The draft proposal Accounting For The Future outlines a complete accounting model.  It may, in a sense, represent the perfect accounting system since it is based on knowledge of the future.  Its theoretical perfection may be its obvious downfall.  Have we replaced the problem of accounting relevance with the problematic construction of many models each based on many questionable assumptions?  Have we gained anything more than complexity?  When we get down to brass tacks is AFTF practical or even possible?

FASB raises these questions and other questions about AFTF in its Special Report: Business and Financial Reporting, Challenges from the New Economy by Wayne Upton, April 2001.  I quote from Chapter 2: New Reporting Paradigm.

"Developing cash flow projections for a single project can be costly and difficult. The cost of implementing a prospective accounting model in a complex organization would be considerable, it essentially requires a second management information system."

I don’t want to minimize the cost or difficulty.  These will be present.  However, cost and difficulty must be put into perspective.

1. The adoption a forward-looking accounting model might be phased in over time and across industries.  For example, the life insurance industry, with its long term assets and liabilities, is an ideal first candidate.  Life insurers already model cash flows and perform valuations.  For the most part, they already have the data, assumptions, programs and expertise needed for prospective accounting.  For example, an insurance reserve liability equals the present value of benefits less the present value of net premiums.*

 

2. Cash flow models can have varying degrees of sophistication and difficulty.  A simple linear extrapolation (Excel least squares fit) based on net cash flows for the entire enterprise would take 5 minutes and would be reasonably representative in many cases.  To meet professional modeling and accounting standards, major cash flow components within each business segment should be modeled and separately validated.  For the smaller simpler enterprises the required cost and difficulty will effort be less than for large conglomerates.  However, large conglomerates may already have some models or projection systems in place for evaluation and decision purposes.  During a phase-in/learning period simple modeling satisfying basic modeling and reduced accuracy requirements might be acceptable, with the goal of ultimately meeting professional modeling and accuracy standards.  An example of such a standard might be a requirement that any cash flow item greater than 1% of total actual or expected cash flows must be "intelligently" modeled.

 

3. The cost and difficulty must be judged relative to the benefits.  In my opinion, net benefits will be substantial so that the operational question may be how to maximize the investment, not how to reduce or avoid the cost.

 

4. It is important to judge benefits of disciplined prospective relative to the cost of continuing the current accounting model.  This cost has many aspects: the decline of accounting, capital market inefficiency, failure to support management decisions, short-term focus, failures of enterprises, etc. Suppose, for example, it cost Worldcom $10,000,000 or even $100,000,000 to understand and model its operations.  This cost is less than 1/10 of 1% of recent losses to investors in Worldcom.  But there is a larger cost: the cost is the gradual erosion of management and capital market efficiency resulting from an accounting which is complex, fundamentally flawed and increasingly irrelevant.  This insidious erosion is a magnitude** larger than recent accounting disasters, but is invisible since it occurs everywhere continuously in infinitesimal increments.  AFTF is based foursquare on decision technologies and will help management and the capital markets allocate capital wisely.

 

5. AFTF unifies accounting and indeed can bring the discipline of accounting to all financial decisions.  In particular, it provides shareholder value information, which can guide both management and the capital markets. Why should there be different types of accounting when there is a single reality (cash flows)?  AFTF provides decision-useful management information because it adopts the decision technology of cost/benefit analyses.  The sum or accumulation of cost benefit analyses is essentially AFTF financial reporting. Hence, AFTF provides at least two layers of benefits through unification.  It doesn’t necessarily require a "second management information system". This may lower total accounting costs.

 

6. Modeling 25 years ago would have been very expensive involving mainframe programming: 1. To collect and process data to establish assumptions, behaviors, parameters, current states, etc. 2. Writing program specifications. 3. Writing programs, documenting, testing and debugging. 4. Running the programs, printing output.

Today a desktop PC with spreadsheet can out-perform the mainframe, at a fraction of the cost, in a fraction of the time, and essentially avoiding programming.  Databases are readily available.  Data transfers and processing are a few mouse-clicks away.  A cornucopia of powerful, easy to use, and inexpensive programs exists to help with any task.  Today, powerful technology is available to help develop cash flow projections. This should reduce the cost and difficulty.

 

7. AFTF is a purely prospective accounting system. GAAP accounting is historical-cost based but impure.  Many measures, especially liabilities, are prospective.  The measure of these liabilities often uses PVECF or some approximation thereof. Many AFTF accounting items will be valued in a way similar to current measures so that the added cost may be marginal. AFTF adheres to most fundamental accounting principles, it preserves bookkeeping and auditing, it eliminates detailed data and non-quantitative measures, and it introduces very little the practicing accountant is unfamiliar with.  AFTF preserves the historic strengths of traditional accounting while adopting a forward view.  It is an expression and formalization (with some new technology and disciplines) of an accounting evolution already in progress. This should lessen the difficulty of understanding and accepting a prospective accounting system.

 

8. AFTF has some fundamental simplicity in terms of guiding principles and in use.  Two examples: the unification of the "balance sheet" (present values) and the "income statement" (value added), and the absence of accounting allocations (time shifting such a capitalized costs).  This will save time and, perhaps, some jobs. The extent of this latter simplicity is illustrated in Appendix 4 of the draft proposal entitled Summary of Unnecessary FASB Statements.  Of course, these statements are necessary under current GAAP but their raison d’être evaporates under a prospective GAAP such as AFTF.

 

9. Much of the cost of AFTF would be a model set-up cost. But if it unifies and simplifies the ongoing cost may be less. Much of the benefit and cost of AFTF will accrue to the enterprise. The SEC, FASB, the AICPA and external auditors will bear only a fraction of cost.  The external auditors do not have to do the modeling and their role in auditing AFTF is carefully defined and limited, as is their responsibility.  Management and the company modelers bear the brunt of the responsibility, as they should.  In any event, external auditors are quite capable of reviewing AFTF valuations since major accounting firms frequently engage in similar pursuits as consultants.

 

10. AFTF requires models similar if not identical to cost/benefit analyses. A well-run company will base its decisions on such models and should already have the basic AFTF ingredients. The company that does not quantitatively evaluate its decisions will be forced to do so under AFTF.  Those companies will incur a greater cost and difficulty ... and enjoy a greater benefit.

A prospective approach to accounting will be costly and difficult.  It will take resources and commitment to implement, but it is practicable.  I believe that it represents an attractive investment in the future.

**  The run-up and subsequent run-down of Nasdaq and the NYSE is a byproduct of the lack of a relevant accounting which might have restrained market swings.  The gains and losses were measured in trillions!