Chapter 15

Problems with AFTF

 

In this chapter, we look into some of the theoretical and practical problems that confront AFTF. Some of these problems have been addressed in prior chapters and are only touched upon here.

 

Acceptance 

"Nothing will ever be attempted, if all possible objections must be first overcome."

Samuel Johnson, Rasselas. 1759

 AFTF is new and unfamiliar. AFTF will require change. Accounting theory and practice will change. We will change. There will be a natural fear and resistance to the uncertainties of the future. The future is not our enemy; it can be our greatest friend, if we are prepared to meet it. Uncertainty is not our enemy; fear of uncertainty is. It is precisely the uncertainties of the future that create opportunities for change and progress: if the future were certain, change and progress would be impossible. 

AFTF will encounter resistance. It may be important to expose prospective accounting early and gradually. This would facilitate acceptance, but would also allow others to contribute to and improve the theory and practice. It is important that the professional accounting bodies both lead and follow their memberships. From this dialogue, general agreement and general acceptance can emerge. It is important that the accounting profession both lead and follow the natural evolution of accounting practice. This means that if accounting needs are not being met, but could be met, then the accounting profession must step forward. This means that if existing capital budgeting, appraisal, and value-added technology is demonstrably useful, then it should be used. It may be risky for the profession to lead, but it may be safer than to just follow. It would be fatal to be left behind.  

The greatest problem faced by AFTF is acceptance of the feasibility. If we believe it can’t be done, we are right. If we believe it can be done, we are right. Positive action, even though difficult, is the path to the future. The path of least resistance goes nowhere. 

 

Educational Challenges 

Some professional accounting education may be required. The AFTF theory is not complex or difficult, but it is not transparent and does have to be exposed. How and why normalization distinguishes between old and new information may not be appreciated. Why the market cost of capital captures some risk, but leaves other risk elements to expected values may not be understood. The greater reliability of expected cash flows compared with actual will not strike a responsive chord with the accountant. The statement of values and value added are elements unfamiliar to traditional accounting. 

A combination of formal continuing education requirements and periodic informal questions and answers may be a comfortable approach. A progressive program of education introducing and exemplifying two or three concepts at a time might be effective. Such steps have already begun, for example, the ECF and entity concepts. I’m not sure how universally effective these efforts were. It may be prudent to enforce some basic continuing education requirements, such as, attendance of a suitable seminar or tutorial. 

Further research and development is required. This book is a crude outline. It is incomplete and few practices or principles are formalized. The purpose of this book is to stimulate thought and initiate action. There may be mistakes and inconsistencies that need to be uncovered and corrected. Almost certainly, the language, terminology, structure, emphasis, examples, etc., could be improved. There are many questions remaining to be answered. Empirical or case studies would be very useful. More testing of sample companies needs to be done to establish AFTF structural and behavior patterns. Perhaps the alternative statement of values, suggested in Appendix 6, should be explored. AFTF (DVA) concepts can be an exciting and fertile ground for many types of research and study. 

There is much research remaining to be done. It will take the involvement and efforts of many people, but it should be very rewarding to those involved. 

Capital Markets will have to learn and adjust to AFTF. AFTF will improve the quality of information to the capital markets. This information is more relevant, but it may take some time before the capital markets become accustomed and trust it. The markets will have to attach their own meanings and significance to such things as, the historic cost of capital, the company valuation, value added, actual-to-expected, and the IRR. Since AFTF provides predictive, decision-useful information, it is anticipated that capital markets will learn quickly. With AFTF financial reporting, it is likely that market valuations will stabilize and improve over what they would otherwise have been. AFTF has the potential to improve capital market efficiency; those (shareholders and management) who cooperate in this improvement will benefit. 

Management will have to learn and adjust to AFTF. Management will have to shift to shareholder value and value-added perspectives. Traditional GAAP balance sheets and earnings statements will be phased out. Management decisions, expectations, and performance will be revealed to the shareholder. It is important that management have complete freedom of thought, decision, and action. AFTF delivers that freedom, but along with that freedom come a responsibility and an accountability. Management must realize that AFTF will hold them accountable, and must act accordingly. If they fail in this, the shareholders will act accordingly. Management will have to adjust to reporting unfavorable results more frequently. Value added is a residual (after the cost of capital) and will often be negative. 

Modelers will have to be trained. There are not sufficient numbers of sufficiently trained modelers, except, possibly, within the insurance industry. It is my feeling that modeling and accounting should be separate disciplines since each endeavor is, by itself, very complex. One possibility is for the Society of Actuaries, to create an advanced education track designed to support AFTF cash flow modeling. The basic education and training of actuaries provides a firm foundation for such a track.

