Capital Markets and AFTF

By Humphrey Nash

 Accounting For The Future (AFTF) was designed to help the shareholder.   Relevant financial reporting was the AFTF starting point, not just an accounting end-product. The AFTF model was reverse-engineered so that supporting structures, measures and mechanisms followed the beacon of relevance. For shareholders, relevance means information that supports their capital allocation decisions, i.e., an underlying economic value to compare with the current stock price.  This dictated, for example, a value-based accounting model as opposed to a cost-based model.   Not only did capital market needs provide an impetus to AFTF, capital market mechanisms showed the way. 

GAAP Versus AFTF

 Many aspects of the AFTF accounting model are already a fact of life in the capital markets.  Unfortunately, they are not part of the current accounting implementation (GAAP).   Accounting must serve shareholder needs if it expects to flourish, especially if that is its purpose.  Accounting today seems trapped by the tyranny of traditional thought.  If accounting theory doesn’t catch up with useful practice, accounting will become a footnote.

Stock analysts, shareholders and their representatives, including management, are all interested in the same thing, namely cash flows.  The Present Value of Expected Cash Flows (PVECF) is the basis for economic valuations and resulting capital allocation decisions.  AFTF is based foursquare on PVECF.  It was not a great logical leap to employ capital market decision technologies for capital market financial reporting.

The cost of capital is required by management, shareholders and others in order to make economically sound financial decisions but the cost of capital is not a part of GAAP.   The cost of capital is a central ingredient of the AFTF model. AFTF uses capital market prices to determine the capital market’s assessment of the cost of capital.  This is the only way of determining an appropriate cost of capital since the cost of capital is intimately related to the price of capital. 

Forward-looking reporting is common and sanctioned by the SEC and the AICPA, but forward-looking reporting is not a part of GAAP. GAAP resides in the past. The capital markets only value the past to the degree that it determines the future, i.e., very little.  Capital market values reside in the future, as does AFTF. 

Cash flows are scrutinized and trusted by investors but are not a part of GAAP. They play several key roles within AFTF.

Actual earnings versus management’s earnings guidance is a major market mover but not a part of GAAP accounting.  Actual-to-expected cash flows are a prominent feature of AFTF financial reports.

Economic value is the holy grail of the capital markets but not a goal of the current cost-based GAAP implementation.  AFTF captures economic value as defined by management and scaled by the capital markets.

GAAP is characterized by many industry specific rules.  FASB, for example has promulgated 150 Statements, most of which address specific industry accounting treatments.  It is not surprising that the balance sheets and income statement are not comparable between companies.  One need only look at the wide variance in Price/Earnings (P/E) ratios between companies or between industries to see that something is wrong.  It is not the capital market Price.  One need only look at the increasing divergence between “GAAP shareholder equity” and market capitalization to see that something is wrong.  It is not the market capitalization.

AFTF is based on cash flows, not on earnings.  Cash flows have the same treatment and meaning across companies and industries.  Instead of an erratic and undisciplined Price/Earnings ratio, AFTF provides a disciplined Price/Value ratio.  This ratio will hover around 1.00 for all companies and industries.  Values, value added, Price/Value ratios, actual-to-expected cash flow ratios, yield rates, cost of capital rates, and several other AFTF measures have the same scale and the same meaning for every company.  With AFTF the capital markets have unparalleled comparability.

The GAAP balance sheet is semi-prospective.  The GAAP income statement is primarily retrospective.  Reconciling the two is a futile exercise which damages both.  GAAP earnings and shareholder equity lack stability and utility.   In AFTF, the statement of values automatically reconciles the status and progress of the company. The scale of measure is always the capital market scale.  It is stable and useful.

AFTF is based on the same valuation technology employed explicitly by the stock analyst or implicitly by the capital markets generally.  

 Capital Market Efficiency

 AFTF will increase capital market efficiency by:  

1. furnishing relevant high-level financial reports to shareholders and their representatives,
2. permitting management to measure and communicate long-term values,
3. easily and accurately incorporating intangibles,
4. allowing management to quantify and communicate its decisions, plans and expectations,
5. allowing the capital markets to directly communicate to and influence management
6. holding management accountable
7. providing simple comprehensible information, not complex data or arcane measures.

Capital market efficiency results from free, informed, and competitive markets where all available information is known to both buyer and seller.  In the case of the stock market this means that the Shareholder (buyer) must have the same information as the company (seller).  This means that the company voice (management) must communicate what it knows, including its plans, decisions and judgments. It also means that the shareholders must communicate what they know to the company, including their value judgments and their required cost of capital.

From this dialogue value emerges and is recognized[1].  This dialogue puts the shareholder on a more equal footing with management and other insiders.  AFTF financial reports make valuations accessible to all shareholders not only those with inside information and/or the services of a financial analyst.  This will increase capital market efficiency.

AFTF’s value basis makes accounting a decision support system at all levels.  This aligns accounting theory with useful accounting practice.  This will increase management efficiency as well as capital market efficiency.

AFTF is anticipatory and accounts for the long term; this will tend to stabilize the markets and further improve capital market efficiency. 

The capital markets are disciplined by active free markets and self-interest if they have relevant information.  GAAP lacks relevance and cannot support market disciplines.   AFTF produces relevant information permitting capital market disciplines to operate.

AFTF also has internal disciplines. PVECF is anchored to cash flows which are unequivocal, unlike GAAP revenues or earnings. Expected cash flows are anchored in the reality of the past since the AFTF cash flow model must at least fit the recent past.  PVECF is anchored to the capital market scale.  PVECF is anchored to current cash flows through the A/E ratios.  Several other disciplines, not available to GAAP, are present in AFTF.

Conclusion

AFTF supports the capital markets and is supported by them.  AFTF engages the capital markets in a useful dialogue.  GAAP is a monologue.