The Basic Purposes of GAAP and AFTF

By Humphrey Nash

GAAP stands for Generally Accepted Accounting Principles.   They are the practices, procedures, conventions, rules, uniform minimum standards of, and guidelines to, financial accounting and reporting.   However, they are not the general principles or underlying concepts that reflect the basic purposes of financial reporting.   Many GAAP "principles", for example FASB statements, are industry or case specific interpretations or implementations of underlying concepts.

The basic theoretical framework for FASB (Financial Accounting Standards Board) is provided, in part, by the very general Statements of Financial Accounting Concepts (SFAC).   Beyond this there is scant formal statement of a cohesive theory of GAAP accounting.   There is a reason for this.

SFAC #1   The objective of financial reporting is to provide information useful to business and economic decisions.

SFAC #2  Qualitative characteristics include: relevance, reliability, neutrality, reasonable information cost/benefit, verifiability, representational fidelity, consistency, understandability, comparability, completeness.

SFAC #5   Recognition and measurement in financial statements should incorporate the financial position at the end of the period, earnings during the period, comprehensive income, cash flows, and capital flows.

SFAC #6  Elements of financial reports include, assets, liabilities, equity, comprehensive income, revenue, expenses, gains and losses.

The above concepts apply to both retrospective accounting (GAAP) and prospective accounting, such as AFTF.   The table below summarizes my subjective ratings as to how well GAAP and AFTF satisfy the above concepts.   In some cases separate lines are shown to describe and distinguish corresponding GAAP and AFTF elements.   For example, GAAP accounting earnings may correspond to AFTF value added.

The shareholder perspective is adopted to judge how well the two systems satisfy the concepts.   This is also management's and the financial analyst's perspective since they represent the shareholder.   Ratings are given as percentages with 0 meaning useless, 100 meaning completely satisfying the concept as far as the shareholder is concerned.   A score of 50 represent moderate shareholder utility.   The overall rating is a simple un-weighted average of all concept ratings.   For example, relevance is weighted the same as consistency.   A weighted average would widen the advantage of prospective accounting, but would introduce additional subjective judgments.


What do such subjective ratings mean when they are assigned by a critic of GAAP and a proponent of a prospective approach?   They are a point of departure from which you can form your own opinions.

Appendix A

1a.  Provide Information.   Both GAAP and AFTF financial reports are capable of providing a reasonable quantity of information in the form of financial statements and accompanying materials.   The edge (85 to 75) is given to AFTF which processes data more completely (producing a valuation) thus creating shareholder information.   GAAP is more data oriented.

1b.  Useful for business decisions.   GAAP is the current accounting model and obviously has some utility.   However, it is not generally used for business decisions.   Pricing, capital budgeting, mergers and acquisitions, profit studies, cost/benefit analyses and business valuations, all use the present value of expected cash flows discounted at a shareholder cost of capital.   This is the AFTF technology so that AFTF can be used directly for business decisions.   In fact, with AFTF the normal perspective is the decision perspective.   A decided advantage to AFTF: 90 to 55.

1c.  Useful for economic decisions.   GAAP does not measure economic value.   GAAP earnings are often negatively correlated with the creation of economic value.   Only if we take the present value of future GAAP earnings do we start to approach an economic value.   Of course, by doing so we also approach the AFTF model.   AFTF is designed to provide economic information as defined by the capital markets.   A substantial advantage to AFTF: 90 to 25.

2a.  Relevance.   Shareholder relevance is the raison d'être for AFTF.   AFTF scores very high because the criterion is shareholder relevance.   It is not, for example, relevance to the AIMR which currently views valuation as its province.   As pointed out in the AFTF draft proposal GAAP net worth is essentially unrelated to shareholder equity and value; last year's GAAP earnings are essentially unrelated to last year's shareholder value creation.   AFTF is rated 95 - very relevant. GAAP is rated 35 - somewhat relevant.

2b.  Reliability.  AFTF has several mechanisms to promote reliability.   The dual validation, for example, guarantees that the cash flow model fits the past and produces valuations in line with capital markets valuations.   There are several more disciplines that work to create reliability.   However new information is less disciplined and management expectations may not correspond to the future.   This may be the fault of an unreliable future not the expectation (in the same way that 50% heads is a correct and decision-useful expectation for a coin flip yet the outcomes may differ).   However the expectation may also be unreliable due to management inexperience, bias, optimism, or outright manipulation.   This may be the price we must pay to enable management to succeed; management must also have the possibility of failing.   GAAP accounting is more reliable and rated 90 compared with AFTF at 80.  The reliability rating for AFTF may seem high but reliability has two components: verifiability and representational faithfulness.   These are discussed in more detail below.

