Chapter 5
Recognition of Value
In this chapter, we explore various recognition issues in a general context and within AFTF. We will ask and answer the basic questions: What? Why? When? and How? The answers are a direct result of the shareholder perspective.
Definition 5.8 Recognition is the process of formally recording or incorporating an item into the financial statements of an entity as an asset, equity, asset flow, equity flow, or the like.
This definition is similar to the FASB definition except that asset flow has been substituted for revenue and equity flow has been substituted for expenses. By asset we mean the AFTF asset (PV of expected positive cash flows). Equity means the AFTF Equity (PV of expected negative cash flows). AFTF "recognizes" the forgoing items and a number of other items, including: the historic cost of capital, company-estimated yield (IRR), actual-to-expected ratios, expected cash flows, company valuation, sensitivities, value-added analyses, etc., as described later.
"All business proceeds on beliefs, on judgements of probabilities, and not on certainties."
Charles W. Elliot
What are the criteria that must be satisfied to recognize (the existence of) an expected cash flow? There is a single criterion or recognition trigger. An expected cash flow comes into being bymental anticipation, by being expected. This criterion allows great flexibility and may encourage great creativity, to say the least. We will see that this is a fundamental strength. We will also see, if you are still reading, that expected values will be strongly disciplined and form a practical basis for an accounting system. When is an expected cash flow recognized (as occurring)? Expected cash flows are recognized as occurring when they are expected to occur. What amount is recognized? The expected amount is the amount recognized. In short, we fully recognize our expectations.
In addition, we measure those cash flows as present values. It is shareholder value (What?) we are measuring and recognizing. It is in the present (When?) that we measure and recognize. It is using discounting (How?) that we measure present values. It is to provide decision useful information to the shareholder (Why?) that we produce company valuations and value-added measures. We have, at least theoretically, eliminated all the tough recognition questions that currently plague traditional accounting.
Under AFTF we recognize expected cash flows and measure them as present values. The result of these two steps is the recognition of value.
The FASB Definition of Recognition
The Financial Accounting Standards Board (FASB) has phrased more detailed requirements than "mental anticipation" for recognition.
"An item should be recognized when all of the following criteria are met:
"The greater part of progress is the desire to progress."
Seneca
Criterion 1: This is either the most difficult or the easiest criterion to satisfy. In traditional retrospective accounting, expected values are used for accruals and deferrals, but they are not central elements of traditional financial statements. The goal of AFTF is to be different from, and to improve upon, retrospective accounting. This means breaking free of the past and defining expected values as central elements of AFTF financial statements. Expected values can be central elements of financial statements if we want them to be. It is a matter of definition.
Criterion 2: The expected values are expected nominal cash flows. Nominal cash flows are directly relevant attributes containing their own reliable measure. Expected values are potentially unreliable, but a good portion of this book explores their reliability, which won’t be re-explored here (see Chapters 6, 7, and 14). In addition, we measure assets and liabilities as present values of the expected nominal cash flows. Present values are a generally reliable and relevant measure expressed in current nominal dollars. Present values make use of a discount rate. In the case of AFTF this discount rate is the historic cost of capital. This is a well-defined objective rate with a balanced blend of stability and responsiveness (see next chapter). Most important is that the net effect of the expected cash flows and historic cost of capital is to reliably approximate shareholder values (this is fully explained in the next chapter). In this way, the company valuation reports relevant and reliable values to the shareholders.
Criterion 3: Expected values and present values derived therefrom are the basis for management decisions. They also form the basis for the company valuation, the company-estimated yield, value-added measures, etc., as reported to current or prospective shareholders. Expected values will be closely related to the value the shareholder can expect; they have maximal predictive value. Expected values are relevant and useful for decisions by shareholders, management, and others.
Criterion 4: Expected cash flows will be as "faithful" as, if not more "faithful" than, actual experience. It is quite likely that actual cash flows will fluctuate around or deviate from the underlying pattern more than expected cash flows do. This is because expected values are designed to replicate the underlying pattern. A past year’s actual cash flows may faithfully represent that year’s cash flows, but they may not be faithful representations of future cash flows or underlying values.
Expected values, as expectations, do not require verification. More important is the fact that expected cash flows are normalized (see next chapter) so that company valuations cannot be exaggerated. Verification is not critical. However, verification abounds with AFTF. Expected cash flows are verifiable in the sense that the cash flow model must be precisely validated to a 5-year base period (see next chapter). They are subject to audit and review. They will be graphically projected so that unjustified discontinuities won’t go unnoticed. There will be strict disclosures for new or changed expectations. When actual results deviate from expected, it will be revealed in the AFTF actual-to-expected ratios.
