Cash is Fact

By Humphrey Nash

There is an old saying in accounting that “cash is fact and everything else is opinion”.  This has an unfortunate ring of truth.  How does AFTF cope with its implications?

AFTF is based on cash flows and only on cash flows.  This helps.  But AFTF is based on future expected cash flows as well as historic cash flows.  Where is the fact in expected cash flows? Are they not just opinions?

Characteristics of Expected cash Flows

Expected cash flows are more relevant (decision useful) than past revenues or cash flows.  In fact, most financial decisions are made based on expected cash flows.  They are widely and successfully used except, paradoxically, for accounting and financial reporting where they would be most useful.

Expected future cash flows may also be more representative and more reliable than reported past cash flows due to:  

1.  Year-to-year fluctuations in reported results due to extraordinary items and to extraordinary experience

 2. Year-end fluctuations in accounts due or receivable

 3. The greater reliability inherent in the longer base period (5 years) used in the model

 4. The addition of knowledge, understanding, structures, and relationships to the model

 5. The fact that the cash flow model is specifically designed to reliably represent the underlying patterns.

In a very real sense the expected cash flow becomes the standard by which the actual cash flow is judged, not the reverse.   If a past or future year's actual cash flow is higher than the modeled cash flow, then, in fact, we would probably conclude that the actual result was better than expected.   We would probably not conclude that the model was unreliable for that year.

Management’s reported expected cash flows are public representations just as concrete and unequivocal as past revenues. In fact, unlike reported revenues, stated management expectations are never wrong; they become the fixed standard by which we assess management.  If actual results differ from expectations, it is due to actual performance or management expectation or some mix thereof.  In any case, the responsibility falls on management and management alone.

AFTF Disciplines

AFTF has several disciplines to insure that expected cash flows are not “just opinions”.

First, we note that under AFTF any cash flow model must be validated (part of the dual validation) to (fit) 5 years past cash flows. The same basic model must be used for expected cash flows. For example, if the model were a crude least squares fit, then, barring new developments, a linear extrapolation of the least squares line would be suggested.  Hence, the cash flow model would be substantially anchored to actual past cash flows, in this example and more generally.

Second, in the AFTF model, management is responsible for the decisions, judgments, and assumptions that produce expected cash flows.  Management may be aided by the modeler, but expected cash flows are the responsibility of management to state and achieve.  Under AFTF, management must formally sign off on all significant assumptions and must certify that the resulting cash flows represent management plans, judgments, commitments and expectations.  Expected cash flows become a public promise to the shareholder.  On the other hand, it is clearly understood in equity markets that expectations are not guarantees.  In fact, equity markets gladly welcome uncertainty and the rewards that risk assumption provides.

Third, management works in conjunction with the modeler who must also certify the cash flows and the resulting present values based on management’s decisions and assumptions.  Even though the professional modeler’s responsibility is primarily technical, he should not certify if he believes that the cash flows are unreasonable.  He never bears external responsibility for assumptions.  Of course, he may provide management with data or recommend assumptions for which he has an internal responsibility to management.

Fourth, the accountant has a well defined audit role which enforces the dual validation so that measured values are properly scaled.  This audit role is rigorous in the sense that the auditor can determine to the penny whether the dual validation is correct.  The auditor bears no responsibility for the technical aspects of modeling or the assumptions set by management, but is free to comment on them in his opinion.  Hopefully, active involvement and communications by the auditor can forestall the need for qualified opinions. 

Hence, internal controls and the oversight of management, the professional modeler, and the auditor strongly discipline expected cash flows.  Usually this will be sufficient but there are additional disciplines that enforce or encourage reasonable valuations. 

Fifth, AFTF recognizes value as the result of recognizing cash flows and measuring them as present values.  The dual validation makes it nearly impossible to exaggerate values by exaggerating cash flows since value measures respond to the cash flows, e.g., the discount rate (historic cost of capital) increases to offset exaggerated cash flows.  This essentially eliminates the opportunity to exaggerate company values and destroys the motive to exaggerate cash flows.

Sixth, actual and expected cash flows are prominently featured in AFTF reports.  In fact, within AFTF, expected cash flows are given greater prominence than past cash flows.  This will discourage exaggeration of expected cash flows since the market extracts a stiff penalty for failure to meet expectations.  Further, it will be a magnitude more difficult to “manage” current cash flows compared with current earnings or revenues.  Shareholders understand that variations from expectations will happen but significant or persistent deviations will not escape notice. 

Conclusion

AFTF has a clear purpose which provides a bright beacon to guide.  That same beacon will illuminate those who stray.  AFTF will, over time, progressively improve valuations and insure accountability.  This is good for shareholders and good for management.

Expected cash flows are a fact of financial decisions.  Within AFTF, expected cash flows are a fact of financial reporting.  Because of the structures and technologies of AFTF, expected cash flows are tightly constrained.  Tight enough, in fact, for relevant and reliable accounting.