On combined relevance/reliability GAAP averages 65 and AFTF averages 80.   Of the two concepts relevance is the more useful for decisions.  A quote may reinforce this point.

"Certainly financial analysts desire information that is both relevant and reliable, but their bias is towards relevance.   In a phrase, analysts prefer information that is equivocally right rather than precisely wrong.   Inexact measures of contemporaneous economic values generally are more useful than fastidious historic records of past exchanges."

Financial Reporting in the 1990's and Beyond, AIMR, 1993.

2c.  Financial reporting cost/benefit.   AFTF will cost more as a financial reporting tool.   Benefits will also be greater (see the Preface to the AFTF draft proposal for a summary of benefits).   The nod is given to AFTF since it unifies accounting and can be used for management and other purposes.   This multi-use aspect reduces the total cost.   AFTF rates 90 compared with 80 for GAAP.   Financial reporting is generally very cost effective for both GAAP and AFTF.

2d.  Neutrality.   AFTF treats assets and liabilities with equanimity.   There is no deliberate conservatism.   There are strong disciplines that encourage neutrality.   The dual validation guarantees that the company valuation, apart form new information, is neutral.   The disclosures and certifications place the responsibility for decisions visibly with management.   The actual-to-expected cash flow exhibits mean there is no escape from the financial consequences of decisions.   The checks and balances inherent in the division of labor encourages neutrality.   The professionalism of those involves fosters neutrality.   Finally the oversight of the accountant and accounting standards promotes neutrality

However AFTF is, in part, based on management expectations and management may not be neutral in its approach to the future.   For example, management may be overly optimistic about the future or in its own ability to control the future.   Management can not objectively judge itself.   It is necessary for management to be judged.   This must be done by those who commit the resources and place their trust in management, i.e., the current or potential shareholder (or financial analyst).   This is only possible if the shareholder is informed about management plans and decisions.   This is what AFTF does.

AFTF ranks 45 - low on neutrality. GAAP ranks 85.


2e.  Verifiability.  Several aspects of AFTF are verifiable.   For example, the dual validation is verifiable and auditable.   Current period cash flows are verifiable, but future cash flows are not verifiable except in the fullness of time as actual cash flows are compared with expected cash flows.   GAAP accounting is verifiable to the extent that it deals with the past.   GAAP has excellent verifiability (rated 90) whereas AFTF rates mediocre at 55.


2f.  Representational fidelity.   AFTF is based on a detailed model (representation) of the company.   It is designed to accurately represent the past and to faithfully represent an expected future.   GAAP earnings do not represent the company financial progress from the shareholder's viewpoint.   The GAAP balance sheet does not represent the future or portray shareholder values appropriately.   GAAP is rated 20 compared with 85 for AFTF


2h.  Understandability.   GAAP is well understood by accountants even though it is somewhat arbitrary and inconsistent.   Less clear is the purpose of GAAP.   AFTF has a clear purpose - measuring shareholder value.   AFTF is not well understood by accountants, especially the dual validation procedure.   This is in part because of the novelty of AFTF and in part due the ostensibly dramatic shift from a primarily retrospective to a primarily prospective accounting model.   Also difficult for the accountant is the switch from the primarily tangible to the primarily intangible.

The methodology of present values and expected values is widely used and understood.   The clear purpose of AFTF provides a context for understanding.   Even though AFTF is currently less understood it is equally understandable.   Both GAAP and AFTF rated 85.

2i.  Comparability.   It should not be surprising that GAAP's lack of relevance and of representational fidelity causes problems with comparability.   The variability of ROE and P/E ratios among companies indicates the failure of GAAP equity and/or earnings to provide a meaningful standard.   AFTF solves these problems and others so that analytical measure and financial reports are broadly comparable.   One reason for the universality of AFTF comparability is that all companies are measured using the unequivocal and universal capital market yardstick.   AFTF rated 85, GAAP 35.

2j.  Completeness.   GAAP is massively incomplete.   Traditional retrospective accounting measures the tangible and the past.   Today's values reflect the future, a future arising primarily from intangibles.   For example, a company like Microsoft pays no current dividend and its accounting tangibles account for only a small fraction of its market value.   The value of a Microsoft resides in its products, structures, people, knowledge, reputation, its dominant size, etc.   In today's economy service industries dominate.   GAAP was better suited to a purely mercantile and manufacturing economy.   GAAP rated 20 and decreasing.