Expectations are specifically designed to be neutral. A knowingly biased expectation is not an expectation. Of course, we must depend, at least to some degree, on the professionalism and integrity of the cash flow modeler. With normalization there is little motivation for bias.
The above discussion of recognition was primarily focused on expected cash flows, but all AFTF items are related to expected cash flows so that the analysis of those items would be similar. For example, AFTF assets, equities, and value added are defined in terms of expected cash flows.
Current period cash flows are past cash flows and are not a direct part of AFTF. They do, however, play very important indirect roles. First, all current period net cash flows contribute to value added (along within other things) and increase the company valuation. However, it is value added which is the direct AFTF measure of company progress. Second, the very important actual-to-expected cash flow ratio is based on current period cash flows. Third, there will be extensive cash flow displays for the most recent year to provide various supplemental information (see Appendix 3).
We have seen that the recognition of income is the nemesis of traditional accounting. Under AFTF income is recognized as received thus avoiding difficult judgments and arbitrary time shifting. It is measured, taking into account the timing, when the triggering action or decision occurs. The amount of future income recognized under AFTF is more precisely defined than under traditional accounting. Under AFTF, the amount of income for a future period is the explicitly expected amount, not a "reasonably certain" amount. Under AFTF, all such amounts are included not just those that are in the "reasonably near" future.
Responsive
An accounting system should measure the full financial impact of events and decisions. It should do so in a timely manner and in an appropriate degree. AFTF will respond to every sale or purchase, every capital expenditure, every change in experience or assumptions, directly and immediately. From the shareholder perspective, financial reporting based on AFTF, is responsive to the shareholder’s need for information. The company perspective is that of the shareholder, so that the company is also interested in a responsive accounting system. AFTF provides direct shareholder measures (company valuation and value added) of decisions or events. The company can also use AFTF methodology in the management decision process. Traditional financial accounting chronicles the past and cannot respond to the future. AFTF responds, in the present, to the expected future. It does not respond to unrealized gains and losses, such as market value changes of investments, except to the extent that expected cash flows change.
Traditional financial accounting is semi-responsive. Period income received from a sale is immediately recognized. Income due and unpaid from a sale at the end of the period is fully recognized, if there is a high probability of receiving it in the near future. At some point, if the receipt of due and unpaid income is less probable, or farther in the future, such income may not be recognized at all. As we have seen in Chapter 1, capitalized expenditure can be considered a crude partial recognition of income. The book value of an asset, such as a bond, is an embodiment or a proxy for the present value of future cash flows arising from the bond. Hence, upon purchase, these future cash flows are immediately recognized. If the value of these future cash flows changes, for example, due to increased expected inflation, this will be immediately reflected if the bond is held at market value. In this way changing experience is sometimes immediately accounted for. Usually GAAP is only partially responsive to changing experience. If future losses are discovered they are immediately recognized. Such cliffs may achieve a quick descent, but hardly represent an ideal path.
AFTF recognizes past financial transactions, but only to the extent that past financial transactions have future financial consequences. In addition, AFTF fully recognizes the future financial consequences of past non-financial triggering events. These triggering events may be completed transactions, such as, a sale, contract, or other commitment. They may also be decisions not associated with any past transactions. These decisions must, however, be strongly linked to future financial consequences. It may seem that incorporating decisions into an accounting system provides management with extraordinary ability to manipulate reported financial results. This will not be the case. Instead, as we shall see, management will be given increased freedom and ability to manipulate actual financial results.
AFTF Decisions
Decisions within the AFTF context will be subject to some constraints. To limit the ability of management to manipulate reported results we adopt a natural, but strict definition of what is meant by a decision.
Definition 5.8 An AFTF Decision is any informed management commitment expected to significantly change future cash flows.
A commitment may be in the form of promised resources, such as new or re-deployed capital, human resources, technology, production, R&D, administrative capabilities, marketing, etc. These commitments may involve substantial or minimal cost, but should involve benefits that at least exceed the costs (including the cost of capital). The commitment may be negative in the sense of a sale, divestiture, discontinued operations, etc. A decision may be a commitment by others to the company, such as a written contract or a written agreement. The AFTF decision framework is flexible and adapts to any analytical requirements. For example, an existing line of business can be periodically evaluated as a decision to eliminate, maintain, or expand that line. The information provided by AFTF is that needed to make an informed decision and vice versa.
