Chapter 7
Additional Disciplines
Accounting For The Future (AFTF) is a Disciplined Value-Added (DVA) accounting system. In Chapter 6, we saw that the dual validation process enforces strong discipline on the company valuation. In this chapter, we will look into how the AFTF financial reports encourage careful and disciplined accounting.
"If we don’t discipline ourselves the world will do it for us"
William Feather
AFTF Financial Reporting
AFTF is designed to provide relevant and disciplined information to shareholders. The AFTF financial reports themselves will be a major source of discipline. The various disclosures, required for AFTF financial reporting, will quickly reveal the quality of those reports and the quality of management.
Sample financial reports, for an insurance company, are shown in Appendix 3. These are designed to be illustrative and are simplified to emphasize the fundamentals. In this section we review these reports from the perspective of the disciplines they provide.
1. The traditional balance sheet no longer exists. It is replaced by the AFTF Statement of Values. The statement of values shows AFTF assets (present values of positive cash flows) and AFTF equities (present value of negative cash flows). The equity cash flows consist of future payments to non-shareholders (liabilities) and future net payments to shareholders (shareholder equity). Shareholder equity is the company valuation.
In addition to current year-end values, prior year-end values (less dividends) are shown. The absolute cost of capital is shown for each cash flow component. This absolute cost of capital is the historic cost of capital rate times the prior year-end values. Value added is shown for each cash flow component and equals the current year value less the prior year value adjusted for the cost of capital (see Equation 5.3). The company valuation equals total AFTF assets less total AFTF liabilities. The historic cost of capital is displayed for reference.
The statement of values will exert a major discipline on AFTF accounting, especially on management’s expected cash flows. If they are exaggerated in the model then, as we noted in the prior chapter, the historic cost of capital will increase to offset the exaggeration. This high cost of capital places a very great burden on AFTF growth rates and value added since they are both residuals above the historic cost of capital. Hence, there is an immediate penalty for such exaggeration. If assumptions are revised (because of new experience or decisions) then the company valuation and value added may be increased. If those assumptions are not realized then later years must soon bear the burden of the prior valuations. Any value added through "exaggeration" will inexorably be value lost in later years. The capital markets tolerate poor results, dislike unexpected results, and detest misleading results.
2. The traditional income statement no longer exists. In its place we have the current year AFTF Cash Flow Record. This shows only the actual cash flows from the books of account. There are no accounting adjustments and no non-cash items. In addition, the expected cash flows from the prior year cash flow projections are shown. The comparison of actual and expected cash flows reveals either how actual experience deviated from that expected due to subsequent events, or how expected cash flows deviated from actual due to prior (modeling) events. No matter what the origin, these variations are important. Deviations of actual are expected to dominate, but the capital markets may be more interested in the effects than in the causes. Any past deviations may be a strong signal to the markets to expect similar deviations in the future.
"I know not anything more pleasant, or more instructive, than to compare experience with expectation, or to register from time to time the difference between idea and reality. It is by this kind of observation that we grow daily less liable to be disappointed."
Samuel Johnson (1709-84)
Actual and expected are compared in two ways: by difference and by ratio. The differences between actual and expected are absolute figures so that the overall importance of each cash flow deviation can be assessed. The actual-to-expected ratios provide easily interpreted information about relative deviation within each cash flow component.
Capital markets dance to the rhythms of expectations. Earnings surprises (higher or lower than expected) often produce a leveraged reaction by the stock market. The reported actual-to-expected ratios of AFTF express surprise and will become a major driver of price movements.
With AFTF it is very difficult to artificially add value, but, if this is done, the artificiality will be quickly revealed with disappointing actual-to-expected ratios and subsequent value lost. The capital markets prefer not to be misled and will extract a significant penalty. A loss of confidence in management will depress the market valuation and produce a higher cost of capital. The actual-to-expected ratios provide a discipline on AFTF and on management.
| Note that value added, cash flows, and the statement of values, all involve the same components. This is substantially different from traditional accounting where income and cash flows are tenuously related, and both are essentially unrelated to "assets". |
3. The Value Added Analysis shows in detail, by individual cash flow item, where value is being created and where it is being destroyed. It also breaks down the value added into value added due to experience of the past year and value added from future years. The value added from the current year experience is assumed to originate from the deviations of actual from expected, so that the current year value added agrees with the actual less expected from the cash flow record. The value added by future years is a balancing item equal to the total value added less the current year value added. The value added by future years captures the value added by changing assumptions or decisions. Those changes generally do not impinge on the current year experience.
The current year value added is somewhat like a traditional summary of operations with a prorated equity cost of capital assessed to each cash flow. It provides a review of the past year for those who are retrospectively inclined.
The cash flow experience of the past year should be the lesser piece of value added. It represents, in essence, an error of actual or expected. As such, it should not be large. The future years’ value added is the present value of newly expected net cash flows; it is also the value of AFTF decisions made during the year. As such, it should be large. The current year value added happens by accident; the future years’ value added happens by design.
The Value Added Analysis provides breakdowns that can facilitate checking and comparison, and, thereby, discipline the overall AFTF process.
