Chapter 9

AFTF Reporting Solutions

 

In this chapter, we focus on AFTF reporting solutions. This chapter is closely related to the next chapter and many of the accounting solutions are also reporting solutions. AFTF was specifically designed to extend valuation techniques to encompass financial reporting, and to do so in a rational and relevant manner. The AFTF statement of values and value added convey vital shareholder information in a meaningful and responsive manner. The various AFTF subsidiary reports and derived figures are designed to facilitate analysis and comparison. The holistic forward-looking view of AFTF is designed to have maximal predictive value.

Useful as a Reporting Tool 

An accounting system should encourage effective communication. The common language of AFTF, among all producers and consumers of financial information, makes AFTF especially useful in reporting. The need to communicate is clarified, since management's interests are demonstrably the same as the shareholder's. It is simultaneously in the market's interest and in management's interest to communicate effectively and, thereby, to efficiently allocate and utilize capital. 

Not only does AFTF facilitate communication, it communicates relevant information. The company valuation is a monetary expression of management and market information. This expression is denominated in and reported in familiar current stock-value units. The nature and purpose of financial reports should be much clearer. 

AFTF is a dialogue, with the market expressing itself through prices, which get translated into the market cost of capital. AFTF is thus a reporting tool of the capital markets. Management does not defer to the market, other than for the market cost of capital. 

The use of actual-to-expected ratios will be accompanied by a mandatory discussion of the principal sources and reasons for deviation. In addition, management will have to disclose and clearly account for any significant discontinuities in assumptions. So, for example, if management assumes a significant increase in sales, management will have to disclose, at some level of reporting, the effects of that assumption on the company valuation and formally state its plan of action to increase sales. The quality of management will be exposed to the light of day. Competent and progressive management will welcome the light; others, hopefully, will see the light. 

AFTF can heal the long-standing rift between the short-term perspective and demands of the marketplace, and the long-term perspective and responsibility that management is governed by. AFTF accomplishes this by combining the long perspective of management, namely, expected cash flows, with the current demands of the market, namely, the cost of capital. 

Another dimension of market values is risk. While this may be assessed somewhat generally by industry, it also reflects the perceived volatility or variability of results of the individual company. The reporting of historic or current actual-to-expected results can be useful to the capital markets and to management in risk assessment. The Value Added Analysis and the Sensitivity Analysis both furnish information on risk. It is also possible to use AFTF stochastically to evaluate the risk element. 

AFTF reveals the effectiveness of management decisions in adding value. It also reveals the quality of management’s ability to anticipate or control the future, through the actual-to-expected reports. 

AFTF is well suited to reporting and disclosure for business segments. It is natural for the cash flow models to be constructed by segment since segments will normally have different characteristics. This makes segment reporting, as required by FASB Statement 131, a natural by-product of, or a natural approach to, AFTF. The use of a uniform discount rate (the historic cost of capital) makes it easy to produce AFTF financial reports by segment, once the cash flow models are in place. Under AFTF capital budgeting decisions are identical with valuation and financial reporting. Segment reporting should naturally emerge from segment management and vice versa. 

  

Rationality 

It is not always desirable to increase traditional accounting assets. It is always desirable to increase AFTF assets. Traditional accounting assets are a possible means to an end. AFTF assets are an end in themselves. Assets have a more intuitive meaning under AFTF. 

Growth, as measured by traditional retrospective accounting, is not always desirable. It is always desirable to maximize AFTF growth. Because AFTF looks to the future, AFTF growth is sustainable. In addition, AFTF measures expected cash flows with explicit provision for the cost of capital (using the discount rate for the cost of equity capital and the normal expected cash flows for any debt financing). Traditional accounting growth is a possible means to an end. AFTF growth is an end in itself. After taking into account the cost of capital, growth has a more intuitive meaning under AFTF. Using AFTF, growth can be more easily understood and better managed. 

The traditional accounting balance sheet is only tenuously related to the traditional income statement, with the artificial traditional shareholder equity making up for the lack of coordination and rationality. With AFTF the Statement of Values is expressed in exactly the same terms as, and is coordinated with, Value Added and Cash Flows. 

