Chapter 10

AFTF Accounting Solutions

 

Indirect Benefits 

In the prior two chapters, we discussed the solutions or benefits to management and to shareholders (financial reporting). Accounting is intended to serve the needs of management and shareholders. The profession will benefit greatly by serving those needs. For example, providing more relevant and more useful information will make the accounting profession more valuable and more valued. For the most part, we won’t repeat points made in the previous chapters. However, two points are worth repeating from the accountants’ perspective. 

First, in prior chapters (Chapter 3: Problems With Traditional Accounting and Chapter 9: AFTF Reporting Solutions) we discussed rationality. The main focus was the rationality for the end-user. However, the accounting profession itself is not immune to the irrational. Greater rationality would make the accountant’s job more understandable to him. He would also be relieved of the burden of trying to explain the unexplainable. The greater rationality of AFTF should make the accountant’s job easier. 

Second, we discussed comparability as a benefit to the end-user. The accounting function is very dependent upon comparability. Comparability is vital to the audit and control functions. The enhanced comparability features of AFTF should make the accountant’s job easier. 

 

Uniqueness, Uniformity and Universality 

There are, as we have seen, many types and purposes of accounting. It may seem difficult to stretch any single system across the gamut of accounting applications, but AFTF can do it.

First, it should be noted that currently differing accounting system values are partly the result of lack of communication. AFTF can improve the information flow and thus narrow differing assessments. A single accounting system means that a common language is used, a prerequisite to efficient communication and to a meeting of minds. AFTF adopts, among other things, the techniques and language of financial analysis, capital budgeting, and appraisals already used within the company.

Second, the basic element of AFTF is cash flow, which always has the same meaning regardless of the application. 

Third, the concept of "present value" is common to all applications. This means the realizable value present or inherent and, simultaneously, the actuarial present value (sum of discounted expected cash flows) 

AFTF unifies the management and shareholder perspectives. The historic cost of capital makes use of management’s perspective on expected cash flows and the capital market pricing perspective to determine the cost of capital. This produces a synthesis of perspectives whereby management makes decisions based on the market’s requirements and where the market makes decisions based on the expectations of management. The shareholder must decide whether to allocate his capital to the company, he must appraise the company. He requires the same information and uses the same methods as management. Financial reporting to shareholders is the assembly and transmission of information that management uses for its capital allocation decisions. If this information is not available, it should be. With AFTF it will be. 

With AFTF, accounting for decisions, change, value, and the future are all closely related. AFTF measures future change associated with decisions by assigning a value. The AFTF value contains its own decision criterion, namely, positive value => positive decision. Hence, AFTF provides a unified perspective for several key concepts. 

An accounting system should satisfy the essential purposes of all potential users. 

Currently, several accounting systems are in place, each one specialized for certain users. This specialization is a disaster. Not only does specialization create complexity and barriers to communication, it misses the main point. The main point is that there is an essential commonalty of interest. Management, the shareholder, the customer, and the regulator are all interested in the solvency of the company. They are all interested in growth, in providing value, in efficient operations, and in efficient capital utilization. It is inefficient to have specialized systems. Some systems are better than others at their particular purposes, but I don't believe that any specialized system is superior for any purpose to AFTF. 

The essential purpose of bookkeeping is to record cash flows. These cash flows are the foundation of AFTF. There are needed to construct and validate the model. They are needed to produce the historic cost of capital. They are needed for the actual-to-expected ratios. On the other hand, non-cash bookkeeping items are not needed by AFTF and could be eliminated. These non-cash items are very troublesome for accounting and their elimination would be a blessing. AFTF satisfies the essential purpose of bookkeeping in requiring and preserving the record of cash flows. 