A decision is a real current action with real current or future effects. Any AFTF decision should be an informed decision. The more significant a decision is, the more informed the decision-maker should be. Any AFTF decision should be accompanied by an explicit business plan and by a formal estimation of the expected cash flow effects of that decision. If this is not done, we have no chance of making optimal decisions and an increased chance of making a costly blunder. If this is done we have a building block for the AFTF structure. No decision is incorporated into AFTF unless future expected cash flows have been estimated. A decision made without such a cost-benefit analysis is not an informed decision.
If future expected cash flows have been estimated and a commitment has been made then those cash flows must be included in the company valuation. Hence the shareholder will be informed in a timely manner and can respond appropriately. Under AFTF, values are recognized when decisions are made.
In addition to a commitment by management to implement the decision, management must be willing to publicly disclose its decisions. In fact, under AFTF, any significant decision must be publicly disclosed. If positive information is withheld by management, then it has only itself to blame for poor market valuations and the consequences thereof.
In the AFTF structure, a decision exists if and only if accompanied by its AFTF valuation (together with a management commitment). In the AFTF structure, management and the shareholder will have essentially the same information and outlook. There will be a timely and visible link between management decisions and financial results.
AFTF recognizes the value of decisions in both management and financial accounting.
Response Time
An accounting system should immediately measure the effect of the cause. There should be a clear link of the effect with the cause. AFTF has immediate recognition of value arising from management’s decisions or actions. AFTF has immediate recognition of gains or losses (in value) arising from past events. AFTF would immediately recognize changes in capital market conditions, the business environment, and deviations of actual from expected cash flows. These factors would be immediately recognized through changing expectations and reported to shareholders. This permits market valuations and company valuations to respond to the same influences in a similar way.
It might be feared that AFTF would be too responsive and might be as volatile as the market valuation. However, we will see that AFTF is well disciplined and depends on a rolling five-year average fit. It is not expected that, each year, actual cash flows will exactly match past expected or future expected cash flows. It is also not expected that each year market valuations will exactly match company valuations. Cash flow projections and company valuations should exhibit substantially less volatility than the market cost of capital or market valuations. Useful buy and sell signals should result from disparities in market and company valuations.
It might be feared that immediate recognition would promote shareholder dividend payouts that are too liberal. This is unlikely to be the case since the net operational cash flows involve careful estimation of liability cash flows. In addition the use of a discount rate lowers the company valuation, generally by more than the dividend. This is because the discount rate is the total cost of capital whereas the dividend payout provides only part of the shareholders’ expected return (the remainder is capital gain).
If the value added is positive then, in theory, all that value added could be immediately provided to the shareholder leaving enough to provide for liabilities and the ongoing cost of capital. In practice dividend policy is likely to be moderated. Further, if the company is adding value then paying no dividend will enhance shareholder value. Immediate recognition is more likely to retard dividend payouts when value is being added.
If AFTF value is subtracted or lost during a reporting period then, at least temporarily, it is to the shareholders’ (and the company’s) advantage to increase dividends since the cost of capital is not being covered. The shareholder will invest elsewhere and thereby promote efficient use of capital.
Immediate recognition will enable the shareholder to more quickly react to positive and negative developments. Management will soon become sensitized to shareholders’ interests and to capital efficiency. In this way, AFTF will hasten the natural selection of capital efficient and capital inefficient companies.
Management, at all levels, has the authority and the responsibility to add value to the company. If management also has the capability and the motivation, value will be added. AFTF provides management with an important evaluation capability. It also provides an effective mechanism for incentives. Incentives can be based directly on value added. The reason for AFTF’s effectiveness is that it immediately and accurately measures the essential management activity, namely, decision making. Immediate recognition of value immediately recognizes and rewards the value of decisions. The actual-to-expected cash flow ratios can be a continuing basis for incentives.
Recognition Judgments
There may be little objection to the immediacy of recognition. Some may question whether a complete degree of recognition is desirable. Currently, traditional financial accounting mandates, permits, or prohibits immediate recognition depending on the situation. Obviously this creates inconsistencies, difficulties in interpretation, and potential abuses.
The immediate recognition of values under AFTF automatically, naturally, and completely matches "revenues with costs". It is not necessary to judge when revenues are "realized" and when then can be recognized. It is not necessary to judge whether a cost is an asset (delayed expense) or a current period expense. It is not necessary to determine if there is a direct enough relationship between revenues and costs to suggest a certain matching treatment. There is one and only one treatment under AFTF. Asset and equities are immediately recognized as discounted cash flows.
With traditional financial accounting revenues received or not yet received, and costs paid or unpaid, are time shifted to fit recognition or matching judgments. These judgments are arbitrary and controversial. Time shifting, without taking the time value of money into account, does violence to that value and makes traditional financial accounting unsound and unusable for most purposes. With AFTF the magnitude and timing of expected cash flows is unequivocal. AFTF present values appropriately capture the time value of money.
