The AIMR and AFTF

By Humphrey Nash
January 1999

Table of Contents

Introduction

Abstract of AFTF

Executive Summary

A Review of the AIMR Report

A Line in the Sand

A Critical Role for the Financial Analyst

The FASB Position

Conclusions and Recommendations

Introduction

The Association for Investment Management and Research (the AIMR) is a non-profit organization of more than 33,000 investment professionals.   The stated mission of the AIMR is "to advance the art and science of investment management and research."   An unstated mission is to advance the interests of its membership.   The AIMR does this by encouraging high ethical and professional standards within its membership.   It also does this by exercising its influence in ways that help the AIMR to fulfill its missions.   This includes influencing bodies concerned with financial reporting.

AFTF stands for Accounting For The Future, the title of an accounting draft proposal by Humphrey Nash.   The draft proposal is a crude outline of a prospective accounting model.   This model suggests technology and structures that make prospective accounting relevant, reliable, and feasible.  "AFTF" will be used to refer both to the draft proposal and to the prospective accounting model it proposes.

This paper comments on the AIMR's views of accounting in light of AFTF and vice versa.   The views of the AIMR are extracted from the 1993 AIMR Report: Financial Reporting in the 1990's and Beyond.   This report represents only certain views of the AIMR as they existed in 1993; current AIMR thought may have advanced somewhat.  Quotes without attribution are taken from the AIMR report from sections with similar titles to the sections below.   These sections follow the order of the report.   Although this paper is best read after or at the same time as the AFTF draft proposal, the financial analyst probably has a basic idea of the AFTF approach.   What he will not know are the AFTF disciplines and structures that make prospective accounting relevant, reliable, and feasible.

Accounting For The Future
Abstract

This draft proposal is designed to encourage a new prospective accounting perspective.   The new perspective would correct many of the basic deficiencies of traditional retrospective accounting.   The new accounting would provide several other major benefits, among them: accounting relevance, accounting unification, efficient capital markets, and effective management.

The proposal reviews the essential purposes of various types of accounting.   It examines the fundamental problems of traditional retrospective accounting and proposes a prospective model (AFTF) which corrects those problems.   The prospective accounting model attaches values to decisions, so that the accounting is automatically decision-useful.   The values attached are shareholder or capital market values, so that financial reporting is automatically relevant.   The proposal explores the important question of income recognition and concludes that immediate value recognition is the relevant measure.   Next the proposal reveals a simple key mechanism (dual validation) by which prospective accounting is made both relevant and reliable.  Additional disciplines resulting from disclosures are examined.

The proposal shows in detail how AFTF provides management, reporting, and accounting solutions.   The proposal explains how AFTF satisfies the essential purposes of all types of accounting and thereby unifies accounting.   AFTF is based on the universal realities of market values and cash flows and, hence, can be the basis for uniform accounting principles and practices across national boundaries.

The proposal suggests a natural division of labor and responsibilities for the new accounting.   This division is a key feature in making the accounting feasible and in providing a system of checks and balances.   The proposal examines the concept of expected cash flows, fundamental to AFTF, and concludes that expected cash flows are objective and reliable.   Even though present, these characteristics are not critical for AFTF.   Finally, some of the problems with AFTF are cited; all of the problems cited are surmountable and arise mainly from the novelty of AFTF.


Copies of the draft proposal are on file at the principal offices of: AIMR, FASB, SEC, AICPA, IASC and other accounting or economic bodies.   The draft proposal is also accessible from the Internet at http://members.aol.com/heinichen.

The AIMR and AFTF
Executive Summary

The 1993 AIMR Report: Financial Reporting in the 1990's and Beyond supports many of the premises and goals of prospective accounting but does not support the conclusion that financial statements should be based on a prospective model.   The AFTF draft proposal was published in March 1998 and a copy was only recently furnished to the AIMR, so that the AIMR position on the specific proposal is unknown.

This paper reviews the major expressed positions of the AIMR and how a prospective accounting model, such as AFTF, corresponds to those positions.   The AIMR and AFTF are in accord on many, if not most issues included in the report.   These issues include: changing needs and conditions, need to report economic realities, value of intangibles, non-value of goodwill, importance of cash flows, need for long term perspectives, need to disclose plans and commitments, comprehensive income, and a broader and more central role for the accountant.

This paper criticizes the AIMR position on excluding value measures from financial statements for a number of reasons, not the least of which is that AFTF proposes such measures.   The AIMR position is, I believe, inimical to the interests of accounting and to the general economic interest.   It is also, I believe, not in the best interest of the financial analyst.

The AIMR is in a delicate position.   The AIMR wants financial reporting to be relevant to its purposes, but doesn't want accounting to be too relevant.   Financial analysts make a living, in part, by seeing through or beyond the deficiencies of traditional financial reporting.   Financial analysts would like financial reports to contain the information needed for them to project cash flows and determine values, but they don't want financial reporting to itself determine or report values.   This position is understandable if you believe that the primary role of the analyst is to produce a company valuation.   This paper argues that producing the company valuation is just one of many roles of the financial analyst and that under a prospective accounting model the financial analyst's valuation role would shift slightly.