The essential purpose of tactical management accounting is to monitor actual versus expected performance. AFTF makes a science of monitoring performance. AFTF requires formal actual-to-expected ratios. It also requires actual-less-expected as absolute differences so that the financial impact to the shareholder is revealed. This formality will make performance monitoring more meaningful and more complete. AFTF is flexible enough to be used at any level of consolidation and for any time period. It is oriented toward decision making, even for the short-term. In addition, many of the AFTF elements, such as IRR or value added, are natural performance measures. AFTF satisfies the essential purpose of tactical management accounting, i.e., monitoring and measuring performance. 

The essential purpose of strategic management accounting is to evaluate alternative futures. AFTF is accounting for the future and is rooted in the techniques of appraisals and capital budgeting. AFTF solves the cost of capital problem and provides continuing follow-up evaluations and monitoring. AFTF, as a long-term reporting system, eliminates the tyranny of short-term accounting pressures and will broaden the scope of the alternative futures that may be comfortably considered. AFTF satisfies the essential purposes of strategic management accounting. 

The essential purpose of financial accounting should be to provide shareholders with meaningful and useful information. This purpose is the raison d’être for AFTF. It was created specifically to be relevant to the shareholder, providing predictive and decision useful information. Value and value added are shareholder value and shareholder value added. The company-estimated yield (IRR), the actual-to-expected ratios, and other AFTF reporting items are designed to be meaningful and useful. AFTF satisfies the essential purpose of financial reporting. It does this in a feasible and reliable manner. 

The essential purpose of responsibility accounting is to provide local goals and measures consistent with the company’s global goals and measures. With AFTF the company’s goals are clearly aligned with the shareholder’s goals. The universal use of the historic cost of capital guarantees that local goals are also consistent. AFTF also provides ongoing measures of performance at any level, including any level of authority and responsibility. AFTF also provides a responsive basis for management incentives using those measures. Using AFTF measures provides a somewhat neutral standard of performance in that value added is net of the cost of capital, i.e., after the shareholder goals have been satisfied. Managers will be held responsible for bad as well as good performance. 

The essential purpose of tax accounting is not accounting but revenue. This purpose is best served by a tax rate rather than by a separate accounting system. AFTF provides net cash flow information and valued added information, either one of which may be a better basis for taxation that adjusted accounting earnings. No accounting system should be bent to the will of the IRS. 

The essential purpose of regulatory accounting varies, but there is a great commonality of interests in the long-term survival of the company and in its effective and efficient operation. It should be clear that AFTF will encourage effective and efficient operations; it does so by requiring efficient capital allocation and encouraging effective management. It is also forward-looking and avoids or anticipates developing problems. As long as AFTF reporting requirements are met, the shareholders will exert an appropriate influence. It is their capital that is first at risk; it is their voice that will be first heard. The same monitoring and measuring capabilities, e.g., actual-to-expected ratios, may be useful to regulators. AFTF will satisfy the general long-term goals of regulatory accounting. 

The essential purpose of M&A accounting is to measure potential value added. AFTF produces a company valuation. For a merger or acquisition, the same technology and some of the same data would be used. There would be some change in the assumptions, but the essentials of appraisals are part of AFTF. A company valuation can be used to determine a price and to measure the potential value added. AFTF is, in part, an extension of appraisal methodology and it is not too surprising that AFTF is useful in M&A valuations. 

The essential purpose of value-added management systems is to take into account the cost of equity capital. AFTF does this using natural present value techniques and using a natural development of the historic cost of capital. AFTF is a value-added management and reporting system. 

AFTF satisfies the above major purposes and, in addition, may be used effectively for strategic and tactical planning, capital budgeting, sensitivity analysis, Monte Carlo simulations, scenario testing, establishing expected values, pricing products or investments, asset/liability matching, risk and opportunity analysis, R&D decisions, resource allocation, debt structuring, lease/buy/outsource decisions, assessing management performance, paying bonuses, divestitures, analyzing growth paths, coordination and control purposes. 

AFTF is elemental and fundamentally sound. It is a single system (uniqueness) which can be applied in the same manner (uniformity) to all accounting purposes (universality). 