 

 Technical Problems 

AFTF depends strongly on the 5-year dual validation procedure. There may be some technical problems if a company has changed radically, as through acquisition or merger. There are also insurmountable problems if a company has no or a very limited history. For example, for an initial public offering (IPO), all AFTF disciplines fail and a reliable company valuation is impossible. In defense of AFTF, it may noted that IPO values are inherently unreliable, so that AFTF fails only where it could not succeed. 

AFTF is designed for publicly traded companies and would require modification for non-shareholder owned companies. This failure is inevitable with an accounting system built around shareholder needs. 

There will be extreme times when market values deviate from company values. This is self-correcting as the company and the market communicate their expectations. Over time it is likely that market values will oscillate around a fairly stable trend of company valuations. This follows from the fact that the discount rate is a 5-year average and the cash flow model is based on long-term projections, which are relatively immune, if not completely immune, to short-term influences. In addition, the dual valuation procedure will constantly pull company and market values closer. AFTF financial reporting should do the same. Some situations are inherently unstable and it is desirable that this characteristic be accounted for. AFTF will remove a good portion of the apparent instability, but cannot and should not entirely eliminate all instability. 

AFTF growth is a relativistic concept in that growth depends on expectations as expressed through the required interest (recall G = Earned Interest – Required interest). So, for example, a high-tech initial public offering may yield 30% over a 10 year period, yet not produce any value added, if the required interest is also 30%. A utility yielding 10% over the same 10-year period may be adding substantial value because the required interest is only 8%. How can this be? What does it mean for value-added accounting systems? One conclusion is that it may be difficult to judge what portion of a given yield is, or should be, required interest and what portion value added. This decision is left to the capital markets. 

In the AFTF reports, value added is detailed for major cash flow components. Value added is defined as the present value, at year-end, of the cash flows less the present value of cash flows at the start-of the-year (increased at interest). The year-end cash flows are before any shareholder dividends. The start-of-year present values are net of any dividends from the prior year-end. This presents a problem since the total dividend must somehow be allocated to the cash flow components. This allocation should be in proportion to the component’s cost of capital for the just-completed year, but there could be other factors to consider. If the components are divisions or lines of business, the allocation of dividends may be politically sensitive. A larger dividend allocation may help or hurt a line depending on whether the line is adding or losing value. A mis-allocation does not affect overall results, but can cause a losing line to appear to add value or a profitable line appear to lose value. 

 

Costs 

There will be a cost associated with AFTF. A good portion of the cost is a transition and setup cost. Experience studies, expenses studies, development of assumptions, constructing models, testing, validation, training, documentation, improving communications, developing data gathering, developing sample financial reports, will all take an investment of time, people, technology, and money. Much of this initial investment will produce a capability, which should be present anyway. Complexity and difficulty are not, or should not be, deterrents since it is precisely the complex and difficult issues that most need to be addressed by management. 

The accountant, as distinct from the modeler, will also have a transition to make, but it is expected that his new role will involve about the same level of activity. In many ways his job will be easier. 

The cost of introducing and maintaining AFTF will be great; the benefits will be much greater. 

The cost of not introducing AFTF will be great. Part of this cost will be an opportunity cost to capital market efficiency. Part of the cost of not introducing AFTF will be incurred by the accounting profession, which may be increasingly associated with an irrelevant past. 

AFTF will create greater capital efficiency. This is generally desirable from a macro standpoint, but it will accelerate the natural evolutionary process. The birth and death rate of companies will increase. Economic factors will dominate decisions and the part will be subservient to the whole. Individual companies, lines of business, projects will be shown no mercy. They will be sacrificed on the altar of capital efficiency. So will individual managers. Society as a whole will benefit, but it is devastating to make a personal contribution to natural selection. There is a human cost. 

 

Unknowns 

It is not known what the market cost of capital will be. There may be some surprises in this regard. There are certain details that have not been specified or determined. For example, should year-end or year-average stock prices be used in determining the historic cost of capital? Are there any non-cash items that need to be added to cash flows to make the cash flow model more representative? Is value being added or lost, on average? What are the AFTF internal rates of return? What is the relative volatility of company valuations? How much will AFTF reporting stabilize market prices? How long will is take for the capital markets to become more efficient? 

