by Humphrey Nash

Abstract

Traditional accounting does not measure economic value.   Most other financial disciplines measure economic value.   An accounting model based on economic value can bring accounting into the mainstream of financial measurement or equivalently bring financial measurement under the control and discipline of accounting.   This would be good for financial measurement and good for accounting.

 

Introduction

One of the purposes of Accounting For The Future (AFTF) is the unification of accounting.   For this purpose, accounting was very broadly defined to include many disciplines which employ economic value measures.   These include pricing, capital budgeting, financial analysis of stocks, mergers and acquisitions, cost benefit analysis, value added management accounting, profit studies, asset or liability or business valuations.   All of these disciplines are different from traditional accounting and it might seem impossible to unifying them within accounting, much like bringing the mountain to Mohammed.   The answer, of course, is to bring Mohammed to the mountain.

First, we observe that the mountain is one cohesive thing.   All of the disciplines cited are shareholder value-based.   All of the disciplines cited use a single technology, namely the Present Value of Expected Cash Flows (PVECF).   All of the disciplines cited are designed to be decision-useful.

Second, we observe that accounting is already moving in the right direction.   FASB has made excellent progress toward a value-based accounting model with its illuminating work on PVECF.

Third, other winds of change are blowing towards the mountain.   The CPA Vision Project has charted a course for accounting for the future.   Concepts like Economic Value Added (EVATM), Economic Profit (EP), business valuation (developing within the AICPA), cash flow testing for insurers, IASC investigations (discounting, intangible and contingent assets), numerous private endeavors, such as the Ernst & Young Value Creation Project, are all heading in the same direction.

Microsoft

Microsoft is the world's most successful corporation.   That success is due, in large part, to one idea repeatedly applied.   That idea is unification.   It is hard to believe now, but early computer users were faced with often insurmountable incompatibility.   There were several competing operating systems.   The operation of software and hardware varied from machine to machine.   Software written for one computer or a diskette formatted for one computer would not work in another machine.   Computer users craved uniformity and Microsoft provided it.   The Microsoft DOS operating system made different machines compatible.   MS DOS was not the best operating system (the Apple operating system was far superior), but it was available on for all machines, except for Apple computers.   The Apple operating system was made available only with Apple computers --- BIG MISTAKE.   Microsoft further unified and standardized the operation of software with MS Windows which provided a common graphical interface and environment.   Microsoft Office also provides a unified and integrated series of applications with similar operation and easy communication.   As long as Microsoft continues to deliver unification to the computer world, it will continue to set the standard.


The Value of Accounting Unification

The financial world craves unification and standardization.   The accounting standard setters should understand this need and the value of meeting that need.   If the standard setters don't understand this, someone else will.   That will be a BIG MISTAKE.

The value of accounting unification within a prospective model arises from two sources: the value of unification per se and the value of the prospective model per se.

Simplicity.   A single model is simpler than multiple models: simpler to understand, simpler to use, and simpler to explain.   A prospective model uses a single technology for all value measures, namely, PVECF.   Judgments are reduced to management expectations, for which management takes the responsibility and to which AFTF accounting disciplines are applied.   This replaces a multitude of accounting measures, such as, cost, amortized or depreciated cost, market values, fair value, salvage value, tax value, present values discounted for interest and/or contingencies.   These measures vary by asset or liability type and from company to company.   They may also be conditional, with discontinuities under triggering events or circumstances.   Standard setters may, from time to time, change or rescind accounting statements.

Communication.  With a unified prospective model all financial decisions use the same technology and satisfy the same goals.   The shareholder's cost of capital is used as the discount in PVECF so that all decisions will satisfy, or at least be cognizant of shareholder requirements.   A positive decision is indicated if and only if PVECF is positive.   Under the AFTF model management and shareholder goals and knowledge will be aligned since both shareholder and management expectations are clearly and precisely communicated.   Prospective accounting will permit accounting to speak the language of value, and be heard, and be understood.

Accuracy.  The quality and integrity of data will be improved because it will be centralized and unified under the care and control of accounting professionals.   Many people will use the same data which can spread the cost of developing and maintaining it.   More detailed and more relevant data will be possible.   Multiple users also provide multiple sources and multiple scrutiny for data.   In addition the PVECF methodology will become familiar as it is applied in various disciplines and at different levels.   The methodology will have to conform to several standards as well as the standards of the accounting model.   The AFTF disciplines are rigorous and auditable.

Coordination.  A unified accounting system provides interdisciplinary coordination not possible with separate unaccounted functions.   For example, much of the work done by management in evaluating projects during a period may enter into the end of period financial reporting.   The use of a single discount rate for all PVECF measures means that expected cash flows can be aggregated or disaggregated without difficulty.   A product, line of business, a decision, or the whole company can be easily assembled from the atomic cash flows.   Assets and liabilities are treated consistently and they can be structured or grouped in a natural way to coordinate assumptions or methods.   A unified accounting system will coordinate the part with the whole.   Since the total system is carefully validated there will be no missing or double-counted parts.

Standardization.  With a unified prospective accounting model a common PVECF yardstick is used for all disciplines.   A single cost of capital is calibrated to shareholder value.   This standard value measure will make accounting decision-useful because accounting will incorporate and serve all financial measurement and decision systems.   This will broaden the scope of accounting and enhance the role of the accountant

Discipline.  The broader scope of prospective accounting will extend the control and discipline of accounting to the valuation and decision processes.   Accountants will control the quality of these processes by controlling the quality, relevance and consistency of information.   For example, if a line of business is evaluated the accountant can guarantee that direct and overhead expenses are reasonably allocated because the accountant assembles the company totals.   In particular, AFTF contains technologies and checks and balances that are designed to insure disciplined valuations and decisions.