AFTF can be also be the foundation for accounting principles and practices that are uniform across all national boundaries. The increasing internationalization of companies and capital markets would make such uniformity very useful.

  

Simplicity 

William Ockham

 

AFTF has the beauty of simplicity. It simplifies or eliminates many of the difficult problems that traditional retrospective accounting has created. 

Unlike traditional accounting, AFTF does not require an active market for either assets or liabilities in order to respond to value changes. 

With AFTF goodwill is eliminated as a balancing item. Because expected cash flows capture the future they also capture all intangibles. The acquired company’s reputation, human resources, administrative expertise, research and development capabilities, etc., are all realized in future expected cash flows. If the company is acquired for more than the present value of all future cash flows, there is an immediate loss, but no goodwill. Negative goodwill translates into an immediate profit (value added). The existence of goodwill under traditional accounting may be circumstantial evidence of mis-pricing, but often indicates an incomplete analysis. 

AFTF is the valuation of expected future cash flows. It is possible to simplify accounting substantially by eliminating all non-cash bookkeeping entries. In addition it is possible to simplify accounting by eliminating many of accounting’s toughest problems, problems that originate from an inadequate foundation. For example, many FASB statements could be eliminated. 

Traditional accounting is based on the tangible. Traditional accounting assets are primarily restricted to tangible physical or monetary items, such as, property, plant, equipment, stocks or bonds. Similarly, liabilities are based on tangible obligations, such as, contracts, debt instruments, amounts payable for goods or services already received. 

One problem is that there is no clear distinction between the tangible and the intangible. 

Another problem is that traditional accounting book values of tangibles are difficult to assign and often bear little relation to the value of the asset or liability. 

Still another problem is that accounting for tangibles lacks flexibility; it is difficult, for example, to value a line of business or a project. 

However, the greatest problem is that tangible assets and tangible liabilities make up only a portion of a company’s net value to the shareholder. A company’s traditional accounting net worth is unrelated to the company’s market capitalization. AFTF does not ignore intangibles, but captures their effect and value through expected cash flows. With AFTF it is not necessary to define or categorize tangibles. It is not necessary to assign book values. AFTF adapts easily to segment accounting (it is assembled from segments). It is not necessary to explain what accounting is or is not. 

The accrual adjustments of traditional financial accounting are not needed under AFTF. Prior year accruals do not have to be subtracted because total period cash flows are what are AFTF is based on. Current year accruals do not have to be added since they are included in the expected cash flows for subsequent periods. Since the cash flow model is very carefully constructed, current year accruals will be very accurate, more accurate than the traditional accrual adjustments. There is no need to apportion or exclude costs or revenues. All expected cash flows are included. With expected values, timing and amount are unequivocal. Adjustments for bad debts will be inherent in the expected values. For example, if a future revenue item is doubtful, the expected value will be low in proportion to the best estimates of that doubt. 

AFTF matches costs (liability flows) with revenues (asset flows) completely and accurately. It does this by associating all costs with all revenues; nothing is left out. It does this by simultaneously measuring cost and revenues. It does this taking into account the timing and the cost of capital through the discount process. It can be applied at the product, line of business, or company levels. 

AFTF eliminates the difficult judgments surrounding deferred income taxes, capitalized expenses and depreciation. It does this by eliminating all accounting allocations and their reason for being. Under AFTF, an expenditure is associated with the income it produces. Since benefits generally exceed costs there is generally no net cost to the company. This is similar to, but more exact than, the traditional accounting treatment of capitalized expenses. However, unlike traditional accounting, any excess of benefits over costs is recognized immediately.

 AFTF values expected cash flows without reference to cost. In particular, inventories are valued for their expected cash flows. There are no questions about inventory treatments (cost or market value, LIFO or FIFO). 