It is argued that the financial analyst cannot produce as accurate a financial picture as the company can.   This paper suggests a shift to a more critical valuation role for the analyst, a shift that would make the analyst more effective.   Prospective financial reports provide the analyst with an array of reports more relevant than traditional retrospective reporting.   The analyst adds to this his broad external view and independence to form judgments as to the value of the company.   His role is that of a critic rather than a producer of the financial picture.   It is argued that only the financial analyst can appropriately provide the independent judgments that guide the capital markets.   It is noted that the financial analyst can also have important direct and indirect roles within the prospective accounting system.

AFTF provides technology and structures that make accounting relevant, reliable and feasible.   It is hoped, in light of AFTF, that the AIMR will support a prospective accounting and financial reporting model.

A Review of the AIMR Report

A Changing World

The AIMR Report identifies three factors affecting financial analysis: globalization, computerization, and industry shifts.

The AIMR supports the development of common financial reporting principles and standards, if they are of sufficiently high quality.   AFTF proposes a disciplined model based on the unequivoal and universal realities of cash flows and capital market values.   This provides a firm foundation for international accounting principles of high quality.

The AIMR states that as a result of computerization "Quantitative analysis become practicable to an extent never dreamed of previously."   This is one of the arguments made in favor of accounting adopting those same tools within a prospective model.

The AIMR observes that "… the accounting model used today was developed to fit enterprises whose economic activity is primarily manufacturing or merchandising."   The shift to service industries of all types has decreased the relevance of traditional accounting.   This problem is identified as the problem of completeness in the AFTF draft proposal (Chapter 3).   Traditional accounting recognizes only tangible assets, yet the bulk of value may today reside in intangibles.

Qualitative Characteristics of Financial Statements

The AIMR states that "First analysts need to know economic reality -- what is really going on -- to the greatest extent that it can be depicted by accounting numbers."

An accounting system and financial reporting based directly on economic values is the "greatest extent" possible.   AFTF is such a system.

The AIMR champions relevance and reliability.   The AFTF proposal reveals a simple key mechanism (dual validation) by which prospective accounting is made both relevant and reliable.

Timeliness is critical for the analyst and the AIMR strongly supports quarterly reporting.   AFTF also supports quarterly reporting for similar reasons and also to spread the difficult modeling work needed over the year.   The AIMR downplays the role of quarterly reporting in producing "short-termism".  AFTF is prospective, always adopting the longest forward view.

Mark-to Market Accounting

The AIMR views differ on this subject, but "Any imminent change in mark-to-market accounting is not welcomed by a majority of financial analysts."

The concern is that market fluctuations will wag accounting results.   Others concerns are its application only to certain classes of assets and not to liabilities at all.   AFTF does not employ market values, only entity specific values based on expected cash flows (taking all contingencies into account).   Such values are widely and successfully used in making management decisions.   Such values may be even more reliable for financial reports because of aggregation (the law of large numbers).   With AFTF all assets and liabilities are valued consistently, providing greater stability because of offsets.   Assets and liabilities are also strongly disciplined.

Accounting for Intangible Assets

The AIMR position is similar to that in the AFTF draft proposal.   "Purchased intangibles are initially recorded at cost and amortized over periods of time that are often arbitrarily determined.   Self-developed intangibles are for the most part not recorded.   Financial statement comparability between and among enterprises suffers accordingly."

These points are detailed in AFTF.

"First, we advocate capitalization of all executory contracts with an initial duration of more than one year."

AFTF recognizes a more complete future.   For example, revenue recognition would not be limited to expenditures.

"Second, we recommend that purchased goodwill be written off at the date it is acquired."

This is the AFTF treatment.   In fact, purchased goodwill should never exist as a positive quantity under AFTF.

Disaggregated Financial Statements

"We believe that segment data are most useful when they depict the way in which the enterprise itself is organized and managed …"

AFTF employs models which will take their cue from the actual structures of the enterprise so that such segmentation will emerge naturally.

Income and Cash Flow Statements

The AIMR recommends the "comprehensive income" approach.   With AFTF there is no separation of income.   Furthermore, the "balance sheet" and "income statement" are always perfectly coordinated, unlike traditional accounting.   AFTF gives prominence to cash flows which are always direct and detailed.

The Standard Setting Process

The AIMR does "not believe the FASB is to blame for many of the complications in financial statements today…"

I have tried to express the same view.   I blame the retrospective accounting model used.   I hope that FASB will work to change the model.

The AIMR suggests that costs/benefits be considered from the user standpoint.   A similar suggestion is made in AFTF.   AFTF is a generalized and unified model benefiting many classes of users. 

The Nature and Role of Efficient Markets

It is written "Sometimes it is asserted that financial statements do not contain new information.   Analysts hope that assertion is true.   If it is, that means that both that the company and the analysts who follow them have done their jobs successfully in making the market as efficient as can be."

This doesn't square well with the earlier statement, supporting quarterly reporting that "We need to have it (information) disseminated even-handedly so that it becomes available to all market participants at the same time, rather than first to a privileged few."

Quarterly statements should convey new information.  If they don't, there is a basic problem with financial reporting.   If capital markets don't react to or are independent of quarterly reports then such reports must lack relevance.  GAAP does not report on value and only reports past earnings.   In contrast, AFTF reports new information about the future and phrases that information in shareholder value-added terms.

