AFTF Basics

Brief Description of AFTF

  "If we begin with certainties, we shall end in doubts; but if we begin with doubts,

and are patient in them, we shall end in certainties."

There is no particular novelty or complexity to AFTF. The beauty of AFTF is its familiarity and simplicity. AFTF is a value-added accounting system based on discounted expected future cash flows. This basis is widely used in pricing, capital budgeting, appraisals, profit studies, economic and financial analyses. It is used in a limited way within traditional accounting. AFTF, as we will see, is a Disciplined Value Added (DVA) accounting system. There is nothing sacred about the title of the book or the label AFTF; this book could just as relevantly be entitled Accounting For Decisions, Accounting For Change, or Accounting For Value. We will see that the future, decisions, change, and value are intimately related.

Basically, the AFTF value is the present value of all expected future net cash flows discounted at the market cost of capital. The market cost of capital is the yield rate the shareholders require before they will buy the company’s stock. The AFTF value at the end of a time period less the AFTF value at the start of the time period (increased at the cost of capital) is the value added during that time period. 

AFTF assets are defined to be the present value of all expected future cash flows into the company. 

AFTF liabilities are defined to be the present value of all expected future cash flows from the company. 

AFTF shareholder equity equals AFTF assets less AFTF liabilities. The process and net result of determining the AFTF shareholder equity for the entire company is called the company valuation. 

As we will later see, AFTF measures actual shareholder values present in the company through the mechanism of present values. Hence AFTF shareholder equity will be exactly that. 

The above terms are used at all levels or types of aggregation. They apply equally well to a product or service, a decision, a line of business, a strategy, a division, or an entire corporation. Hence, for example, the company valuation equals the sum of the values of all its products and services, and also equals the sum of the values of all its strategies. Assets and liabilities are themselves a type of aggregation. 

The normal valuation perspective within AFTF is the decision perspective. Whatever aggregation is desired or needed, is for a purpose and that purpose involves a decision. AFTF is accounting for value and for decisions, at the same time. The AFTF valuation contains its own decision criterion, namely, a positive valuation is necessary and sufficient for a positive decision. This results from the cost of capital built into the present value discounting. It should be clear that AFTF valuations are useful for capital allocation decisions, whether by management or by the shareholder. 

AFTF is purely prospective and is designed to produce maximal predictive ability. Value added is designed to measure the growth and progress of the enterprise. A steady state company with constant earnings, no matter what they are, will not be adding value.

 AFTF methods are similar to appraisal, capital budgeting, and pricing methods. AFTF uses the market cost of capital and expected cash flows. It combines reliable stock price information with reliable management information. AFTF is not simply a market-based evaluation system. It is not simply a management-based evaluation system. It is a synthesis of the two.  

The philosophical foundation of AFTF already exists. 

"Future events are implicitly embodied not only in the assets definitions (future economic benefits), but also in the liabilities definitions (transferring or sacrificing economic benefits in the future). … Thus there is a clear link between future events and the definitions of elements of financial statements."

  

Example of AFTF: Value of a Computer Purchase

 

A computer with a useful life of 5 years costing $200,000 is purchased at the end of the year on December 31, 2000 and replaces two clerks whose combined salary and fringe benefit costs are $100,000 per year (assumed to be payable at the end of the year). What is the value of that computer purchase to the company?

 The traditional financial accounting answer is a Book Value between 0 and $200,000. If the computer purchase is treated as an expense then it will have no asset value at year-end. Because the computer is useful in future periods, the expenditure is generally capitalized and its year-end value would be the computer’s cost. This is tantamount to transforming one asset (cash) into another asset (equipment) so there would then be little or no effect on profit in the year of purchase. Generally the computer asset would be written down or treated as an expense spread over its 5 year life so that the asset values would follow a pattern similar to that shown in Table 1.1 below (using a straight-line depreciation method).

  

Table 1.1 Traditional Accounting

 

 

Note that with traditional accounting earnings, the savings on the two clerks would never actually be directly measured as a cash flow.

  

A Perspective on Capitalized Expenditure

Traditional financial accounting does not recognize an actual cash expenditure if it is associated with future benefits (income). Another, perhaps more revealing, way of phrasing this is that traditional financial accounting recognizes benefits (income), but limits that recognition to the amount of the expenditure. In the computer example, $200,000 of future income is immediately recognized (shown as a Year End Book Value) so that there is no net income effect from the expenditure. In later years actual income is decreased to reflect income already recognized; this is the depreciation. This may not be the conventional view of capitalized expenses, but it may be the more natural view. It may be easier to envision a stream of future income as an asset than to envision an expenditure as an asset. Hence, after the $200,000 expenditure, $200,000 of the total $500,000 benefit is recognized immediately and $60,000 is recognized each year for 5 years thereafter.