AFTF replaces the artificial depreciation of traditional accounting with a declining set of present values of expected cash flows. If a building owned by a company actually has a 35-year lifetime and no salvage value that will be recognized in the AFTF valuations. If the building has appreciated in value over 35 years, that appreciation is recognized under AFTF. Traditional accounting generally does not recognize such appreciation. This recognition is implicit in the AFTF valuations. There will be no explicit building asset, but there also will be no building rent as a cash flow. Only if the building is to be sold and gives rise to an expected cash flow would it be necessary to assign an AFTF asset value to the building. 

AFTF also ignores past capital investments and hence conveniently avoids the thorny and unnecessary problem of allocating capital among endeavors to determine detailed returns on investment (ROI). 

It is not necessary to supplement AFTF financial reporting with a cash sources and uses statement. The AFTF balance sheet is such a statement. AFTF assets are cash flows into the company (sources). AFTF liabilities are cash flows from the company (uses). AFTF furnishes both current and future period sources and uses. It is also not necessary to break down cash flows into operations, investments and financing since the purpose for doing so is satisfied by AFTF directly. AFTF will clearly reveal whether, and to what extent, an endeavor generates cash, now and in the future. 

The AFTF historic cost of capital provides a general-purpose discount rate and thus avoids any need to determine or select a rate for a specific asset or liability. This rate is a price-based equilibrium value whose meaning is clear and whose determination is not subject to judgement. Discounting is consistent for all cash flows, which is useful when assembling cash flows or considering assets and related liabilities. 

The traditional short-term measures of ROI or ROE are less reliable and more difficult to define than the AFTF growth rate. AFTF does not require definition or determination of investment or equity. The AFTF growth rate is positive if and only the shareholder’s goals are met. ROI and ROE must be compared with another rate, which must be determined. AFTF measures are simpler. 

AFTF eliminates window dressing. Window dressing is taking an action, just before a reporting period ends, that has only a temporary effect on reported results. AFTF looks past the temporary. AFTF would also eliminate actions taken based on temporary accounting gains which have permanent sub-optimal effects "Managed earnings" will be left in the past.

  

Feasible 

"Whether you believe you can do a thing or not, you are right"

Henry Ford

An accounting system should be feasible. It should not exceed the human and technological resources and capacities at our disposal. This includes the capacity to absorb and understand. It should also be politically feasible 

"It is evident that many great and useful objects can be attained in this world only by cooperation."

Thomas B. Macaulay

 

Feasibility, or perception thereof, has been the principal reason, or excuse, for the accounting profession’s inability, or reluctance, to be more relevant. Feasibility is genuine concern, which I share. I don’t believe that AFTF is feasible for the accounting profession. The accounting profession has its hands full today and is at the limits of its knowledge and capacities. I recommend that the accounting profession undertake a central but limited role with AFTF (see Chapters 11, 12, and 13 for more details). If the accounting profession can cooperate with the modeler and with management then AFTF will be feasible for the accounting profession. 

AFTF depends on a multi-profession approach; AFTF is simply too extensive for the accountant to do everything. It is not necessary for the accountant to do everything. It is not desirable for the accountant to do everything. Management will set the assumptions, make the decisions and commit publicly to its plans. This is not something the accountant should do or would want to do. The modeler will develop the models, perform the dual validation, and produce expected cash flows. This is not something the accountant should do or would want to do. If the accounting professional can see fit to delegate the appropriate responsibilities, AFTF will not be more difficult, and may be easier, than traditional accounting. 

"Few things are impossible to diligence and skill."

Samuel Johnson

Is it feasible to delegate the AFTF responsibilities and work to others? Will AFTF impose an impossible or unjustified burden on others? I believe the answer is no. 

First, AFTF distributes the workload among management, the modeler(s), and the accounting profession. Each group is given formal responsibility for their de facto responsibilities. 

Second, if management is professionally fulfilling its responsibilities then AFTF will not be difficult. AFTF requires only what good management requires. 

Third, once AFTF is in place, updating will become natural and routine. 