Expanded Relevance.  The expanded scope and relevance of a unified accounting will mean that accounting will be of greater service.   Accounting will be of more relevance to the shareholder, but at the same time it will better serve the financial analyst or portfolio manager.   This follows from the adoption of the methods and the generation of data that the financial analyst uses or would use, if available.   The analysts role is not eliminated, but facilitated, providing an opportunity for the analyst to make more accurate judgments and to occupy a more appropriate and more critical role.   Management will benefit by having decision-useful valuations.   In fact, the shareholder value attribute of PVECF is directly decision-useful.

Cohesive Reporting.  The traditional accounting balance sheet is semi-prospective and the traditional accounting income statement is semi-retrospective.   The traditional balance sheet and the income statement are artificially coordinated.   For example, the income statement may have artificial items that are not cash flows which are only present to account for changing asset or liability values.   Balance sheet values may be artificially forced to equal cost in order to reconcile with the income statement.   The past and the future can only be reconciled if balance sheet values and income statement items are complete and coordinated.   Cutting off income at 12/31/2000 is not complete.   Ignoring intangible assets is not complete.   The prospective statement of values is a unified statement which shows the current and prior valuations and value added.   Value added is the interest adjusted change in the valuations and uses the same classifications as the valuations.   Hence the prospective "balance sheet" and "income statement" are perfectly coordinated and unified (see page 9 of April's Future Accounting News for more on this coordination).


Continuity.  It might seem that a radically different accounting model would radically change accounting theory and practice.   Surprisingly, many of the goals and principles of accounting are compatible with a prospective model.   This is because those principles and goals are more fundamental than the GAAP model and are based on general principles of logic, equity, disclosure, representation, accuracy, and relevance.   The accountant's role under a prospective model will continue traditional accounting functions.   These include bookkeeping, financial reporting, and auditing.   Prospective accounting has surprising unity with the accounting of the past.

Workload.  It might seem that a substantially broadened role for accounting would substantially increase the workload for the accountant.   The role of accounting under a prospective model is broadened primarily by virtue of being more widely relevant.   It is not the total quantity of work that changes, but rather the quality or character of work that changes.   True, prospective accounting requires more that traditional accounting, but the bulk of the increased workload is assumed by management and the modeler.   Management makes assumptions and judgements about the future, which is management's natural and proper role.   The modeler constructs the cash flow model according to management assumptions and validates that model.   The accountant starts with the expected cash flows and determines the historic cost of capital and present values.   These present values are the assets and liabilities reported on.   This relationship of management, modeler, and accountant is structured and formalized and will improve communications and unify company operations.

Responsibilities.  The fact that other disciplines may use accounting information or must coordinate or comply with accounting practices or principle will not substantially increase the workload.   It is however anticipated that accountants will be found to be of greater use, for example, as internal auditors or modelers.   Under AFTF management, modeler, and accountant will have separate responsibilities, but they will be interdependent and will provide help and oversight to each other.   They work within a common framework with a single goal and responsibility.

International Accounting.   Prospective accounting is based on capital market values, cash flows, and present values.   These translate unequivocally into any language.   AFTF proposes simple, unique, uniform and universal methods.   Prospective accounting is decision useful and unifies financial measurement under the banner of accounting.   Accounting systems like US GAAP are based based on cost, not value.   US GAAP also tolerates accounting allocations which are arbitrary.   There is no hope of getting international agreement on such controversial accounting practices.   There is also no need.

Other Professions.  Prospective accounting is of vital interest to other professions and, since it better satisfies their needs, those professions should welcome it.   Economists should welcome the measurement of economic value.   The financial analyst should welcome the abundance of value-based information.   The bank or lender should welcome the forward-looking information and the protection provided by explicit shareholder value.   Management should welcome the decision-usefulness of information phrased as shareholder value.   Standard setters and regulators should appreciate the improved relevance and disclosure of a prospective accounting model.

Time.  The time value of money is an essential element of PVECF and prospective accounting.   Taking into account the time value of money allows us to travel through time.   This permits the experience of the past and the expectation of the future to influence the present in useful ways, for example, to make informed decisions.   The past and future are unified with the present.

Conclusions


Prospective accounting broadly unifies financial measurement and financial decisions.   It unifies by bringing accounting into a larger and more useful setting.   It unifies because it brings to that setting the skills of the accountant and the principles and disciplines of accounting.

Unification is not a dream.   It is within reach.   All the components are in place for a prospective accounting model.   The technology is already in widespread use and is of proven decision-usefulness.   An excellent foundation has been laid by FASB with the development of the PVECF model.   The AFTF draft proposal suggests a prospective accounting model which is relevant, reliable, and feasible.   Furthermore, the suggested model continues the general goals and principles of accounting while preserving the essential functions of traditional accounting

All that is necessary to unify accounting internally and with other financial measurement disciplines is to make accounting forward-looking and value-based.   However, for unification to succeed and for accounting to be decision-useful, the attribute of PVECF must be shareholder value.   The attribute cannot be cost or "fair value".

Unification will create opportunities for accounting, accountants and accounting organizations.   Accounting can be broadened, made more relevant, and integrated into the financial measurement and decision process.   Accountants can fulfill their vision, occupy a more vital role and expand their opportunities.   Accounting organizations can have new and exciting research, development, promotional, educational, implementation, and enforcement roles.

   

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