and makes traditional accounting matching unsound and unusable for decision purposes.  In particular, time shifting makes financial reporting less relevant to the shareholder since the shareholder is vitally concerned with the time value of his investment.  GAAP matching is conditional and asymmetric.  For example, if costs exceed revenues then the excess is recognized immediately as a loss, but not conversely. In addition many current period costs that generate future revenue are expensed during the current period because the future revenues are not objectively measurable under GAAP.  Hence, research and development or employee training costs are current period expenses.  The accounting message is that such expenses hurt results.  The downstream benefit-effect is so far removed from the cost-cause that the link between cause and effect is broken.  This is not good for decisions.  Management and the capital markets have to work overtime to overcome the deficiencies of such accounting. "The proper classification of cost and expenditures as either assets or expenses is one of the most difficult problems in accounting." Accounting Principles, Anthony and Reece

Prospective accounting recognizes cash flows only when they are expected to occur. The measure of those cash flows is the present value which takes into account the time value of money using the shareholder cost of capital.  This makes prospective accounting decision-useful since a positive valuation implies a positive decision.  This works at all levels.  The company valuation is useful for capital market decisions.  A line of business valuation is useful in deciding whether to expand, maintain, or discontinue a line.  A project valuation (cost/benefit analysis) provides a launch decision. Within each such decision the valuation involves expected cash flows, both positive and negative.  The present value of negative cash flows (expenses) is matched with the present value of positive cash flows (revenues).  Hence "costs are reported as expenses in the period in which the associated revenue is reported". This matching is symmetric, complete, and relevant.  Prospective matching is not restricted to cases where the association between expenses is direct and obvious, but takes into account all expenses.  It might seem difficult or impossible to match expenses with revenues when the association is not obvious, but a complete model implicitly captures indirect associations and matches all expenses with all revenues.  The completeness of the model is essentially assured by the dual validation. The reason for the difficulty with GAAP matching is that it is arbitrary; there is no guiding light.  Prospective accounting solves matching questions easily.  This should be a clue.

The February Problem of the Month discussed analytic problems resulting from the lack of relevance of retrospective (GAAP) accounting, such as, the Return On Equity (ROE) where the numerator and denominator were each criticized.  Another problem cited was that the definition of equity doesn't include major value producing components. Any meaningful ratio must have its numerator and denominator coordinated.  In this case the measure of production (earnings) must be related to the measure of the means of production (assets).  For example, a high tech company's primary assets (means of production) may be its technologies, structures, and personnel, which are not valued under GAAP. This same lack of coordination impacts GAAP financial statements.  The measure of production (the income statement) is poorly coordinated with the means of production (the assets in the balance sheet).  For example, a major source of insurance company earnings are premiums paid.  These premiums arise from the existing block of business and new business issued by the field force (company's sales representatives).  A company's existing block of business and its field force are a major part of the value of an insurance company.  This value is well recognized by the capital markets.  Where are these assets on the balance sheet?   In the GAAP world they don't exist; premiums arise by spontaneous generation. Why does traditional accounting have such an obvious flaw?  The answer is that traditionally tangible assets were the dominant means of production.  Manufactured goods were produced by capital, plant, and equipment. Production and the means of production were roughly coordinated in financial statements for manufacturing and mercantile enterprises.  We now live in a different world, a service economy where traditional accounting tangibles don't account for much.  Even in the manufacturing and mercantile sectors intangible assets are increasingly important. Why is such a flaw tolerated?  Outside of GAAP accounting, it isn't.

In prospective accounting, the measure of production (value added) and the measure of the means of production (value) are perfectly coordinated.  This follows from the definition of value added as the current value less the prior value (adjusted for interest). The progress is coordinated with the result, overall and in detail. The classifications of values (assets) are the same as the classifications for value added.  In fact a single Statement of Values reports both values and value added. For example, a major asset for an insurance company is the present value of premiums (expected premiums taking all contingencies into account).  This present value is a measure of the value of the inforce block of business plus the value of the field force to maintain that block and add new business.  Hence the present value is the measure of the means of production. The Statement of Values is internally coordinated, but is also externally coordinated with capital markets.  All reported values are scaled to shareholder values.  The results from the AFTF dual validation.  The measure of production (cost or yield of capital) is coordinated with the measure (price and value of the company) of the means of production.