Analysts Look for Anomalies Between Price and Value

"In sum, if markets are efficient, they are made so by the work of financial analysts who continually are seeking to find discrepancies between price and value and who advise on portfolio transactions accordingly."

This has damaging implications for accounting, but I believe they are true.   Traditional retrospective accounting does not measure value.   The financial analyst makes a living correcting this accounting failure.   I don't believe this is desirable.  It is not good for accounting, for capital market efficiency, or for the analyst.

The financial analyst adds value by translating retrospective accounting into valuations by forming "projections of future earnings, usually as a surrogate for estimating future cash flows."   The analyst tries to elicit as much information as he can from management about its decisions, plans, commitments, and strategies.   The analyst combines this with public information from quarterly statements, SEC filings, and press releases made by management.   In short, the analyst tries to discover the expectations of management.   The analyst then translates these expectations into value by using the present value of expected cash flows.   This process may be undisciplined and crude, but it is still more relevant than traditional accounting measures.

Distinguishing Financial Analysis from Financial Reporting

The AIMR report attempts to draw a clear distinction, if not a line in the sand, between financial analysis and financial reporting.   On one hand the AIMR report states,

"It is quite easy to make a conceptual distinction between financial reporting and financial analysis.   Although both result in expressions of worth or value, their perspectives are diametrically opposed.   Financial statements express net worth as the surplus of total assets over total liabilities.   Because assets and liabilities are both the result of past transactions and events, so is the accounting measure of net worth.   Financial analysis, on the other hand, assesses, estimates, and gauges value solely in terms of expectations of the future."

On the other hand the AIMR report concludes,

"Thus, financial reporting should provide information to help investors, creditors, and others assess the amounts, timing, and uncertainty of prospective cash flows to the related enterprise"


The AIMR is trying to make very delicate distinctions.   The AIMR seems to want as much prospective information as possible from financial reports yet wants to define financial statements and accounting in narrower retrospective terms.   The following quotes from this section reveal the basic conflict in the AIMR objectives.

"We believe that financial reporting should be concerned with presenting the economic history of specific economic entities and that is best done when managements are also willing to disclose and discuss their strategies and plans, and expected outcomes."

"Forecasts of the future and similar material enhances financial report usefulness, but they must be separated from and not confused with the financial statements themselves."

"Financial analysts avidly seek management's forecasts as part of the financial reporting process, accompanying but not incorporated in the financial statements."

"It is the function of financial reporting to provide data useful to analysts making assessments of an enterprises future cash flow and its value today."

"The other type of forward-looking information comprises forecasts, projections, and certain pro-forma presentations.   These numbers are of great importance and usefulness to analysts, but they are not part of the economic history of the firm and therefore not proper financial statement components.   Nor are they auditable, although the participation of an independent accountant in their preparation could enhance their credibility and "user-friendliness" as well as provide some assurance that management's methodology was sound, its assumptions reasonable, and its calculations accurate."

"Financial reporting and financial analysis cross paths because, ultimately, economic value (wealth) is created by expectations of future inflows of economic benefits, primarily in the form of or the equivalent of cash flows."

It is difficult to draw distinctions between useful financial reporting (which the analyst requires) and prospective financial statements (which the AIMR wants to proscribe).   This difficulty arises from the fact that they are the same.   The AMIR naturally wants to monopolize the reporting of decision-useful value information.   AFTF would end that monopoly and shift the role of the financial analysts to a more informed and a more critical role.

How Financial Reporting Can Serve Financial Analysis

"The financial reporting process is most useful when it goes beyond the past and present to include management's views of its future strategies, plans, and expectations."

AFTF would quantify those views.   This is good management and good accounting.

"The SEC strongly encourages but does not require similar (to the MD&A) discussion of how management expects results of future years to differ from those of the past.   Why have managements been so slow to respond to this urging?"

AFTF would require management to express expectations in a cohesive, consistent, disciplined, and quantitative manner.

Business Activities That Do Not Fit a Manufacturing/Mercantile Accounting Model

"The traditional accounting model was developed originally to fit mercantile firms by matching to sales revenues the costs of products sold together with the periodic costs of running the business."

AFTF fits all industries equally well.

"It was modified, through the aegis of cost accounting, to include manufacturing activities.   That modification was less than perfect and often resulted in the need for additional information to be generated outside the accounting system for use in decision making and control."

AFTF accounting information can be used directly in decision-making and control.

Changes in Business Ownership

"… we also find it peculiar that many accountants deem writedowns to be good because they are "conservative" whereas writeups are not.   It seems to us that whatever criteria are applied to determine writedowns would be every bit as verifiable and useful if also applied to writeups."

AFTF treats all cash flows, negative or positive, with the same objectivity.

Rise in the Proportion of Economic Activity Conducted by the Service Sector.

"Much of the value added by business enterprises in those economies now comes from services; business services, personal services, and financial services.   These are businesses in which physical assets, plant, inventories, and the like, have little importance.   In turn, traditional accounting-based performance measures have also suffered reduced usefulness.   For example, return on invested capital is not a very meaningful in a law firm or accounting firm, or even an investment advisory firm, because so much of the capital is formed from human resources, inherently unmeasurable under current accounting practices."

