Chapter 12
The Modeler’s Role
In this chapter, we look the critical role of the modeler. We will look at the range of activities and scope of responsibilities of the modeler. AFTF has many applications, all making use of a central technology and a central technician – the modeler.
"Nothing of worth or weight can be achieved with half a mind, with a faint heart and with lame endeavor"
Isaac Barrow
Modeling the future is a complex and pervasive endeavor. It cannot have sufficient accuracy or sufficient benefit unless a sufficient effort is expended in creating the models. This is to be expected. The bulk of the modeling effort and responsibility falls on the modeler. If he is capable, motivated, empowered, and supported, the task will be accomplished.
Feasibility
We have discussed the general feasibility of AFTF in Chapter 10. At that time, it was noted that a threefold division of labor and responsibility was appropriate and necessary from a practical standpoint. This, nevertheless, leaves the bulk of the AFTF work to the modeler. There generally will be a further division of labor.
The modeler is generally not a single person, although the chief or lead-modeler will be. In a large complex organization there will be many modelers each modeling various segments in different ways. Some may go through detailed capital budgeting or cost/benefits analyses producing and distributing formal written proposals or reports. Others may have informal mental models that have not been documented or communicated. AFTF and good management both require that company modeling be formalized to the extent that cash flows are estimated. The process of constructing formal models of the future will be easy if the segment and its dynamics are clearly understood. If they are not, then constructing a formal model is vital. There can be no strong objection to explicit and formal consideration of the future; it is management’s explicit responsibility to plan and measure.
In practice, some managers fly by the seat of their pants and would have difficulty formally expressing their expertise, let alone quantifying the future in a cash flow model. They will need help from an experienced lead-modeler who can structure questions to elicit experience, understanding, and expectations. This process may be painful to the individual, but the long-term gains to the individual and to the company will be worthwhile. The modeler will often be the manager. If not, the lead-modeler will help and be helped by the manager. Hence the lead-modeler will assume the role of educator, researcher and communicator.
The projection of cash flows is not something that could be easily accomplished twenty years ago. Today, powerful PC’s and powerful software make projections feasible. Spreadsheets, projection software, databases, integrated software (office suites), Intranet and Internet communications, all are extremely powerful tools. In addition, today’s workforce is experienced and receptive to these capabilities. With today’s capabilities, sufficiently detailed and sophisticated calculations become practical.
Modeling for accounting purposes does not, or at least should not, impose a major additional burden on the company’s resources. AFTF mechanisms are not substantially different from the normal capital budgeting process. The detailed and careful projection of cash flows (pricing, capital budgeting, cost/benefit analysis) is a normal function of the management decision process. Hence, new (and old) commitments often incorporate the ingredients of AFTF valuations. Once AFTF mechanisms are in place, the resources needed are reduced.
At the current time there are not sufficient numbers of prepared individuals to fill the role of lead-modelers. This is not a great problem since I believe there is time to establish and acquire educational and experience requirements. It is not expected that AFTF can immediately and universally be adopted. It is proposed that the AFTF starting point be the insurance industry where cash flow modeling is already in place and where the actuary, especially the valuation actuary, is adequately prepared (see Appendix 5).
General Responsibilities
The modeler(s) are part of the accounting and financial reporting process and they have a responsibility to insure that the essential purposes are supported. This means that the models must be based on reasonable expected cash flows as covered in more detail in Chapter 14. There are external disciplines to the modelers’ work, as discussed in Chapters 6 and 7, so that the accounting edifice is not completely dependent on the models. The models are primarily intended to convey relevant (decision useful) information to the shareholder and should be designed with that intention. They are also intended to serve other purposes, such as, pricing, capital budgeting, dividend policy, incentive compensation, etc., which they will comfortably do, if they satisfy the primary purpose. This is the accounting unification.
The modeler is responsible to the public through financial reports. He is also responsible to management since the same types of reports are useful for management decisions. He is responsible to the company accountants and auditors since they depend on the models to produce company valuations and value added. He is a vital link in the general communication process. The modeler will be the point man for the AFTF effort. He will be the researcher and developer. He will be the designer and the implementer. He will be the promoter and coordinator and the quality controller. His responsibility is to do most of the work, making sure that nothing goes wrong and that everything goes right. He will be answerable to management, the auditors, and to himself for the quality of his work.
