Chapter 11
The Accountant’s Role
In this chapter, we define and propose a limited role for the financial reporting accountant. This role is the second key ingredient in making AFTF feasible. This limited role does not add complexity and preserves accounting objectivity.
Background
Traditional accounting is retrospective, dealing primarily with actual past financial events. This makes accounting feasible and somewhat objective, but not necessarily relevant. Over the years, the accounting profession has gradually become more sensitized to the future. In recent years, it has become evident that the accounting profession is not satisfied with the retrospective accounting model and has tried to address the future, in a number of ways. The profession has struggled to embrace a more proactive prospective accounting model. These efforts have been piecemeal, controversial and, in general, unsuccessful.
One difficulty is that accountants are not well equipped by reason of training or experience to deal with expected values. It is my view that they should have a basic understanding, such as, the educational effort now under way, but that accountants should not try to be expert statisticians or modelers; it is much too large a task and would divert from their central role.
Accountants have traditionally been conservative as a means of protecting the public, management, and themselves. They often struggle with opining on retrospective measures and would be naturally reluctant to express an opinion on expected cash flows. It is proposed that the accountant’s role and opinion be limited to an oversight and auditing role. The accounting profession will benefit if it focuses on its essential purpose.
The Accountant’s Role
The accounting role within AFTF will be similar to that of traditional accounting. The bulk of the AFTF effort will be left to the financial statement preparer. This will be the modeler under the direction of management and the company accounting professionals. The modeler could be an accountant, but more often it will be all those managers who study experience, develop assumptions, perform cost benefits analyses, project detailed cash flows, make decisions and commitments, etc.
It will be the accounting profession that formalizes the concepts and practices of AFTF (or whatever name is chosen). This will be done by the various organizations and committees of the profession, such as, the AICPA, FASB, IASC, ASB in cooperation with regulators and taxing authorities. For example, the SEC may take an active role.
It will be the accounting profession through company staff accountants and public accounting firms who oversee the entire process. It will be the staff accountants who prepare the financial reports and the public accountants who express opinions. Some of the oversight roles appropriate to the accountant include checking to make sure that,
Financial accountants should not study the past, develop experience tables and other assumptions, study relationships, gather voluminous data, construct asset and liability models and their interactions, study sensitivities, guess at future environments, estimate the timing and expected amount of future cash flows, assess and quantify risk and its cost, discount and sum expected cash flows, analyze actual-to-expected results. These are jobs for modelers, jobs for those whose training, experience, and outlook equip them to measure the future. Modelers may, of course, include internal accountants, but there should be a separation of function, a division of labor, an appropriate degree of specialization, a system of checks and balances, and an external auditing relationship.
A feature of AFTF is the cooperative modularization of functions and responsibilities. This modularization (management, modeler, accountant) makes possible a system which is simply too large for a single profession to cope with. The multi-disciplinary approach is really a formalization and extension of mechanisms already in place. The unification, cooperation, and focus of AFTF should improve and exploit those mechanisms. Modularization is desirable from another aspect, namely, it distributes the AFTF costs (resources, responsibilities, time and effort) and benefits (decisions tools, incentives, understanding, value focus) to the appropriate managerial level.
We saw the income recognition has a different look when viewed from a company or macro perspective compared with a single transaction perspective. A similar observation may be made for expected values. If a future outcome is 99% certain, most accountants would completely recognize that outcome, especially a liability. If a future outcome is 1% certain, most accountants would completely ignore the outcome, especially an asset. If the future outcome is 25%, 50%, or 75% certain to occur the accountant might pause. For example, the accountant would be reluctant to attach a $50,000,000 value to the future receipt of $100,000,000 based on the future flip of a coin. The risk is great (too great for the accountant). The same accountant might, however, be willing to attach a $50,000,000 value to 100,000,000 $1.00 flips of a coin, or even to 100 $1,000,000 flips of a coin. This last case is representative of the company scale and perspective. A company faces the future with many different uncertain individual endeavors (coin flips) so that the overall outcome is made more certain. Financial reporting of the company’s results should use a total company perspective. The company perspective should increase the accountant’s comfort level. More comforting is the division of responsibility whereby the accountant’s role is restricted to general oversight and a defined audit function. Even more comforting is the fact that expected cash flows are generally not critical to the company valuation because of the normalizing effect of the historic cost of capital.
The Auditor’s Opinion
The auditor’s opinion will be limited in scope and will be supplemented by the formal opinions of management and of the modeler. The auditor will reference and depend on those opinions.
The opinion will state that the cash flow model fairly represents the historic cash flows. This should be easily verifiable and the match over the five-year validation period should be exact.
The opinion will also state that the discount rate used is the historic cost of capital based on the cash flow model. This also should be easily verifiable and the match over the five-year validation period should be exact. Hence the auditor would certify as to the correctness (or fairness) of the dual validation procedure.
The auditor would then state that, based on the expected cash flows and the historic cost of capital, the company valuation fairly represents the value of the company. This too should be easily verifiable since it is simply a matter of multiplying the discount rate by the expected cash flows and summing. These are very important overall checks that can be part of a well defined audit process.
Note that the auditor never states that "the company valuation fairly represents the value of the company"; that statement is contingent on the expected values either directly or indirectly via the cost of capital. The auditor could, however, comfortably make that statement, in my opinion. The way envisioned leaves a major responsibility in the hands of the modeler. Again note that the expected cash flows are generally not vital because of the normalization.
Conclusions
AFTF involves more than a single professional discipline and depends on a modularization of responsibilities and an active cooperation with other professions. The accounting role within AFTF would be limited. The accountant or auditor would be specifically responsible for: the dual validation, the theory of discounted expected cash flows, the proper use of the historic cost of capital and the presentation of financial reports. He would have general oversight of the assumptions, the modeling methodology, and the production of financial reports. The accountant or auditor will be answerable to his profession: its theory, its practices, its principles and ethics.
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