AFTF captures the value of intangibles through disciplined expected cash flows.

Financial Services and the Proliferation of Financial Instruments

"Financial services firms, primarily financial institutions and other intermediaries, are like service firms in that tangible assets are insignificant to them.   But their other assets are different, being composed almost entirely of financial instruments."

AFTF is superior in evaluating financial instruments.   It uses the expected value to the company.   With appropriate diversification those expectations will be realized.

"The success or failure of such a firm is to a large extent dependent on how well its management matches, from one side of the balance sheet to the other, maturities, yields, and other characteristics of its financial asset and liability positions."

AFTF projects cash flows so that future imbalances are made visible.   Projections are the core of asset/liability matching.

Qualitative Characteristics of Financial Statements

Referring to the qualitative characteristics of accounting the AIMR mentions "relevance" and "reliability".

"That grouping is appropriate because in many cases the format and content of accounting data require a trade-off between the two.   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 value generally are more useful than fastidious historic records of past exchanges."

AFTF also concludes that needs and conditions encourage greater accounting relevance.   AFTF is at least as relevant as financial analysis.   Economic relevance is designed-in.

Relevance

"In an ideal world, the most relevant accounting data would be those that reported assets and liabilities in a way that would allow analysts to impute the future cash flows emanating from them individually and collectively."

All shareholders should have access to shareholder value information, not just those who employ the financial analyst.   In addition, this same information is needed by management.   The proper place for value information is where value is created, i.e., by management and by the capital markets.

"Some assets, such as receivables, are stated explicitly as the amounts expected to be received in cash.   Other assets, such as certain types of securities, are stated at market value, implicitly the amount of cash that could be received.   Some assets are stated at the amounts paid for them (historic cost) pending receipt of evidence that they are worth some other amount (realization).   Some assets may not appear in the financial statements at all because there is no sensible way to report them."

AFTF would treat all assets uniformly as value generators.   The only AFTF assets are value generators.

"Historic costs are sunk costs and there is little disagreement that they are often irrelevant to financial decisions.   But there is considerable debate as to whether they should be totally replaced by more relevant current values, whether current values should be provided only as supplementary data, what version of current value should be used, and how (in the absence of a firm-specific exchange or organized auction market) value should be determined.   There is some opinion among AIMR members that determination of current values of specific assets is a function of financial analysts, not financial reporting.   However, almost all would agree that so-called "lower of cost or market" methods are neither informative nor useful.   They are based on the untenable premise that market value is a good accounting measure when it is lower than historic cost, but not when it is higher."

AFTF measures only the future and automatically ignores sunk costs, which is the proper decision perspective.   It is difficult to defend company valuation as a financial analyst function while permitting specific assets to be valued by accountants; hence the view by some AIMR members that all asset valuation is the exclusive province of the financial analyst.  

"The point is that stock prices reflect expectations of the future only, and that past events do not change stock prices as such, they only change expectations."(from Page 55)

Hence an accounting model based on expected values will have the greatest shareholder relevance.

Reliability: Verifiability

"As the standard-setting process has infiltrated areas in which measurements are less than precise, …, the rules have become more detailed. …   It is possible that detailed rules are now the only way to inculcate verifiability into measurements that otherwise are subject to honest difference of opinion.   Can better ways be found?"

Yes.

"Another aspect of verifiability is knowledge of its absence.   Most accounting numbers have the appearance of precision.   But other than contemporaneous exchanges involving cash, accounting numbers are determined by estimates of various degrees of inexactitude."

AFTF is cash based.   Cash flows are projected and disciplined.   Actual-to-expected cash flows are reported.   The AFTF "dual validation" depends on cash flows.   This makes AFTF at least "equivocally right".   AFTF suggests a well-defined audit role for the accountant.   In this role the auditor can precisely verify.

Reliability: Representational Faithfulness

"Assets and liabilities are probable future economic benefits and claims against those benefits, and users of financial statements expect to see them depicted accurately."

GAAP accounting does not do this.   AFTF does.

"Under current accounting practice, intangible assets are recorded at cost only when they are purchased from another entity, either separately or part of a business combination.   The effect is that self-developed intangibles are not recorded at all or at the nominal amounts spent to assure monopoly rights.   Furthermore, the cost of both purchased and self-developed intangibles are amortized over arbitrary future time spans, even though their value may decrease in some other pattern or, in many cases, increase as the enterprise makes additional expenditures to maintain or enhance their value."

Under AFTF all assets are recorded as the present value of expected future cash inflows.   In fact, this is the definition.

"Moreover, there may well be no accounting measure capable of expressing well over time that the sole economic benefit of intangible assets is their potential contribution to the future cash flows of the enterprise."

We need only define the measure.

Timeliness

"… it is unlikely that rational investors will punish a firm for undertaking projects that promise extraordinary long-term payoffs as long as that firm is willing and able to communicate to those investors its strategy and tactics."

AFTF is that communication, using the shareholder's measures.

"A further irony is that business managers themselves often are compensated or otherwise rewarded for short-term performance, measured either by accounting numbers or by the market performance of their employer's securities.   Relief from so called "short termism" is more likely to be successfully effected through changes in corporate governance, including fundamental and radical change in the paradigm used to reward certain executives, than by abolishing one of the most important sources of analytic information available." (quarterly reporting)

Value added (by decisions) is the incentive compensation basis ne plus ultra.

