Chapter 6
Basic AFTF Disciplines
Accounting For The Future (AFTF) is a value-added accounting system that is subject to rigorous disciplines. Hence, it may be characterized as a Disciplined Value-Added (DVA) accounting system. AFTF is the only known DVA accounting system. We have seen that, under AFTF, the company’s perspective is similar to the perspective of the shareholder. The disciplines defined in this and the next chapter will force these perspectives to converge and to converge on a useful reality. One of the key features of AFTF is the dual validation process.
Reality
"We don’t leave in a world of reality, we live in a world of perceptions."
Gerald J. Simmons
It is almost a contradiction to talk about accounting and reality in the same chapter, but not quite. There are certain economic or accounting realities that are unquestioned. Those realities are the foundation of AFTF.
"Everything is worth what its purchaser will pay for it."
Publius Syrus, 50 BC, Moral Sayings
The first reality is that of market prices. In an efficient free market, transaction prices represent market values. In particular, the total share price of a company is the consensus value (market valuation) of that company. A share of stock is worth what an investor will pay for it, nothing more and nothing less. Even if the market valuation is significantly different from the underlying company value, the market valuation (price) still exactly represents what the shareholder charges for the use of his capital. The market cost of capital is a reality, which enters AFTF as a discount rate.
The second reality is that of cash flows. Past cash flows are real and their amount and timing is exact. Double entry bookkeeping of cash flows is exact to the penny, as long as the books are balanced. There is also is no question of timing, as long as the books are up-to-date. AFTF will use historic cash flows to validate the company model. The expected cash flows from the validated model are then used in determining the market cost of capital. New information, such as management decisions, may also affect modeled expected cash flows. This new information represents the real expectations of management.
Dual Validation
The dual validation process is the technology that provides the central discipline needed for a reliable accounting system. There are other important disciplines, as we shall see in the next chapter, but they are less important and more transparent. The dual validation process is a powerful, yet subtle mechanism for achieving accounting relevance in an objective and feasible manner. AFTF would require a double linkage of the cash flow model to historic experience.
I. Cash Flow Validation
First, the cash flow model, used to project all future cash flows, would have to produce an exact retrospective match to the total prior five-year actual net cash flow. This model would not have to be a perfect model in the sense of matching each separate year’s cash flows. In fact, we do not want it to, since we want a simplified model of reality not the impossible complexity of reality itself. More to the point is that actual annual past cash flows are not as reliable as expected annual past cash flows. This is due to,
In a very real sense the expected cash flows become the standard by which the actual cash flow are judged, not the reverse. If a past or a future year’s actual net cash flows are higher than the modeled net cash flows, then we would probably conclude that actual results were better than expected. We would probably not conclude that the model was unreliable for that year.
The cash flow model would have to conform to professional modeler’s standards as discussed in the Chapter 12: The Modeler’s Role. Not only would the cash flow model have to conform to the past it would have to conform to the future, or at least the future expected by company management. Management’s cash flow expectations provide half of the information that determines the company valuation.
II. Market Price Validation
Second, the average company valuation over the prior 5-year time period would be required to exactly match the average market valuation over the prior 5 years. This would be accomplished by setting the discount rate for validated cash flows to that value which produces the average Market Valuation. This discount rate would vary from company to company and would represent many things: risk, volatility, industry trends, current general market discount rates, management credibility, perceived growth prospects, the quality of earnings projections, etc. This market discount rate represents the historic cost of capital for the enterprise and is an appropriate general-purpose discount rate (called an implicit rate by accountants). The historic cost of capital provides the other half of the information that determines the company valuation.
Management and the model are given credibility in estimating expected cash flows after the five-year validation of the cash flow model (the expected cash flows for the validation period are exact). The stock market is given credibility in pricing accurately and determining its cost of capital over the five-year validation period. It is not possible for the company to produce a company valuation without some appropriate assumption about the market cost of capital. It is not possible for the capital markets to determine a cost of capital without some appropriate assumption about expected cash flows. We combine the best information from management with the best information from the capital markets with AFTF. This approach is superior in that more information and more appropriate information is employed. This is done in a natural and disciplined way. The result is to produce more reliable and more relevant information. This will be made crystal clear in the next section.
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Dual Validation Procedure Diagram
The Normalization Process
The above method for determining the historic cost of capital seems simple and natural enough, but its ramifications are far-reaching. We first give a name to the discounting process.
Definition 5.8 AFTF Normalization: the process by which cash flows are discounted using the historic cost of capital.
Normalization forces company valuations to resemble market valuations. Company valuations and value added are expressed in shareholder units. Market valuations may differ from company valuations, but the burden may now be on the market to reconcile valuations. Company valuations will exhibit greater stability that market valuations. The company valuation is the expected standard and, as such, conveys useful information to the market.
The normalization process is the central discipline that makes possible an accounting system based on "mental anticipation". This reason for this is that with normalization the exact level of expected cash flows is not critical. If expected cash flows are exaggerated then the historic cost of capital will increase to counterbalance and match the market valuations. Although the company valuations would look normal with exaggerated expected cash flows, the historic cost of capital would look abnormal.
Un-normalized Values
It may seem that normalization "marks to market value". If normalization did this exactly it would be empty since it would not be using company information. It differs in at least four respects.
First, the historic cost of capital is a motivated stable average based on expected cash flows. This is different from a spot rate. A spot rate would exactly reproduce the market value and would cancel out all company information. The goal is not to reproduce market values, but to produce a company valuation that conveys expected cash flow information.