There is some question as to the speed and scope of implementation. Obviously it will take several years to research, develop and implement AFTF (or whatever the name might be). There will be no comfortable timetable. Should AFTF be required for all shareholder-owned companies? Even small ones? Should the IASC participate or take the lead? What will the SEC’s involvement be? Are there enough qualified modelers? What should their qualifications be? Does it matter? Will management be willing to publicly commit itself in financial reports and opinions? How about the modeler or the public accounting firm? These questions can all be answered if the accounting profession has a vision, assumes a leadership role, and takes action. 

A goal of AFTF is to produce a company valuation representative of the underlying value of the company. If stocks are temporarily overvalued then company valuations will be lower than market valuations. This will not be popular with management, since reported company valuations will adversely affect market valuations. If stock valuations are depressed then the company valuations should be higher than the market valuations. The range of discrepancy between the market and company valuations is unknown, as is the effect of such discrepancies on market values. It is not known by how much such discrepancies will help or retard the acceptance of AFTF; obviously a down market would be a psychologically better time for introducing AFTF. 

 

Manipulation 

With AFTF, Management is given unprecedented freedom and ability to manipulate the future. The price of this freedom is responsibility. The cost of this freedom is potential manipulation of financial reports. Management can, to a limited extent, temporarily exaggerate the company valuation, despite the many disciplines that make such manipulation difficult and ultimately unrewarding. 

It is often difficult to determine, even in retrospect, whether such manipulation is present. Oscillations in value added and deviant actual-to-expected ratios may be indicative, but are not conclusive. Business is not a controlled experiment. The unexpected is expected. Business exists and thrives in this sea of uncertainty.

In some cases it may be obvious that management assumptions are unjustified. It is up to the modeler or the accountant/auditor to question those cases and, if need be, issue a qualified or contingent opinion. However, it is management that makes the ultimate decision and formally signs off on the assumptions. Management must be permitted to make the difficult judgments that it is responsible for. Management must be permitted to make mistakes. Take away those freedoms and you take away progress. Under AFTF, the quality of management will be clear enough, soon enough. 

I don’t believe that manipulation or over-optimism will be a significant or enduring problem. If it is a real problem in a particular case, it will be quickly and clearly revealed under AFTF. The shareholders will decide the appropriate response. This response may take the form of lower share prices, a higher cost of capital, and a lowered company valuation. The response may be to forcefully improve the quality of management. 

 

Tradeoffs 

AFTF is not perfect. It is not possible for AFTF to be perfect in theory, let alone, in practice. There is no intent or necessity for it to be perfect. It is designed to be a decision-based, decision-useful accounting system whose cost is less than its benefits. For example, cash flow models are designed to be functional tools, not fine jewelry. If we just get the magnitudes and directions correct, it will be a vast improvement over traditional accounting. 

The five-year dual validation is a necessary tradeoff between stability and currency. A shorter period would more closely reproduce current market values, but would be less stable and would transmit less information to the capital markets. The five-year period creates a blend of company and capital market information in financial reports. 

AFTF is relevant, consistent, complete, broadly comparable, verifiable, enforceable and strictly disciplined. Hence, AFTF may have an acceptable degree of reliability. At the end of Chapter 3 we concluded that traditional accounting lacks relevance and may have an unacceptable degree of unreliability. In any event, it is up to the accounting profession to judge degrees of reliability and to decide what tradeoffs, if any, are needed. 

AFTF is a disciplined compromise between complete management freedom and no management freedom. This is a tradeoff (see prior section). 

The various roles defined by AFTF are tradeoffs. For example, it is proposed that the accounting profession relinquish some control over the AFTF process in order to make it feasible. In fact, the entire system of checks and balances inherent in the multi-disciplinary approach represents a tradeoff of interests. 

The various tradeoffs will create controversy. This will be a problem.

  

Conclusions 

AFTF is not painless and free; there will be problems and costs. Producers and users of financial reports will need to acquire education and experience with AFTF. AFTF itself needs further research and development. There are several unknowns regarding AFTF, which can only be determined by empirically. There are technical problems with AFTF, which must be dealt with. AFTF will require resources. AFTF promises more efficient capital markets which is in the general interest. The general interest is not always each individual’s interest; AFTF may extract a human toll. There is a potential for manipulation, which should not be ignored. Finally, AFTF involves tradeoffs to produce an acceptable and workable system.

 

Many of the problems of traditional accounting are insurmountable. None of the problems of AFTF are insurmountable. The costs of maintaining traditional accounting may be too high. None of the costs of AFTF are too high.

   

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