Fourth, AFTF is decision oriented so that decisions and valuations, management and accounting, are the same. There will be increased cooperation and communication within the company; this will make everybody’s job easier and more rewarding. 

AFTF is a consistent single system eliminating much of the complexity and inconsistencies of multiple accounting systems. AFTF is conceptually simple and should be manageable in practice. There should be little difficulty understanding and modeling assets or liabilities; these models should be in place in advance of acquiring those assets or liabilities, especially for the more exotic, more difficult to model instruments. Existing management technologies are a foundation of AFTF. 

AFTF is technologically feasible. The software technology needed for AFTF is essentially operational in the form spreadsheets and specialized commercial programs. The great power of today's personal computers can easily handle large sophisticated models. There is no excuse, from a software or hardware technology standpoint, for shying away from the future. The technology of the Discounted Cash Flows (DCF) approach is widely used and accepted outside of traditional financial accounting. This provides a pool of potential modelers for AFTF. It provides a receptive audience to a DCF approach. 

The internal technology of AFTF, especially the dual validation process, provides a disciplined capability to be relevant and reliable. Value-added accounting is now feasible.  

Is AFTF politically feasible? Are traditional accounting systems permanently entrenched? Are vested interests impossible to overcome? 

The Securities and Exchange Commission's interest and essential purpose is disclosure and informed markets. AFTF will disclose more and inform more and should make for more efficient capital markets. The SEC's orientation is toward the shareholder and AFTF is aimed precisely in this direction. It may take time for the SEC to become familiar with and to appreciate AFTF, but I believe the outcome is clear. 

The Financial Accounting Standards Board (FASB) will be greatly affected in that many of FASB pronouncements will no longer be needed. There will have to be a radical rethinking of their purpose and role. I believe a prominent AFTF role is appropriate for FASB. For example, FASB may develop and give formal expression to AFTF principles and practice. 

FASB has approached present value-based accounting several times, only to back off when faced with the inevitable complexities and uncertainties. 

The AICPA will be affected in that it will be necessary for accounting to look forward as well as back. The essential purpose of accounting will be greatly enhanced and the AICPA should embrace AFTF. It will add value to the accounting profession. 

Forces outside and within the accounting profession seem to favor a new accounting model. To the extent that political views mirror or follow society, I expect the political will to shift to a new prospective model. AFTF may find a receptive audience in the profession’s leadership.

  

Transitional 

A new accounting system should be as consistent as possible with traditional accounting practices while still satisfying other desirable characteristics. Obviously AFTF means the end of traditional accounting. It will, however, leave bookkeeping essentially the same. The balance sheet will have a familiar appearance. Corporate reports, as an interim measure, could be supplemented with AFTF information. 

It is not necessary to require AFTF for all companies or industries simultaneously. In fact, that would be undesirable from several standpoints. AFTF is designed primarily for shareholder owned companies, so that other implementations would be delayed. The insurance industry may be a good starting point; this is discussed in Appendix 5. 

AFTF has an interesting characteristic in that it is based only on future cash flows and hence does not require that past accounting allocations be preserved. Indeed, since accounting allocations are not cash flows, they cannot be counted; they are prior period "mistakes". The prospective nature of AFTF means that it is not necessary to dovetail into the past. A fresh start is possible.

  

Costs and Benefits 

Cost is no object. The benefit is the object. This doesn’t mean that we ignore costs, but rather judge them relative to benefits. As long as marginal benefits exceed marginal costs, the objective should be to maximize costs. The larger the investment the larger the reward. 

Costs and benefits are difficult to assess for a company. For a professional field as pervasive and universal as accounting, objective monetary measures of costs or benefits are not available. In addition to the specific benefits outlined in other sections of this chapter or in other chapters in this book, I will add three more general views. 

The first view is that of the accounting profession. More specifically, the view that others have of the accounting profession. The accounting profession has been very successful and is highly regarded. This is a testament to the skill, integrity and diligence of accountants. It is also a testament to the utility of accounting theory and practice over the years. Things change. 