4. The Sensitivity Analysis reveals how sensitive the company valuation is to the various assumptions. It first requires a study of the historic record to determine the normal range of variation for each assumption. It then determines (by rerunning the model) the range of variation in the company valuation that results. The Sensitivity Analysis provides checks on the stability of the model and the company. Some assumptions may be more important or more critical than others in determining the company’s value. The analysis provides information to the market about the company’s exposure to risk. Management will also have this information and may become careful when estimating, monitoring, or controlling an important parameter.
5. The Effect of Assumption Changes Exhibit is a cross tabulation showing the effect of the major assumption changes on the major cash flow components. This information comes from the model runs where the model is run before and after the assumption changes. This is done for each individual assumption change and for all assumption changes combined. The combined total effect may or may not be the same as the sum of individual assumption change effects because of interactions between assumptions. The only way to avoid this display is not to change assumptions.
6. The Opinions may be the strongest discipline of all. There are three separate opinions,
Management Certification: The management certification will state that management has determined, or reviewed and approved, all significant assumptions used in determining expected cash flows. This is needed since we are specifically attempting to capture management’s expectations. In addition, management must certify that any new decisions are management commitments, for which a cost/benefit analysis (cash flow model) has been performed, and for which a business plan has been submitted to the modeler. Management has a general responsibility for oversight, but must be made specifically responsible for what it has de facto control over. The business plan is a descriptive summary explaining how management intends to implement its decisions. It must contain enough detail to allow the modeler to project cash flows. This should not be a major problem since the cost/benefit analysis should be similar to the cash flow projection. In practice, the modeler may also produce the cost/benefit analysis, supply assumptions, and may even draft the business plan, but management must sign off. Management will rely on the modeler to produce expected cash flows and the company valuation. Management must go on record with its assumptions, decisions and plans; this will encourage careful reflection. Management will be answerable to the shareholder.
Modeler’s Certification: 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, refinements, or 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. 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.
Independent Auditors Opinion: The independent auditor will depend on the modeler for the reliability of the expected cash flows. He will certify that the cash flow model fairly represents the cash flows during the validation period (in fact, it will match exactly) and that the historic cost of capital fairly represents the cost of capital based on the projected cash flows. The auditor would state that, based on the expected cash flows, the company valuation fairly represents the value of the company. Hence the auditor would specifically be responsible for the dual validation, the theory of discounted expected cash flows, the proper use of the historic cost of capital and the presentation of financial reports. He would have general oversight of the assumptions, the modeling methodology, and the production of financial reports. The accountant or auditor will be answerable to his profession: its theory, practices, principles and ethics.
Hence the opinions delineate natural roles and responsibilities. Inherent in these opinions is a system of checks and balances and disclosures, which provide additional disciplines to AFTF.
The Discipline of Expected Values
The concept of expected value is an internally disciplined concept. A biased estimate is not an expected value. Expected values are always moderated and discounted by the various forces that impinge on those values. It is not possible to ignore the probable, or the improbable. Expected values are specifically designed to capture all significant contingencies in a measured and balanced manner.
Expected values may occasionally be updated or revised as events warrant, but they possess inherent stability. Fluctuations in experience should not, and generally will not, disturb expected values. Expected values are forged in experience and tempered by judgement and can well endure "the slings and arrows of outrageous fortune". They are designed to be applied at the macro (company) level so that the risk of not realizing expected values is minimized. Actual-to-expected ratios should fluctuate around 100%, which gives them a natural interpretation. If ratios vary significantly from 100%, they will send a message to the capital markets and to management.
The cash flow model and assumptions will be responsive and self-correcting. This is partially guaranteed by the annual validation process. It is further encouraged by the actual-to-expected reports and Value Added Analysis. In addition to the expected cash flow validation, there are further standards of practice that provide discipline. These are discussed in detail in Chapter 14: Expected Cash Flows.
AFTF will be further disciplined by market or company forces. If the Market Valuation is lower than the Company Valuation then attentive investors will buy. Management should also buy company shares since doing so will maximize shareholder gain. This will, in itself, improve the market by supply and demand, but it also sends a strong statement of management's confidence in its cash flow projections. Alternatively, management can increase dividends to signal that higher expected cash flows are a reality. If the Market Valuation is higher than the Company Valuation then attentive investors or the company should sell shares or decrease dividends to maximize gain. Management may have to respond to its own expectations and may become cautious.
AFTF will satisfy many purposes and will have to satisfy the requirements for all those purposes. For example, the discipline of the pricing process would be present in determining asset adequacy, which in turn would discipline financial reporting.
Conclusions
AFTF is subject to very strict disciplines, as we have seen in this and the prior chapter. Despite these disciplines, AFTF cannot be exact in predicting future cash flows. AFTF is accurate in expressing the expectations of the market and of management. It is these expectations which determine real current values. If subsequent events change expected values, AFTF will clearly reveal those changes. The fact that actual differs from expected is to be expected and says as much about the actual as it does about the expected. If traditional financial accounting is characterized as being precisely wrong, AFTF may be characterized as being approximately right. The disciplines of AFTF will make the approximation close and reliable. These disciplines will make value-added accounting more widely acceptable.
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