Prospective Accounting

By Humphrey Nash

Prospective accounting is designed to measure value, specifically shareholder value. Value is defined as the present value of expected cash flows.   The present value of all net expected cash flows for an enterprise is its valuation.   The change in the valuations, adjusted for interest, is the value added.   Hence prospective accounting is value-added accounting.   This is not new.

Surprisingly, prospective accounting can be made both relevant and reliable, so that it becomes suitable for financial reporting as well as management decisions.   This is new.

A new approach to valuation is proposed which combines and coordinates capital market information with management information.  This approach, called the "dual validation", is one of the disciplines that makes prospective accounting simultaneously relevant and reliable.   The "dual validation" is described in the draft proposal Accounting For The Future and in the paper Disciplining Prospective Accounting, both by the editor.   It will also be fully described in later issues of Future Accounting News.

In addition to the "dual validation", other disciplines are proposed to enhance reliability.   These take the form of disclosures and checks and balances.   The checks and balances arise from a natural division of labor and responsibilities.  This division is also a key ingredient in making prospective accounting feasible.

The traditional accounting income statement and balance sheet would be replaced by a unified statement of values showing consecutive valuations and the value added.  The value added is defined as the current valuation less the prior valuation (adjusted for interest).   The interest rate used is the historic cost of capital that emerges from the dual validation.

The unified statement of values automatically coordinates the progress of the company with the status of the company, unlike traditional accounting where the income statement and balance sheet are uncoordinated.   Among other things, this coordination makes it possible for shareholder equity to be shareholder value.

Using a shareholder cost of capital as a discount rate means that values correspond directly with decisions; a positive valuation implies a positive decision.   This make prospective accounting automatically decision-useful.   In fact, with prospective accounting we don't value traditional accounting tangibles at all.   Instead we value decisions.

At the broadest level, the company valuation provides a decision criterion for stock purchase.

At the line of business level, the valuation provides information as to whether the LOB is covering the cost of capital.   A positive LOB valuation suggests continuation or expansion; a negative valuation suggests dropping or changing the LOB.   The LOB or division level of aggregation would be the normal financial reporting level of presentation.

At the micro level, a prospective valuation provides decision criteria, for example, for pricing an individual product or for capital budgeting decisions.

This multilevel decision framework of prospective accounting will improve management and capital market efficiency.   It will also improve the efficiency of accounting functions within an enterprise.   It does this by unifying all accounting and decisions measures.   For example, management must explicitly quantify its plans in order to evaluate and decide, but this same process is used for financial reporting, i.e., to determine value and value added.

A prospective accounting model will enhance the role and opportunities for accountants.

First, accounting will become more relevant so that the accountant will be adding more value and be more valued.

Second, accounting will be improved and simplified within a clearer purpose and vision; detailed practice prescriptions or proscriptions will give way to the general principle.

Third, accounting unification creates an opportunity for the accountant to assume a broader role within a company.

Fourth, that role involves the accountant in the decision process.  This is good for the accountant and good for the decision process.

Prospective accounting has a clear, relevant purpose.  It can be made reliable and feasible with the technologies and structures proposed.

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Value Based Accounting