 

 

 Table 1.3 shows the corresponding AFTF treatment, using 15% interest discount. The AFTF Value at the end of the year 2000 is $335,216. The value of the purchase decision (the value added) is $135,216. Note that, due to the assumed limited computer life, value is only added temporarily and that the net value added after 5 years is zero. If the purchase decision is phrased as purchase and maintain a computer capability, then the savings will continue. The value added will consequently be larger and will not decrease appreciably (maintenance, upgrade, or replacement costs will make occasional dents in the value added). Negative value added is a red flag, in this case a 5-year early warning.

 

 

There is nothing especially novel in the above example. It is the standard capital budgeting approach, except that, under AFTF, it would be used for financial reporting for the entire enterprise and would be subject to certain structures and disciplines. 

It is recognized that AFTF is generally inconsistent with generally accepted accounting principles and would require a fresh start for accounting. It is believed that in many instances FASB statements could be retired and not replaced, thus simplifying the accounting model. It is recognized that AFTF presents real difficulties that must be surmounted and imaginary difficulties that must be dispelled. These difficulties are the price we pay for progress.

  

Conclusions 

AFTF is an accounting system based on valuations from the capital market perspective. These valuations use a market cost of capital as a discount rate that takes into account shareholder requirements so that the increase in valuations is shareholder value added. AFTF valuations are designed to provide decision-useful information to management and to the shareholder. AFTF does this simply and directly by valuing decisions. Physical or monetary tangibles are not AFTF assets although they may be associated with AFTF assets. AFTF assets and liabilities are present values of positive and negative cash flows, respectively.

 

 

 

Structure of This Book 

This brief introduction has probably raised a myriad of questions. It will take the rest of this book to address them. We think you will be pleased with the answers. 

In Chapter 2: Types and Purposes of Accounting, we will review the various types and purposes of accounting. This will set the scene for the development of a general theory. 

Chapter 3: Problems with Traditional Accounting will outline the principal deficiencies of traditional accounting. This outline will motivate a new perspective and, perhaps, a desire for change. 

In Chapter 4: Accounting For The Future, we will more formally develop basic AFTF theory. The AFTF balance sheet and AFTF value added are precisely defined. Some simple illustrations are provided to clarify basic structures. Later chapters expand on the theory and practice of AFTF. 

Chapter 5: Recognition of Value investigates basic recognition issues: What? Why? When? How? We distinguish recognition from measurement. 

In Chapter 6: Basic AFTF Disciplines, we outline the dual validation procedure, which strictly disciplines AFTF. These practical disciplines are part of the theory of AFTF and are one of the two main keys to AFTF implementation. 

Chapter 7: Additional Disciplines summarizes other disciplines that will encourage accurate reporting and discourage manipulation. We shall see that AFTF is very responsive and very revealing. 

In Chapter 8: AFTF Management Solutions, we look at the flexibility of AFTF as a management tool. We see how AFTF solves day-to-day and strategic problems. We will see why AFTF is the ideal base for incentive compensation. 

Chapter 9: AFTF Reporting Solutions examines how AFTF solves the problems and deficiencies of traditional financial reporting. 

In Chapter 10: AFTF Accounting Solutions, we consider the impact of AFTF on the accounting profession. We will see that AFTF delivers more, mainly because it requires more, but not of the accounting profession per se. The benefits of AFTF far outweigh the costs, especially to the accounting profession per se. 

Chapter 11: The Accountant’s Role proposes a significant, but limited role for the financial accountant. This limited role is the second main key to AFTF implementation. 

In Chapter 12: The Modeler’s Role, we outline a central, but again limited role for the AFTF cash flow modeler. The modeler’s role is to quantify the future for management decisions and for AFTF. 

Chapter 13: Management’s Role defines management’s responsibility to visualize, initiate AFTF valuations, approve assumptions, make AFTF decisions, and develop business plans. Management will also have the responsibility to support and exploit AFTF. 

In Chapter 14: Expected Cash Flows, expected cash flows are discussed in detail. Expected cash flows should capture a complete and representative picture of the company’s past and future. Expected cash flows are shown to be reliable and objective. Various aspects of modeling expected cash flows are introduced. 

Chapter 15: Problems with AFTF considers some of the theoretical and practical problems that need to be addressed. 

Chapter 16: General Conclusions summarizes the main points of the book and challenges the accounting profession to accelerate its progress. 

In Appendix 1, we delve into the vital interest assumption (cost of capital). 

Appendix 2 compares AFTF with Expected Cash Flows (ECF) as exposed by Wayne Upton. 

In Appendix 3, we illustrate simplified AFTF financial reports (for the life insurance industry). 

Appendix 4 summarizes the potential impact of AFTF on FASB Statements. 

In Appendix 5, we suggest the insurance industry as an appropriate and easy AFTF first step. 

Appendix 6 briefly considers a new type of balance sheet. 

In Appendix 7, we explore some behavior patterns for AFTF accounting. Stability reigns. 

Appendix 8 briefly compares AFTF with EVATM. 

In Appendix 9, we provide formulas for the dual validation and a few other formulas. 

Appendix 10 (addendum to book) comments on the AICPA Business Reporting Project Study.

Back                 Home