The February and April Problem of the Month discussed the failure of the Return On Equity (ROE). ROE is often used (or misused) as a measure to determine whether or not a product, a facility, line of business, or the entire company is providing an adequate reward to the shareholder.  If the ROE exceeds the hurdle rate (however that is chosen) then the reward will presumably satisfy the shareholder.  We won't repeat the flaws with the ROE previously identified.  We will discuss a new one which casts general doubt on the soundness of traditional retrospective accounting as a decision tool. Traditional accounting equity is the book value, often the current or historic cost or some variation.  Book values are generally assigned only to traditional accounting tangibles.  Such "values" are sunk costs, not differential costs, and are generally unsuitable for decisions.  For example, plant and equipment have some sort of GAAP book value which enters into the GAAP equity, but that plant and equipment is a sunk cost and, apart from the salvage value, is not germane to the question of expanding, maintaining, or discontinuing plant operations.  The effective question is: given the current situation what is the best course of action?  Such a decision relates to the future and cannot be based on the past.  The cost of the plant and equipment is unrecoverable (sunk) and to burden the future with an irrelevant past will not optimize the future. Example: A manufacturing plant was purchased for $1,000,000 and produces $200,000 in annual profits for a 20% ROE.  In this case the ROE suggests continued plant operation.  If the same plant had been purchased for $10,000,000 and produces $200,000 in annual profits then the ROE would be 2% which suggests closure.  In the absence of a salvage value or residual book value, closing the plant would, in both cases, produce a differential loss of $200,000 per year.  Book values based on historic cost are sunk costs and are not an appropriate basis for decisions.  It makes no difference if the cost of the plant is capitalized, the real cash cost has been incurred and upon closure the accounting would unavoidably catch up to the reality.

Under AFTF the normal perspective is that of the decision.  This perspective is used to measure value and value added.  New decisions are the principal method by which value is added.  Old decisions may have created value which persists.  Those decisions are constantly reborn in their implementation.  Hence, for example, a line of business must be periodically re-evaluated to decide whether to abandon or continue the line.  This re-evaluation is the valuation (present value of future cash flows) for that line.  The sum of the such valuations (disjoint and exhaustive) is the company value. Decisions under AFTF, or any prospective model, take into account the future and only the future.  The past is ignored except to the extent that it affects the future, even then we only measure its future cash flow effects.  The past is not measured and cannot distort values or decisions.  Sunk costs are automatically excluded from prospective accounting.  In fact, the cost concept is entirely replaced by the value concept. Sunk cost are irrelevant to decisions.  Traditional accounting book values measure the cost of accounting tangibles.  These costs are generally sunk costs.  Hence traditional accounting measures are generally irrelevant to decisions.  The is backwards.  Accounting should be decision useful.

The GAAP income statement tells it like it was.  Most profitable investment decisions typically have up-front costs with downstream benefits.  GAAP reports on the past cost with little attention to future benefits.  This often conveys a backward message.  GAAP measures are generally not suitable for decision purposes. In particular, GAAP measures are not a suitable base for timely incentive compensation. How can accounting provide a useful basis for incentive compensation?

A prospective accounting model measures the long-term, capturing costs and future benefits.  This makes it more suitable as a basis for incentives than a retrospective reporting model, which may fail to fully capture future benefits.  The AFTF implementation is especially effective for incentives in that AFTF accurately measures the essential management activity, namely, decision making.  Immediate recognition of future value immediately recognizes and rewards the value of decisions.  AFTF has the ability to separate and measure management performance (Value Added) for the current period.  It closely associates the effect (value creation) with the cause (management actions or decisions). Decisions add value and are measured as Value Added. Value Added is scalable; we can measure Value Added for a pricing decision, a capital expenditure, the expansion or closure of a division, or a dividend change.  Since Value Added measures at any level, it can be used to motivate at any level. Even without incentive compensation, AFTF may motivate.  AFTF focuses on the future and requires explicit judgments about to the future.  Managers may have a better understanding of the future and may feel a commitment to see their judgments vindicated.  AFTF will provide ongoing actual-to-expected ratios related to specific decisions.  It will be clear when a manager has misjudged or mismanaged; managers will be exposed for what they are.  AFTF also requires continual re-evaluation so that changing conditions are measured and reacted to.  Once employees know that value is being visibly measured, they may work more creatively to add value.  Careful and active management will evolve more quickly as the forces of selection operate more openly. Unlike earnings, which are generally positive, Value Added is a residual (after the cost of capital is deducted) and is quite likely to be negative.  Hence incentive compensation may conveniently include a negative incentive for value lost.  Managers will be held responsible for bad as well as good performance.  Management will quickly become sensitized to the company's and shareholders' interests. Fear and greed can be put to a good use. AFTF provides an appropriate basis for incentives, but at the same time makes incentive compensation less necessary.