Neutrality

"Financial reports should inform traders on both sides of a transaction in such a way that neither is favored."

Hence conservatism or one-sided balance sheet treatments should not be employed.

"Historic costs, even more so lower of cost or market procedures, tend to introduce bias in favor of buyers of securities by suppressing good news while revealing the bad straight away.   The absence of adjustments to reflect price changes, even as supplementary information only, in North American accounting standards institutes a bias that varies in proportion to (1) the rate of price change, (2) the dispersion of those changes among the various goods and services traded, and (3) the holding period for assets whose prices change."

AFTF replaces the cost concept with a value concept.

Mark-to-Market Accounting: Value versus Valuation

"Almost all agree that if mark-to-market accounting were to be mandated, it should be applied with equanimity to both the left-hand side and the right-hand side of the balance sheet.   All agree that it is only specific identifiable assets and liabilities that should be marked to market; determination of the market values of entire firms is the business of financial analysis, not financial reporting."

A Line in the Sand.

Knowing What Market Value Is

"The is no financial analyst who would not want to know the market value of individual assets and liabilities."

The can be useful as a guide or point of departure, but AFTF uses the entity-specific perspective scaled to shareholder value.

Applicability Limited by Measurement Problems

One problem cited with marking-to-market is the lack of an active market from which to obtain a market value for many financial assets.   Another problem cited is the one-sided application of market values to assets only.   Still another problem is that comparability is hampered by companies which "have different costs of funds and local or regional variations in business conditions and credit risk."

AFTF solves these problems by,

1.  Not requiring an active market, but instead using an entity specific value based on management's expectations of future cash flows.   These expectations would take into account all contingencies and would be disciplined.   For example, a hedging investment may have little or no market value, but the related item hedged against has its value stabilized.   This matching creates value since, if it didn't exist, the matched asset or liability might have a different expected value.   Such a entity specific value may seem difficult to assess, but that assessment must be within the capability of management, otherwise management has no business acquiring that asset (or liability).   In fact, the value should already be known.

2.  Valuing assets and related liabilities simultaneously and consistently.   Since AFTF is based on a complete company-wide model, there is little risk of major omissions of assets or liabilities; the cash flow model used is very carefully validated and subjected to further strong disciplines.

3.  Solving the problem of differing costs of funds elegantly and precisely by the dual validation methodology.   Variations in business conditions and credit risk are handled as variations in management expectations.

AFTF would also reduce the volatility associated with market valuations since management's long-term expectations would be somewhat stable.   This could lower the cost of capital.


The AIMR considers assigning market values to individual assets or liabilities "to be appropriately within the domain of the accounting function.   On the other hand, when it comes to the valuation of business enterprises -- either singly, in groups, or by components -- we rightfully regard that as the province of financial analysis and a matter beyond the scope of financial reporting."

This is an understandable position, but inappropriate and mistaken.   It is understandable since the AIMR perceives the conversion of traditional financial reports and other data to a value-based measure as a valuable and central function of the financial analyst.   It is inappropriate since the AIMR should not dictate the scope of financial reporting, especially if financial reporting is thusly made deficient.   It is mistaken since the role of the financial analyst will not be diminished by a better accounting model.   It is my belief that the role of the financial analyst will be significantly enhanced by shifting to a higher gear.

Accounting for Intangible Assets

Service firms "have few tangible assets and in many cases have balance sheets that under conventional accounting show meager or even negative owner's equity.   In fact, however, they may possess unrecorded economic resources in the form of anticipated future cash flows.   Yet under traditional accounting methods, the value of those future cash flows is recorded only when (1) the cash flows are acquired in a purchase transaction with an unrelated party or (2) the anticipated cash finally is received.   On the other hand, equity investors and lenders are forced to acknowledge the value of future cash flows to make sensible investment and lending decisions in competition with other rational suppliers of capital."

AFTF accounts fully for tangible assets and intangible assets.   There is no distinction between tangible and intangible things; assets are simply present values of cash inflows.   In fact, the normal AFTF perspective attaches values to decisions, not to things.

A Note on Stock Compensation Cost

The AIMR recommends that such costs be recognized.   If a stock option is exercised (with the exercise price greater than the market price) then there will be a direct and visible cost if the company purchases those shares at the higher market price to be sold at the lower exercise price.   Often the cost is disguised by issuing new shares.   This has a similar effect on existing shareholder value through dilution.   Such employee compensation would be a cash flow expense from the AFTF perspective of the existing shareholders.   The AIMR and AFTF agree.

The Problem of Goodwill

"Once it has been established for the record how much was paid to acquire goodwill, it ought to be removed from the list of assets forthwith."

AFTF adopts a stronger position.   Under AFTF positive (price > value) goodwill should never exist since its existence implies a negative decision.   Note that AFTF takes into account all future cash flows which implicitly incorporate such things as economies of scale, synergy, franchises (brand names, markets etc.), decreased competition, and other sources of "goodwill".   The AIMR and AFTF agree.