We live in a New World, where what sufficed yesterday may be ineffective today and fatal tomorrow. It is my view that there is an increasing need for relevance and an increasing need to value the future. These needs will be filled, sooner or later, by the accounting profession or by others. It would be to the accounting profession’s benefit and credit if it could anticipate and satisfy these needs. It may be costly to the accounting profession if it doesn’t. Financial accounting is under siege by critics within and outside the profession. It is faced with competition on many fronts. Several other accounting models have evolved to fit the gaps or deficiencies in the accounting environment. Traditional financial accounting must evolve or be mired in an irrelevant past. 

Ian M. Rolland, CEO, Lincoln National Corporation, Annual Report, 1995.

 

 The second view is biologic. AFTF is an environment that accelerates change. Within a company, those lines of business, or projects, or products not meeting the market cost of capital will be clearly identified. The decision framework of AFTF will continually force management to make choices. The reporting requirements, value-added perspective, and incentives will motivate a desire for change. A company which doesn’t learn, grow, adapt, and stay fit will fall prey to those who do. Companies adapted to the past will die; those adapted to the present will survive; those adapted to the future will thrive. The prospective view of AFTF will make such distinctions. Death is a fact of life. Companies die. They can be artificially kept "alive", prolonging a costly death process or they can be allowed to die naturally. This may be acquisition or merger or by recycling capital through dividends. AFTF will speed up the evolution of companies, internally and in the capital markets, to fit a capital efficient environment. 

The third view is a macro-economic view. Accounting For The Future will have far reaching benefits to society. It is an accounting system that combines company and market information. It focuses all essential information on the valuation process. It captures the future where the principal values reside. AFTF is a system expressed in market terms. It will improve communications and the information flow to and from the capital markets. The significance of this cannot be overstated. The free flow of information is vital to efficient capital allocation and utilization. This is important to the individual investor who wants to efficiently employ his capital. 

Efficient capital allocation is also vital to our national economic health and ultimately to our national security. For example, we need look no further than at the former Soviet Union to see the devastation of controlled markets and inefficient capital utilization. The great advantage of free capital markets has been their ability to produce, process, and transfer information. AFTF is a major advance in processing and communication of financial information: it not only facilitates communications, it communicates relevant information. It should make our capital markets even more efficient and should help maintain the position of the United States as the economic leader of the world.

 It is not necessary to take a sweeping macro-economic view to understand or appreciate AFTF. The micro-economic view is sufficient. AFTF will help investors and management make more informed and better decisions.

  

Choices for Accounting 

The accounting profession needs to choose a future. If prospective accounting is chosen the profession needs to simultaneously start research, development, education, and promotion; the sooner the better. These efforts would require a small full time staff, but would actively involve the whole profession and other interested parties. I would suggest a communication and research center be created with the goal of introducing limited prospective accounting on an optional basis or to a defined target at the earliest time. The reason for this approach is to phase prospective accounting in over a period of time. A phase-in period is necessary, but is also desirable in that it allows a natural evolutionary development and for mid-course adjustments or fine-tuning. It may too difficult to develop final accounting concepts and statements without some body of practical experience. New cooperative relationships with other professions should be explored. 

There can be exciting and rewarding times for the accounting profession in accounting for the future.

  

Conclusions 

The accounting profession is aware of its problems and should be made aware of potential solutions. AFTF will solve many of the problems that plague traditional financial accounting and reporting. AFTF will make accounting more user-friendly to the accountant and to others. It will replace the multiplicity of accounting systems with a single system and will, in the process, simplify accounting. Many of the inconsistencies, complexities, and judgments of traditional accounting are eliminated. AFTF is amply justified from a cost/benefit standpoint, even though the investment is substantial. New information technologies make possible a new accounting technology, namely, AFTF.

   

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