Accounting: The Broad Perspective 

Accounting can be viewed from differing perspectives. Our perspective will be to view accounting from a distance, through wide-angle binoculars. We will only use the microscope on AFTF.

 

We will consider accounting to be any system of communication of information expressible in monetary terms. This definition is broad enough to encompass traditional accounting systems and value-added accounting systems, in particular, AFTF. 

 

Basic Accounting: Bookkeeping 

The basis of all accounting is the books of account maintained by the enterprise. These books of account record monetary quantities associated with the financial transactions of the enterprise. In modern accounting these quantities are simultaneously recorded as debit and credit entries. For each transaction a debit entry is kept and an equal credit entry is kept so that total debits always equals total credits. This double entry system of keeping the books has been of enduring usefulness. This system is vital to the day-to-day operations of any sizeable enterprise. In general the books of account record real cash flows into or from the enterprise or into or from various defined sub-enterprises. Some difficulties naturally arise when entries other than real cash flows are booked. 

Retrospective cash flows are real, exact, and incontrovertible. Their magnitude is accurate to the penny and not subject to interpretation. In addition, their timing is real, exact, and incontrovertible. Magnitude and timing are a matter of record. 

The essential purpose of bookkeeping is to record real cash flows. 

 

Tactical Management Accounting 

Management has the responsibility for the overall operations of the enterprise and must have the appropriate information needed to make daily decisions and take action. A primary basis for these decisions is information obtained from the books of account. Quantitative and qualitative information may be also be obtained from the various sales, administrative, or production systems. This information may be direct data, but more often is processed information, such as, summaries, differences, or ratios. This management information is often in the form of defined periodic computer reports that are used for the monitoring and control of daily operations. They are useful in identifying existing short-term problems and variances. This tactical type of information is not aimed at measuring or creating future value, but more in the direction of maintaining existing value. 

The essential purpose of tactical management accounting is to monitor actual versus expected performance. 

 

Strategic Management Accounting 

Management may request special reports or studies for the purpose of identifying and evaluating non-routine long-term risks or opportunities. Since these risks or opportunities are generally part of a changing or different future, the usual retrospective reports of traditional accounting are inadequate. Planning may make use of traditional accounting information and structures, but a prospective approach is required to plan effectively. 

The essential purpose of strategic management accounting is to evaluate alternative futures. 

 

Financial Accounting 

In contrast to bookkeeping and management accounting, which are used for internal purposes, financial accounting is primarily used to convey information to interested parties outside of the enterprise. These parties include the shareholders, creditors, customers, and suppliers. Each of these parties has its own special interests and special information needs. There is, however, a great commonality of interest. Like management, these parties are interested in the survival of the enterprise and in the efficient and effective deployment and use of its resources. The shareholders are the primary focus of financial accounting and financial reports. 

In contrast to bookkeeping and management accounting, which are primarily defined by the end-users, financial accounting has been defined by the accounting profession. Principles of accounting are spelled out by the Financial Accounting Standards Board (FASB). These principles are adhered to very closely by the accounting profession and by those who depend on the opinions expressed by accounting professionals. This includes almost all publicly traded companies in the United States. These accounting principles are labeled Generally Accepted Accounting Principles (GAAP) and they are generally accepted and understood by the accounting profession. They are less accepted and less understood by end-users. 

The essential purpose of financial accounting should be to provide shareholders with meaningful and useful information.

 

Responsibility Accounting

Just as the overall authority and responsibility for a company rests with its chief executive, each manager within the company should have authority and responsibility for his or her division or department. It is important to have accounting systems that support and measure the activities of that manager. This is done by defining the unit (department, division, etc.) to be a profit center, often in the same manner that the entire enterprise is a profit center. In this way the accounting for the whole is the sum of the accounting for the parts, but, more importantly, local actions are aligned with global (shareholder) interests. Hence, responsibility accounting is usually no more effective than more general accounting. 

Each manager must be authorized and empowered to make decisions and effect change, otherwise they are not managers. The goal of each manager must be to make the best decisions. To do this the manager must have appropriate information and measures. Each manager must also be accountable to the company and this requires measures of the manager’s activities and results. 

Responsibility accounting may be used as a basis for incentives. These may be rewards or punishments to those who are empowered to make decisions and effect change. Incentives, to be most effective, should be clearly linked and immediately responsive to decisions and actions. This requires a measurement system based on decisions and their future results. The measurement system must isolate the present cause and future effect. This can not be accomplished with a retrospective accounting system. 

The essential purpose of responsibility accounting is to provide local goals and measures consistent with the company’s global goals and measures.