Contractual Arrangements

"We have observed the machinations that often accompany the classification of lease agreements.   We are also overwhelmed by the excessive volume of extremely detailed accounting definitions, procedures, and rules designed to foil such intrigues.   We suggest a standard that would be far simpler in its application.   We would require capitalization of all executory contracts with an initial term in excess of one year."

AFTF requires the use of expected cash flows similar to capitalization, but more representative of financial values.   The AIMR and AFTF agree.

Discovery Values

Oil and gas reserve recognition accounting, as I understand it, uses expected net gains from unproven resources to "bring financial reports closer to the economic reality of how wealth is created in the oil and gas industry, but also in other types of enterprises in which significant values are created by 'discovery.' "

"Many analysts found the information it generated, although primitive, was both unique and useful for valuations purposes."

The expected cash flow approach recognizes (taking all contingencies and probabilities into account) the value of unproven reserves.   The AIMR and AFTF agree.

Costs to Create Intangible Assets

"We are not enamored of recording self-developed intangible assets unless their value are readily apparent."

"Furthermore, it usually is next to impossible to determine in any sensible or codifiable manner exactly which costs provide future benefit and which do not."

AFTF does not use costs.   AFTF provides a sensible and codifiable setting for valuing intangible assets.   The AFTF perspective is the decision perspective so that informed decisions are accompanied by sensible measures.   Those measures are strongly disciplined.   In terms of financial reporting the sum of all decisions, however they are phrased, must account for all cash flows so that a balanced and complete picture emerges (see the dual validation of AFTF).   AFTF proposes the codification and implementation of a prospective accounting model.

"We cannot quarrel with capitalization of the costs of intangible assets that are purchased."

I agree that purchase price establishes a value.   In the case of a widely traded security that value becomes unequivocal.   This fact is used in scaling the financial measurements within AFTF (see the dual validation of AFTF).   In essence the intangibles inherent in AFTF represent assets that are purchased by the shareholder.   Hence the AIMR and AFTF agree, although in a roundabout manner.

The Importance of Cash Flows

"…it is important in extremis for financial reports to disclose clearly the amounts and sources of past cash flows."

This is also true for AFTF.   The cash flow models must validate to past cash flows and the actual-to-expected cash flows ratios are important indicators.   The reports within AFTF provide relevant and revealing cash flow information.   The AIMR and AFTF agree.

"The discussion above makes it clear that intangible assets derive their value from the prospects they engender for future cash flows and that it is difficult or impossible in many cases to obtain a sufficiently reasonable measure of their value to place on the balance sheet."

The AMIR and AFTF part company on this.   First, the dual validation procedure of AFTF provides values that are both relevant and reliable, i.e., reasonable values.   Second, values must validate to the company's and to the capital markets historic record.   Third, there are several additional disciplines that come into play, for example, the certifications, the actual-to-expected record, disclosures and analyses, the professionalism of those involved, the oversight and guidance of the AFTF accounting, and auditing practice and principles.   AFTF provides technology and structures that makes the incorporation of intangibles into a balance sheet reliable.

It is mentioned that "the expectation of future benefits from research expenditure is so uncertain, their value cannot be recorded in advance."   I would agree that, for a small company with a single research effort in a new field, valuations are uncertain.   For a company like Microsoft or Lucent there are a diversified multitude of research efforts, constantly evolving and sustained for many years.   These efforts are so certain to produce future value that the capital markets attach very substantial current values to those efforts.   Management expectations are not inferior to market expectations in measuring value so that reported values convey information.   Hence the AIMR and AFTF apparantly disagree.  However, the AIMR makes a living on recording expected "future benefits from research". 

Conclusions about Intangible Assets

"We believe, however, that financial reporting can be modified so as at least to recognize more of the economic reality of intangible assets than it now does."

The AIMR and AFTF agree.   In fact, AFTF seeks to completely recognize the economic reality as defined and measured by the capital markets and management expectations.

Auditor Involvement

"First, we advocate the continuous involvement of the auditor in the process that generates the financial information an enterprise disseminates externally."

"We also envision instances in which much of the increase in audit activity could be provided by an internal audit team elevated in size and status."

With the accounting unification that AFTF promotes, that continuous involvement should also improve management decisions.   Hence the accountant will also support the internal decision process.   This will elevate the accountant.

Comprehensive Income

"We have profound misgivings about the increasing number of wealth changes that elude disclosure on the income statement."

AFTF replaces the income statement with a value-added statement, which is defined as the change in valuations (taking into account the cost of capital).   It is impossible for a wealth change not to be in the value-added statement.   The AFTF statement of values precisely coordinates the progress and the result.   The traditional accounting income statement and balance sheet are poorly coordinated often dealing with different classifications!

Recent Criticism of FASB

In general the AIMR commends the FASB for its efforts and takes to task some of the criticism of FASB. Some criticisms emerge.

"Financial reports have become difficult to understand."

The AIMR attributes this to the complexities and variations in business.

"We do not expect the financial affairs of multifarious economic organisms to be reducible to a few simple comprehensive easy to read numbers.   It just is not possible."

AFTF does provide a few simple easy to read numbers, namely the company valuation, value added, estimated yield, the cost of capital, actual-to-expected ratios.   These items distill financial results to relevant and broadly comparable measures.