Second, any pattern within the expected cash flows will emerge as a trend in the company valuations. Normalization leaves patterns intact. In fact, normalization leaves all expected cash flows intact changing only their present value.
Third, the actual current year results, as they differ from expected, will change the company value unaffected by normalization.
Fourth, new expectations are not normalized. New expectations from the current year have no affect on the historic cost of capital and conversely. It is difficult for a model to spontaneously generate new expected cash flows. The model would require some help from management in the form of new decisions or revised assumptions. If management changes the assumptions for the model then the historic cost of capital will not offset those changes. Nor do we want it to. We want to fully measure the value added by those changes. This is a fundamental reason for using a historic cost of capital. It provides a fixed standard from which we can measure change.
Not only do we want to measure the effect of assumption changes, we generally want the assumptions to change as much as possible. We want management to take actions and make decisions that will add value. We want to measure the long-term value of those actions or decisions, so that adding value to the company coincides with value-added measures. We want to free management from the tyranny of short-term accounting.
"Discipline without freedom is tyranny. Freedom without discipline is chaos."
Cullen Hightower
On the other hand, any revised assumptions will require explicit disclosure and justification; the effect of those changes will have to be disclosed in detail and in total. It is expected that assumption revisions will be made only infrequently and then only under legitimate circumstances. No assumption lock-in will be required. Valuations can thus be responsive to changing circumstances and expectations. At first it may seem unnatural to allow assumptions changes to affect reported results. However, it is more unnatural for a changing outlook not to affect values. Indeed, this is precisely the information that the shareholder needs.
Normalization preserves and captures changing experience or new expectations. Normalization re-calibrates old expectations so that they, in essence, become the standard from which we measure change. The scales are set to zero to measure new change. Hence AFTF accounts for change.
AFTF Volatility
The Gordon Growth Model (see section 5.7) showed that the company valuation was very sensitive to both the cost of capital and the assumed growth rate. In the AFTF setting, much of this sensitivity evaporates.
First, we note that the cost of capital is a five-year average rate that dampens year-to-year oscillations.
Second, we note that the company valuations are normalized to historic market values so that the historic cost of capital eliminates valuations outside the market price range.
Third, we note that the assumed growth rate must be in the historic growth range since the past projections generally use the same cash flow projections.
Hence, under AFTF, valuation sensitivity is restrained. Appendix 7 provides some examples of the behavior of company valuations and value added under AFTF. It shows that AFTF disciplines the valuation process, but does not abuse it.
Capital Efficiency
A free capital market will be efficient if and only if it is informed. It can only be informed through communication of relevant information. AFTF, in particular, the dual validation process, represents a major communication advance. This communication is a two-way communication. The capital markets communicate the market cost of capital through stock prices. The historic cost of capital, used as a discount, is a message received. Management communicates its cash flow expectations to the shareholder with its AFTF financial reports. These two components (the cost of capital and expected cash flows) are sufficient to establish value and to promote capital market efficiency. These same two components also permit management to efficiently employ its capital.
Capital market experts live or die, as experts, by their judgments and are strongly motivated to accurately measure underlying value. If the market valuation differs from the underlying value it is because the market has incomplete information. Market prices can and do change in response to information, especially new information about the future. Information about the future is expectation. Expectations may be the capital market’s expectations or they may be management’s expectations. It is not possible for the market valuation to equal or converge on the company valuation unless management expectations are communicated. AFTF is designed to do this.
Why Five Years?
Most of what has been presented in this book is not a matter of choice. The five-year dual validation base period is somewhat arbitrary. It could equally well have been 4 or 6 years. However, 2 years or 10 years would both be inappropriate. It is my judgement that a five-year smoothed cost of capital is a good compromise between responsiveness and stability, and produces a reasonable weighting of market and company information.
The spot cost of capital and market valuations tend to react to short-term factors, such as, short-term interest rates, an economic downturn, or the psychology of the moment. Using a current spot cost of capital captures more of the current capital market environment (interest rates, the economy, market psychology) and less of the company’s underlying value. In theory, a spot rate would permit company valuations to exactly track market valuations, but they would do so trivially. Company valuations are designed to inform and lead the market and they cannot do this by tracking the market. On the other hand, market valuations are designed to inform and lead company management and they cannot do this without producing some sensitivity to a changing cost of capital.
The underlying long-term value of the company is relatively unaffected by short-term factors and the use of a long-term historic cost of capital would reflect that. The historic cost of capital is a discount rate for the long-term, designed to be used for cash flows extending 20 or more years out. The degree of variation of a spot or short-term cost of capital is inappropriate for a long-term application. It could be argued that a 20-year projection requires a 20-year historic cost of capital. This is certainly true from the standpoint of variability. On the other hand the use of a very long-term average may produce a lingering and untenable difference between the market valuation and the company valuation.
Conclusions
An accounting system should be based, as much as possible, on real cash flows, real time, and real valuations. AFTF is; traditional accounting is not. The dual validation procedure provides a central discipline to value-added accounting. It normalizes old information to the market level, but leaves new information intact. It makes the company valuation a reliable and relevant measure of value. It is designed to serve the shareholder as an end-user, but, in the process, it will serve the essential purposes of all users. It makes use of market and management information in a balanced way. It communicates that information to and from the capital markets so that capital can be more efficiently allocated.
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