Traditional retrospective accounting ignores accounting intangibles.  This omission is well known and acknowledged and so are the effects of this omission.  One effect is that "There is a growing and dangerous gap between balance sheets and market valuations".  This gap is primarily a balance sheet failure. To some degree the gap could represent a market valuation failure; if that is the case, it is a result of the lack of relevant and believable financial reporting. Clearly accounting needs to be fixed, but there are difficulties.  One difficulty is identifying what these intangibles might be; they are hard to put your finger on.  Another difficulty is assigning a meaningful or reliable value to accounting intangibles.  For example, what value do you place on the intellectual or human capital of a corporation like Microsoft (the capital market's answer for Microsoft is about $10,000,000 per employee based on 50,000 employees!).

The solution to the problem of intangibles lies in the answer to the question; why are intangibles of value?  The answer is that intangibles eventually manifest themselves as tangible future cash flows.  Hence, all we need to do, to capture the value of intangibles, is to measure the effects of those intangibles. AFTF is a prospective accounting model which eliminates the traditional concept of an asset.  AFTF assets and liabilities are defined in terms of the Present Value of Expected Cash Flows (PVECF).  In particular, assets are defined as the present value of expected cash inflows, regardless of whether the cash inflow arose from a traditional accounting tangible or a traditionally ignored accounting intangible.  Under AFTF, it is not necessary to distinguish tangible from intangible things.  In fact, the normal AFTF perspective attaches values to decisions not things. For example, it may be decided to undertake a large new employee training program.  The benefits of such a program may be greater employee professionalism, enhanced employee creativity, increased productivity, fewer mistakes, improved communications, better morale and team spirit.  These benefits will affect future cash flows.  It may be difficult to assess those benefits but that assessment (cost/benefit analysis) is a prerequisite to making the decision to invest in training.  Hence, AFTF only requires what good management and an informed decision process already requires.  Good management should welcome prospective accounting; poor management must welcome prospective accounting. AFTF is a disciplined prospective accounting model.  In particular, AFTF scales values to historic capital market valuations.  The "dual validation" guarantees this.  The "dual validation" also guarantees that the historic value of existing intangibles is captured since the dual validation requires that past cash flows be reproduced by the cash flow model.  New intangibles, like employee training, may be added.  If they are, they will emerge, under good management, as value added.

The United States has been very fortunate to have escaped the ravages of inflation.  However even modest inflation can ravage accounting statements.  For example, a company which increases annual reported profits by 3% is standing still if inflation is 3%.  Worse is the insidious erosion of assets, the growth of liabilities, pressure on costs, prices, and wages that accompany even modest inflation.  The worst problem is that accounting has no mechanism to cope with severe inflation of the Mexican, South American, African, Asian or European varieties. In 1979, FASB addressed the inflation problem with Statement No. 33 Financial Reporting and Changing Prices, but the solution was incomplete and temporary.  Among other things, this statement required an income statement adjusted for inflation and on a current cost basis, purchasing power gains or losses on monetary items, current cost amounts for inventory plant and equipment and changes thereon, and a five year historic summary.  Such supplemental inflation accounting was made voluntary in 1986.

The problem of accounting for inflation does not have an easy solution under the traditional accounting model.  Under a prospective accounting model, provision for inflation is built in.  It is not necessary to restate or supplement financial reports.  How is this possible? In general, the provision for inflation results from the proper use of the time value of money.  The interest rate used, either to accumulate past cash flows to the present or to discount future cash flows to the present, is the cost of capital.  The capital markets are keenly aware of the economic effects of inflation and require compensation for the actual or anticipated effects of inflation.  Hence, during times of high inflation the interest rate used to discount expected cash flows increases causing PVECF and share prices to drop.  With the AFTF dual validation this is, in a sense, reversed; falling prices will produce a higher cost of capital and lower company valuations.  Company valuations and market valuations influence each other, but in a non-trivial manner.  There is a dialogue of new and relevant information between the company and the capital market. In particular, the dialogue transmits inflation information. The provisions for inflation may not be perfect.  For example, the historic cost of capital is used both as an accumulation rate and as a discount rate, yet past inflation may not equal future inflation or future expected inflation.  I don't believe this is a real difficulty.  The past may be a good unbiased estimate for the long term future.  The historic cost of capital is substantially forward-looking.  Company inflation may be different from general inflation.  Trying to parse the investor's long-term cost of capital into its components (market risk, company risk, uncertainty, inflation, real return, etc.) is an exercise in futility and is unnecessary. More importantly, the cost of capital must ultimately fit prices and cash flows.  In any event, the markets can fine-tune prices to reflect any perceived bias. Value added takes into account the cost of capital which, among other things, contains an inflation component which restates past valuations in current dollar terms.  Valuations discount future cash flows with the same cost of capital which reflects, among other things, the anticipated decline in the value of future dollars.

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