"Financial reports have taken on the appearance of compliance documents rather than communication tools."

The AIMR attributes this to management's failure since "The FASB and the SEC set minimum disclosure requirements.   There is no proscription on relating more or explaining that which is disclosed."

"In fact, the FASB in many cases has issued standards that are obviously contrary to good accounting theory."

In my judgment, the problem is the accounting theory.   Traditional retrospective accounting is fundamentally flawed and is inferior to a disciplined prospective model.

Set Information in a Business Context

"Businesses are for the most part operated according to plans, either explicit or implicit.   Investment professionals aspire to allocate capital to those plans that seem most likely to succeed.   To do so they need information of two types."

"First, management should explicitly describe it strategies, plans, and expectations."

AFTF requires this and requires quantification.

"Second, results should be reported in a manner that is consistent with the organization and management of the firm."

AFTF requires the construction of cash flow models.   These models will generally be influenced by the organization and management of the firm.   In some cases the organization and management may be influenced by the models.  A more rational relationship will emerge between the firm's activities and reports thereon.

Conclusions

"The role of the external auditor might subtly shift from attestation to "reliability enhancement".

With AFTF a traditional but enhanced role is envisioned along the lines suggested by the AIMR (see the paper The CPA Vision Project and AFTF by the author).

"Financial statement users need much more of a direct voice in the process than they have been given in the past."

The AIMR has an important role to play.   It is hoped that the AIMR will support not just its own perceived needs, but all users.   This includes management, the shareholder, the capital markets, and the accounting profession.   The AIMR properly owes it first allegiance to the financial analysts it represents, but it must very carefully identify their best long-term interests.   I believe the AIMR has a critical choice.

A Line in the Sand

There is a great commonality of purpose and in the specific recommendations of the AIMR and AFTF.   There are some significant differences.   The principal difference is that AFTF would combine individual asset and liability valuations to produce a company valuation for financial statements (or reports).   The AIMR states that company valuations are distinct from traditional financial statements and should remain so and that it is the vital, rightful and exclusive role of the financial analysts to produce the company valuation.

There are several things about this position that are inappropriate

1.  No profession can claim exclusive use of a technology, especially when that technology is widely used and accepted.

2.  The financial analyst is generally not capable of producing valuations as sophisticated or as accurate as those that can be produced internally.   Some reasons,

· the internal valuation will be a collaboration of the accountants, modelers, and management
· the collaborative knowledge of company structures, operations, and capabilities
· management's special knowledge of its industry, markets, and competition
· management's intimate and complete knowledge of its own plans and expectations
· the collaboration performs cost/benefit analyses, capital budgeting decisions, pricing studies, profitability investigations, all using valuation technology
· the company would produce valuations routinely and consistently
· the analyst would have to perform two valuations to determine value added
· the valuations would be disciplined by the accounting technology, such as AFTF
· the magnitude of the task
· the company would employ a staff dedicated to valuation of a single company
· the cost of capital used as a valuation discount rate is problematic for the analyst

3.  Accounting needs to be made more relevant for internal users and for accountants.

4.  It is inefficient for several competing analysts to each construct complex and detailed cash flow projection models.   If they don't construct such models they can't hope to approximate a complex and detailed reality.   The analyst should not try to duplicate these complex models, but rather to assess the company's ability to realize its future expectations.

5.  Management needs to produce valuations for decision purposes anyway.

6.  Shareholders would generally not be provided with value information.   They can't produce a company valuation no matter how much data they are given in reports.  This is unfair and subverts the purpose of financial reporting.

7.  Traditional retrospective accounting is fundamentally flawed in that it doesn't report on the future, doesn't include intangibles, does not measure economic value, is biased towards conservatism, according to AIMR and AFTF analyses.

8.  The company valuation is only one of the many functions of the analyst.   It is the heart of relevant accounting.

9.  With AFTF the analyst's role is shifted to a more critical and cooperative role.

10.  The AIMR position is fundamentally inconsistent.   The AIMR naturally wants accounting to be more relevant and value oriented, but it doesn't want financial reporting to report values.

A Critical Role for the Financial Analyst

If the financial analyst does not project cash flows, what is the role of the analyst?   For one thing the financial analyst could directly project cash flows within the company on a full time basis.   There will be a need for modelers of the future.   He could use the same technology he now uses.


The analyst adds value in many ways.   One way, has been to estimate future cash flows (or earnings as a surrogate for cash flows).   Under a prospective model, the company's cash flows will be projected by the company.   The analyst is then free to criticize those projections.   This role of critic is an extremely valuable one.   

As an analogy, consider the movie critic.   He doesn't produce the movie, but does make useful judgments and recommendations about the movie.   He provides a unique and independent perspective on the movie.   If he were also a movie producer, he would less effective as a movie critic.   He would not be objective in reviewing his own movie.

An independent external view is the strength of the analyst.   He can contribute in a unique way that management cannot, namely,

· compare one company against other companies in a knowledgeable and unbiased manner
· objectively judge the record, style, capabilities, and quality of management
· assess the general economic outlook and the outlook for the particular industry
· independently rate the quality, price competitiveness, and effectiveness of the company's products or services
· consider external forces, such as possible takeovers or mergers
· factor-in market psychology or trends
· actively gather information from company external or internal sources
· assess risks and rewards
· perhaps draw different conclusions about the company's value.