With AFTF, it is not necessary to judge whether an item of revenue or cost is material enough to require, permit or prohibit a given financial accounting treatment. The boundaries of judgment required in traditional accounting will create arbitrary discontinuities that cannot present a complete picture. Capitalized expenditures require some amortization method be chosen. With AFTF no amortization method needs to be chosen. Matching is complete, consistent, and accurate within the context of expected cash flows.
A Recognition Example
This example is taken from the life insurance industry and clearly illustrates many recognition issues. We will consider the issuance of a life insurance policy.
First, it should be made clear that AFTF does not recognize "income"; instead it recognizes net income taking all expenses and policy benefits into account with complete and timely matching. Net income will be a fraction of income.
Second, it should be made clear that AFTF does not recognize "net income"; instead it recognizes expected net income taking all contingencies, which would decrease net income, into account. For a life insurance policy, these contingencies include: death of the insured; lapse, surrender or maturity of the policy; contractual premium patterns; the effect of inflation on expenses, etc. Expected net income will be fraction of net income since contingencies predominately decrease net income.
Third, it should be made clear that AFTF does not recognize "expected net
income"; instead it measures the present value of expected net income
(cash flows). The present value of expected net cash flows will be a
fraction of the sum of expected net cash flows.
Hence, AFTF recognizes only a small residual. That residual represents the profit or value of the policy. It represents the value of the policy to the company and may tend to understate the value of the policy on the open market. Another company buying a block of policies, or the whole company, would usually count on synergies and efficiencies that would lower costs and tend to make additional business more profitable. Further, as we will see in the next chapter, it is not possible to exaggerate this value with the AFTF disciplines in place. Finally, as we will see, the AFTF value is the value of that policy to the shareholder; it is the capital market value. The capital market immediately recognizes the value of profitable issues; AFTF immediately recognizes the value present as a "present value". AFTF recognition is the right approach
The policy's AFTF value is the immediate recognition of all "profits". This approach is carefully avoided by most accounting schemes. However, I believe that the traditional approaches that spread profit over the life, or premium-paying life, of the policy are the wrong approaches.
The error with delayed recognition arises from the micro-perspective of looking at a single policy and thinking that what is appropriate for an isolated policy must be appropriate for the sum of such policies. It is helpful, for the moment, to consider the steady state case, which for the life insurance industry is not too far from the mark. No matter what system of profit recognition is employed, be it immediate, over the policy lifetime, or at the end of the policy lifetime, the annual profit for a steady state company will be identical every year under all systems. Hence, when the reality of layered issues of multiple durations (older business) is considered, all spreading systems produce essentially the same result. The real problem is too much spread, not the opposite. The insurance industry is flat-lined. When a steady state company finally does have an increase in profitable issues most earnings recognition schemes will unfortunately show a downturn in earnings!
If profits are recognized immediately (as with AFTF), there will, in general, only be a "small residual" upturn in results. This is because it is difficult to increase field production quickly and because each year’s total new premium production is only a small fraction of an insurance company’s premiums in force.
Let's consider the immediate recognition from the standpoint of the key activity. The key activity, in my opinion, is the issue of the policy. Others contend, for example, that collecting premiums is the key activity, or at least a key activity. AFTF takes collection, claim and other maintenance costs, surrender and death benefits, fully into account. These activities are funded and timed within the present value so that the question of timing and matching is answered.
Another perspective based on relative cost also points to immediate recognition. The present value of first year commissions, acquisition costs, and other first year expenses dominate the present value of expenses. If one wants to look beyond the time of issue why not also look at advertising, product development, agency development and other costs that precede the policy issue and contribute to the future stream of cash flows. It seems that if most costs are incurred in or centered about the first year, it is not inappropriate to also take profits in the first year.
The most important argument, however, is the argument that issuing a policy, or more particularly, issuing a profitable additional policy ought to have some positive effect on current results since the value of the company has been enhanced. If we do not measure positive actions in a positive manner, we can’t expect to get positive results. If we do not directly and immediately measure the effect of the cause, the perceived cause-and-effect relationship is weakened. Traditional accounting does not provide appropriate measures; in fact, they are backwards.
Conclusions
AFTF, or similar DVA approaches, measure and recognize value. If we value the future we must have measures of future value. In this chapter we have argued that immediate recognition of value and value added are the appropriate measures. The immediate financial measurement of decisions not only technically improves the decision process, but also the capital market’s evaluation of that process. The improved ability of the capital market to assess management performance should, in turn, motivate improved management performance.
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