 

Tax Accounting 

Tax accounting is often based on financial accounting, but there may be substantial differences. The regulatory purpose of taxation is to provide a desired level of tax revenue. Tax accounting has borne the brunt of the changing tax needs in the sense that accounting principles, rules, and methodology, as opposed to tax rates, are often changed to generate the desired tax revenues. It would be far easier to change tax rates than to complicate accounting to redefine taxable income. The company’s goal is to minimize taxes and maximize after tax revenues within the constraints of tax accounting. Tax accounting is the set of "rules of combat" in the never-ending battle over taxes. 

The essential purpose of tax accounting is not accounting, but revenue. 

 

Regulatory Accounting 

Various regulators prescribe accounting different from GAAP financial accounting. These regulators may be state insurance regulators, through the National Association of Insurance Commissioners (NAIC), who require the preparation and filing of quarterly and detailed annual statements for insurance companies. They may be utility, bank, pension or securities regulators. This list is long. The SEC has filing requirements, similar to GAAP, for all publicly traded corporations. In general, regulation of any type is accompanied by special accounting and reporting requirements. 

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. 

 

Merger and Acquisition Accounting 

Generally this type of appraisal or value accounting is done only when a company is to be acquired. This is very unfortunate since this type of accounting is the most meaningful, current, and accurate. It is most meaningful because it is customized for the situation and is designed to provide the most relevant information. It is most current since it uses current information and is not locked into old or artificial assumptions. It is most accurate because very detailed models are constructed to project actual cash flows. Often substantial resources (money, time, and personnel) are expended to obtain a complete picture of the company’s value, either as a separate entity or as a merged operation. One important characteristic of M&A valuations is that they attempt to capture all future values. Such valuations also use a realistic cost of capital to discount those future values. 

A similar, but cruder type of valuation is employed by stock analysts to establish a price or value of a company’s shares.

The essential purpose of M&A accounting is to measure potential value added. 

 

Value-Added Accounting 

There are several types of value-added accounting. They all share a common purpose, i.e., they attempt to measure the shareholder value added to the company. They do this by subtracting the cost of capital, in some way, from net cash flows. This approach essentially treats the expense of borrowing capital, whether equity or debt, like any other expense. The shareholder net profit or value added is what remains. 

One form of value-added management accounting is the EVATM approach, as popularized by G. Bennett Stewart, III, of Stern Stewart & Company. In this form, value added is defined as adjusted traditional retrospective earnings less the total cost of capital. The adjustments to earnings include adding to net operating profits any: preferred dividend, minority interest provision, debt interest expense after taxes and any increase in equity equivalents. This last item is somewhat troublesome since equity equivalents are designed to "… gross up the standard accounting book value into something I call economic book value…". If a true economic book value is produced then the true economic value added follows easily. The total cost of capital is based on a weighted-average of debt and equity rates applied to the total capital. The cost of debt is generally well defined, but the cost of equity is more difficult. It is based on a risk free rate plus four main risk components (with 18 sub-components); operating risk, strategic risk, asset management risk, and size and diversity risk. The weighted-average cost of capital is then applied to the total capital. Again the debt portion of capital is well defined, but the equity portion is not and must be obtained as a complex and questionable adjustment to the traditional book value. There are substantial benefits to the EVATM approach, but they are only available with very careful development, as might be expected. EVATM is not specifically designed as a financial reporting system. It is not easier than the AFTF approach. 

There are other approaches to value added and I mention them in passing. They are the free cash flow model, the dividends model, the abnormal earnings model, and the adjusted present value model. All these models, the EVATM model, and the AFTF model are generally equivalent, under certain conditions. See Appendix 8 for a comparison of EVATM and AFTF.

 

Value-added accounting has a logical appeal and is used extensively, but not in the United States as financial accounting. Value-added accounting systems, while theoretically intriguing, have proven unworkable in practice. This is not due a fundamental flaw, but rather bad practice. AFTF is a type of value-added accounting. It is designed to replace all of the above accounting systems and to satisfy all their essential purposes. It is specifically designed to satisfy financial reporting purposes. AFTF incorporates features that promote or require good standards of practice. These features are crucial to AFTF and are described in Chapters 6 and 7. 

 

Conclusions 

There are many types of accounting each with its own special purpose. Those purposes are not necessarily in conflict. In fact, we will see that there is a great commonality of ends and, even more important, a great commonality of means. The essential purpose of this book is to accelerate the acceptance of a disciplined approach to value-added accounting, a single approach that can satisfy a variety of purposes.

   

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