Specific Responsibilities
The modeler will have many specific responsibilities; we will consider only the principal ones.
The modeler will have to abide by AFTF accounting principles and statements of the FASB. It is hoped that such statements would provide general guidance rather than specific or restrictive procedures. The modeler will also have to adhere to professional modeling principles, standards and practices.
The modeler is responsible for the dual validation process. At a minimum, he must make sure that the model reproduces cash flows for the five-year validation period and that the discount rate (the historic cost of capital) and the cash flow model reproduce the company’s market price for the validation period.
In addition to fitting total cash flows, the model should represent the trend in cash flows. For example, the model should closely reproduce the least squares trend line (the best linear fit) for the net cash flows. It would be wrong, for example, to assume increasing cash flows in the face of cash flows trending downwards, unless there was a very good reason. The model should produce and fit the major cash flow components exactly for the five-year base period. The model would have to be rational and flexible enough to model the past exactly and the expected future to a degree of reliability.
The entire modeling process must be structured and coordinated so that there are no gaps or overlap. The sum of all sub-model cash flows must equal the total cash flow, for each type of cash flow. Often these sub-structures already exist in the form of reporting divisions, lines of business, or product areas. These existing sub-structures probably already contain a complete retrospective cash flow development. These cash flows must be modeled and extended into the future by that model.
The lead-modeler must handle various larger-scale modeling aspects not directly the province of the individual managers. These include the determination and allocation of overhead costs, taxes and tax implications, financing, dividends, incentive compensation, modeling consistency and coordination.
The lead-modeler must actively communicate with management so that management provides or approves all assumptions employed. The modeler must fully document and formally submit all assumptions to management for its approval. The modeler will often be responsible for developing assumptions, but also must concur with assumptions provided to him. He should not use assumptions, which, in his judgement, are clearly inappropriate. In his modeling role he has a special responsibility to make sure that assumptions are complete and consistent. These responsibilities are part of the checks and balances that discipline AFTF.
The lead-modeler will express a formal opinion on the representational accuracy of the model. The modeler will certify that the model has been produced in accordance with the assumptions, decisions, and business plans approved by management. He will certify that the cash flow model has been validated and is the basis for projected cash flows, except as described. Such descriptions will include any assumption changes and decisions that have changed, or added to, the model. In addition, the modeler should state that the company valuation is based on expected cash flows, as projected by him and on the historic cost of capital. The modeler will have the sole responsibility for translating management experience and vision into expected cash flows and then into company value. An abbreviated form of the modeler’s opinion will accompany published financial reports. The modeler’s opinion will depend on management’s opinion and will be depended upon in the auditor’s opinion.
In addition, the modeler should study the past, develop experience tables and other assumptions, study relationships, gather all data, construct asset and liability models and their interactions, study sensitivities, project 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, and analyze actual-to-expected results. These are jobs for the modeler, whose training, experience, and outlook equip him to translate the future into the present.
"A business man’s judgement is no better than his information."
Robert P. Lamont
General Effects
The modeling effort will be a learning experience and will provide a greater understanding of the company’s operation, its sensitivities, its weaknesses, and its potential. It will encourage better management by providing better information, better information processing, and better communication. The models are professional decision tools at all levels. Since AFTF is a value-added system, all models will be phrased in terms of value added and those involved will naturally be sensitized to the value they may, or may not, be adding. Since AFTF is a prospective system, the manager involved in creating the AFTF model will have an increasingly forward-looking view. The modeling effort will involve many people and will involve those people with the goals of the company. It is expected that those who model the future will have an increased motivation, increased ability, and increased authority to mold the future.
In addition to the direct beneficial effects of modeling, per se, all of the general benefits of AFTF depend on the models. These benefits are outlined in Chapters 8, 9 and 10 and won’t be repeated here.
Conclusions
The modeler’s role is central and pervasive. He has the primary authority and responsibility for modeling cash flows and producing the company valuation. The modeler’s job is feasible since the modeler will have the service of other modelers, of modern technology, of existing models, and management expertise. The modeler has a general responsibility to others and to the purposes of his work. His specific responsibilities include: the dual validation, general coordination and communication, and his formal opinion or certification. The creation of models of the future is the essence of management; it is also the essence of accounting for the future.
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