AFTF is equally well suited to all industries.   The completeness of AFTF is essentially guaranteed since the cash flow model must be carefully validated.   All existing tangibles or intangibles are represented in the validated cash flow model.   All significant new tangibles or intangibles which add value are captured in management's expectations (assumptions or decisions).   To the extent that expected future cash flows tell a complete story AFTF will be complete.   AFTF rated 95.



5a.  State financial position at end of period.   The GAAP balance sheet describes the accounting state of the company at the end of the period, but it does not describe the financial state in the way that management, the financial analyst, or the capital market require.   Rated 55.   AFTF provides shareholder value measures useful to management, the financial analyst, and to the capital markets.   Rated 95.

5b.  GAAP earnings.   GAAP earnings do not measure the progress of the company from the perspective of the shareholder.   Often GAAP results look worst when progress is made.

The shareholder takes a bigger risk and reaps a smaller (or nonexistent) current reward compared with the bondholder.   The shareholder must be compensated at some minimum rate to at least place him on par with the bondholder and compensate for his risk.   This is the cost of capital.   Only compensation above that rate is shareholder value added, GAAP ignores the cost of capital which means that GAAP does not let management or the shareholder know whether an adequate return is present.   It may be just as well that GAAP ignores the ROE since equity is also poorly defined.   GAAP equity does not measure shareholder value.   Rated 45.

Value added is takes into account a well defined cost of capital.   This cost is the historic cost of capital (rate) times a capital base.   Both the rate and the base reflect capital market assessments.   The market value added should track reported value added so that financial reporting becomes useful for shareholder decisions.   Rated 95.

5c.  Comprehensive income.   Often the income statement is less that comprehensive.   The income statement does not entirely account for the change in the balance sheet.   Rated 80.

With value and value added the progress and the result are perfectly coordinated since value added is defined to be the change in valuations (adjusted for interest).   Rated 95.


5d.  Current period cash flows.   Cash flows would be roughly the same with GAAP and AFTF.   In both cases they are retrospective and lack value relevance.   Past cash flows may be somewhat more significant under AFTF since they are needed for model validation.  Under AFTF past cash flows are compared with expected past and expected future cash flows.   Both rated 40.

5e.  Current period capital flows.   Capital flows would be roughly the same with GAAP and AFTF.   AFTF provides clearer guidance for dividend policy.   Both rate 95.

6a.  GAAP accounting assets.   Many problems including conservatism, poor coordination with liabilities, poor coordination with revenues, variable valuation treatments, incompleteness.   Rated 35.

AFTF values solve those problems and are expressed in shareholder terms.   Rated 95 from the shareholder's standpoint.

6b.  GAAP accounting liabilities.   Many problems including conservatism, poor coordination with assets, poor coordination with expenses, variable valuation treatments, incompleteness.   Rated 35.

AFTF values solve those problems and are expressed in shareholder terms.   Rated 95 from the shareholder's standpoint.

6c.  GAAP accounting equity.   Many problems including conservatism, poor coordination of assets and liabilities , poor coordination with the income statement, incompleteness.   Poor coordination of assets and liabilities may severely affect this residual, hence, only rated 25.

AFTF values solve those problems and are expressed in shareholder terms.  Rated 95 from the shareholder's standpoint.

6d.  GAAP accounting revenues.   Current period revenues are retrospective and suffer from inadequate adjustment.   They do not represent the positive progress of the company.   Rated 45.

Current period cash inflows are retrospective.  They do not represent the positive progress of the company.  
Rated 40.

If GAAP revenues are compared with positive value added (the increase in the present value of expected cash inflows) then the AFTF rating would be much higher.


6e.  GAAP accounting expenses.   Current period expenses are retrospective and suffer from inadequate adjustment.   They do not represent the negative progress of the company.   Rated 45.

Current period cash outflows are retrospective.   They do not represent the negative progress of the company.   Rated 40.

If GAAP expenses are compared with negative value added (the increase in the present value of expected cash outflows) then the AFTF rating would be much higher.

6e.  GAAP accounting expenses.   Current period expenses are retrospective and suffer from inadequate adjustment.   They do not represent the negative progress of the company.   Rated 45.

Current period cash outflows are retrospective.   They do not represent the negative progress of the company.   Rated 40.

If GAAP expenses are compared with negative value added (the increase in the present value of expected cash outflows) then the AFTF rating would be much higher.

6f.  GAAP accounting gains and losses.   Current period gains or losses are retrospective.   They do not represent the net progress of the company.   Rated 45.

Current period net cash flows are retrospective.   They do not represent the net progress of the company.   Rated 40.

If GAAP gains(losses) are compared with value added (the increase in the present value of expected net cash flows) then the AFTF rating would be much higher.