There is nothing stopping the analyst from revising or discounting management's expectations or even making his own earnings estimates or cash flow projections.   But the analyst can be most valuable in bringing his own perspective to the process, not trying to duplicate management's expectations.


The financial analyst's responsibilities go far beyond the valuation of single company.  In addition to focusing information on the valuation process the analyst must know the special needs of the client (risk tolerance, diversification, hedging purposes, time horizon, social responsibility, yield requirements, etc.).   The analysts deals with statistics, economics, finance, banking, foreign exchange, mergers and acquisitions, real estate, asset allocation, fixed income securities, hedging, derivatives, institutions/individuals, and much more.



The AFTF draft proposal illustrates some prospective accounting financial reports (see Appendix 3).   The reports present revealing high-level information.   Specifically the analyst will find the following statement information invaluable in making judgments.

1.  projected cash flows
2.  the record of actual-to-expected cash flows by source
3.  the cost of capital
4.  the company estimated yield
5.  sources of value added
6.  the value added analysis (separating current year experience from current year actions)
7.  effect of assumption changes on cash flow components
8.  sensitivity to assumptions (used to assess risk)
9.  statement of values and value added

In addition, a prospective model provides, as a by-product of relevance, analytic solutions and comparability between companies not possible with retrospective accounting (see Chapter 9 of AFTF).   The analyst can have a field day with the new financial reporting.

The analyst can also play an important role within prospective accounting.   Although many strong disciplines exist to scale valuations within AFTF, new value added is less disciplined.

Value added is created by management actions and commitments.   These actions and commitments must be based on informed decisions, which in the case of AFTF means that a professional unbiased cash flow projection (cost/benefit analysis) must be made.   This, not coincidentally, measures the value added.   The discount rate applied to the expected cash flows is that rate obtained through the "dual validation" process.    Management must not only quantify its expectations, it must disclose and describe them.   In addition, management must certify to the commitments and to the completeness of the valuation of those commitments.   The development of realistic and effective plans and their assessment (measurement) is the function of management and, in general, nobody is better equipped or better motivated than management to accurately weigh the company's future.

However, management expectations may be judged differently externally.   This is a vital function for analysts.   If analysts generally view management as overly-optimistic then they will let their views be known.   This will decrease the stock price and raise the cost of capital.   The cost of capital is the discount rate so that management over-optimism is soon discounted within the company's own financial reports.   Hence the analyst performs an invaluable function in calibrating value added.   This is very similar to the function now performed by analysts within a less relevant or disciplined setting.

AFTF goes a long way in providing useful information to the financial analyst.   The analyst's judgments will be more informed if he has management's quantified expectations to evaluate.   There will be ample room for the analyst to contribute; his judgments will be easier, more accurate, and more effective.

The FASB Position

FASB, as unofficially represented by Wayne Upton, has reacted very negatively to the AFTF draft proposal.   One of the arguments used is that "Many observations in the AIMR study seem to argue against your (AFTF) approach."   The draft proposal was published four years after the AIMR report so that the draft report certainly did not directly argue against the AFTF approach.   A closer characterization might be that some AIMR observations argue against the AFTF approach and that most AIMR observations seem to support the AFTF goals.   On balance, I don't believe that the stated AIMR position argues against a prospective accounting model.

More importantly, even if the AIMR opposes prospective accounting, accounting must follow its own dictates.   Accounting must do whatever is needed to itself become relevant and effective.

Most importantly, the reality of the technology used by financial analysts strongly supports the AFTF approach.   It is the same.


I hope that FASB will support a prospective accounting model and give serious consideration to the AFTF technology and structures that make prospective accounting relevant, reliable, and feasible.


The AIMR feels somewhat under-represented in the standard setting process.   I believe that they would be listened to quite carefully if they came out in support of prospective accounting, since the AIMR has substantial experience with this approach.   It would take foresight, leadership, and great courage by the AIMR to support prospective accounting.

Conclusions and Recommendations

The following conclusions are drawn from comparing the 1993 AIMR report with the AFTF draft proposal.

1.  The AIMR and AFTF agree that the current accounting model has major deficiencies and should be improved.   Most of the criticisms in the AIMR report are also in the AFTF draft proposal.

2.  Many of the solutions suggested by AFTF are along lines suggested by the AIMR.

3.  The AIMR's 1993 stated position does not support the reporting of values in financial statements.

4.  Valuation is but one function of the financial analyst.   Within a prospective accounting model the valuation role of the financial analyst would shift qualitatively toward a more informed, more critical, and more effective role.

5.  The financial analysts can play a more valuable capital market role within a prospective accounting model.

The following recommendations are made to the AIMR.

1.  The AIMR should adopt a broad long-term view.   It should strengthen its efforts to improve capital market efficiency by improving financial reporting.

2.  The AIMR should reverse its opposition to reporting values in financial statements.

3.  The AIMR should actively support a prospective accounting model.

4.  The AIMR should consider the disciplines and technology suggested by AFTF as a means of making prospective accounting relevant, reliable and feasible.

5.  The AIMR should encourage a shift in the financial analyst's valuation role to a more critical and complementary approach.