Value Added
By Humphrey Nash

Recognition

FASB has done an excellent job of researching, developing, and exposing the concepts of expected cash flows and the present values of those cash flows (PVECF).   Interest is used, (as a discount) to take into account the time value of money.   FASB states that measures that make use of the time value of money are more relevant than those that do not.

AFTF supports this view and it is stated in Chapter 4 of Accounting For The Future that,

"Cash flows or values can be added or subtracted at will, but they must all be measured from the same time perspective, i.e., with the appropriate adjustment for required interest."

To be consistent with the time value of money, it is just as necessary to accumulate past cash flows with interest as it is to discount future cash flows.

Hence, if PVECF(0) is the value of an asset at the start of the year then the relevant value at the end of the year is given by PVECF(0) * (1+i) where i is some interest rate (for AFTF, i = the historic cost of capital).   If PVECF(1) is the new value of the asset at year end then the Value Added during the year by the asset is given by,

Value Added by the asset = PVECF(1) - PVECF(0) * (1+i)

We do not have to depend on an artificial definition to arrive at the concept of Value Added.   All we need do is consistently apply the time value of money when adding or subtracting values from different points in time.

The same development applies to aggregated assets and/or aggregated liabilities so that we can define Value Added for a decision, for a capital expenditure, for a line of business, or for an entire company.   In essence, FASB's recognition of the time value of money gives rise to both the concept of value (PVECF) and the concept of Value Added.

Definition

To measure or weigh value we need to define what is meant by value.  First we note that value, like beauty, is in the eye of the beholder.    This follows, in part, from the fact that value is a relative concept.   The value of an asset may vary with the situation.   A buyer of an asset may, and generally does, have a comparative advantage over the seller when it comes to using or profiting from that asset.   That comparative advantage ("the fair value of the real options controlled by the entity") is already included in the the concept of value inherent in the expected cash flows   The expected flows are those future cash flows to the buyer.   The value of the expected cash flows to the buyer will be greater than the price (value to the seller).   Unless we somehow remove the effects of comparative advantage from the expected cash flows, FASB's recognition of expected cash flows gives rise to an entity-specific value as opposed to a cost-based fair value.   We have achieved a degree of relevance by recognizing entity expected cash flows, but PVECF also depends on the interest rate used to discount the expected cash flows.   We also require an entity-specific interest rate that preserves or enhances the relevance of the expected cash flows.

Again we encounter a word which requires focus.   One of the principal requirements of accounting is financial reporting, primarily financial reporting to shareholders and their representatives (management, financial analysts, and portfolio managers).   Creditors also have an interest in financial reporting, but there interest is limited since they don't generally participate in the risk or rewards.   They are, of course, interested in solvency, but solvency is assured by protecting shareholder value.   Shareholder reporting is necessary for shareholders and more than sufficient for creditors.   It is useful to define relevance as relevance to the shareholder and value as value to the shareholder.

A Procedure

If shareholder value is the goal then the interest rate used in discount expected cash flows must be the shareholder cost of capital.   AFTF provides a disciplined and unequivocal procedure to determine this cost of capital.   That procedure depends on capital market prices and is coordinated with the expected cash flows.   This cost of capital varies with the characteristics of the company (quality of management, diversification, resources), with the financial environment (inflation, economic outlook, competition), and with the expected cash flows (for example an optimistic expectations may require a higher interest rate).

It is not the precise allocation of factors between expectations and discount which is critical; it is the net effect of the discount applied to the expected cash flows.   With AFTF the net effect takes into account all significant factors leaving none out nor duplicating any - and the net effect is shareholder value.

The AFTF procedures determine properly scaled shareholder values (PVECF) and a coordinated and properly scaled cost of capital for discounting or accumulating with interest.   Hence, Value Added, as defined by the time value of money, is readily determined

Stumbling Block

If accounting acknowledges shareholder value as an attribute of financial reporting then the relevance of financial reporting will be more widely acknowledged.   Creditors will not be damaged; they will be protected by shareholder value.   Accounting will then become decision-useful at all levels.

If accounting does not recognize the primacy of the shareholders' interests then accounting can not maximize those interests.   The question then becomes whose interests are maximized?