Positive and negative cash flows are discounted using the same market cost of capital so that asset and equities are valued and reported consistently. 

  

Analytic Solutions 

The analytical problems associated with the traditional accounting ROE or ROI are not present with AFTF. The total discounted return is the AFTF equity so that, by definition Total AFTF ROE = 100%. The Current Year AFTF ROE is more a familiar measure. One advantage is has over the traditional ROE is that numerator and denominator are clearly related. The denominator is expressed in terms of shareholder equity; it is not traditional accounting "book value". The numerator is the current year contribution to shareholder equity; it is not traditional accounting "earnings". 

Another ratio of that may be of interest is the value added to value ratio. This is the AFTF value added divided by the company valuation at the start of the year. This ratio is the AFTF growth rate and is the excess (above the cost of capital) rate of return on equity. Inherent in the discount rate (the market cost of capital) are provisions for company risk, industry risk, stock market risk, inflation, shareholder taxes, etc., as determined by the market. 

The traditional Price / Earnings ratio is extremely variable and could be replaced by the Price / Company Valuation (P/CV) ratio. The company valuation is the present value of "earnings" (net operational cash flows, to be more exact). This ratio will be very steady and will be approximately 1.00. If this ratio deviates from 1.00, it means that the market expectations differ from company expectations. AFTF is the two-way communication process that will unify those expectations and tend to make the P/CV ratios converge to 1.00.

   

Comparability 

AFTF facilitates comparisons between companies and between industries. Each company or industry has its own characteristics, such as, current dividend yield, growth patterns, and risk. Many of these differences are embodied in the different costs of capital that are applied under AFTF. After being discounted at the cost of capital, company valuations and value added may be meaningfully compared. 

As we have seen, inter-period comparisons under AFTF are always adjusted for the shareholders’ time value of money through the discount (or accumulation) process. The use of the cost of capital inherently compares actual shareholder yield to expected yield. In addition, AFTF reports will provide detailed comparisons of actual-to-expected cash flows. AFTF disclosures and comparisons will provide relevant answers to relevant questions.

 AFTF is based on simple and universal measures: market prices and cash flows. These items do not change meaning from country to country. AFTF can be the foundation for an internationally agreed standard accounting. It does away with all geographic idiosyncrasies and will make financial reporting more comparable and compatible. 

AFTF will make present value measurement a clear first choice.

 AFTF provides several measures for comparisons. There will be a five-year historic comparison of expected (modeled) with actual cash flows so that the fit, trend, and variability can be observed. Current year actual cash flows will be compared with expected cash flows, in significant detail. Value added is a comparison of consecutive company valuations and implicitly compares company progress against the capital market standard (the historic cost of capital). The historic cost of capital and the company-estimated yield may be meaningfully compared with the prior year and between companies. The value added as a percentage of the beginning valuation (the AFTF growth rate) may be meaningfully compared with prior figures and with other companies. The company valuations at 5%, 10%, and 15% are designed for inter-company comparisons. The company valuation is directly comparable to market prices. Excellent comparability is a by-product of the relevance of AFTF.

  

 Measure of Value 

An accounting system should provide absolute and relative measures of value. The AFTF annual report will show the company valuations and show how they've changed. In addition, the report would disclose management's assessment of the shareholder's long-term yield. This is the discount rate for which the current company valuation equals the current market valuation. If management is able to increase net cash flows it will be immediately expressed as a higher company valuation and a higher shareholder yield (company-estimated yield). 

The company valuation reflects the entire future stream of cash flows so that the value of all monetary or non-monetary, tangible or non-tangible, assets and liabilities are recognized and measured. For example, the value of the sales force translates into future production and expected cash flows. These cash flows are fully incorporated in the company valuation.

 The company valuation will be similar to the market valuation. If these valuations differ then the capital market is trying to pass new information to management or vice-versa. 

The Capital Asset Pricing Model (CAPM) works beautifully in theory, but in practice, is less attractive. The book value of the company is often quite different from its market price. AFTF should narrow this gap and should allow CAPM to be less of an ugly duckling. 

AFTF measures assets and liabilities consistently in terms of their expected cash flow components, using the same discount for each. Hence, the net value will not be distorted. The value of those cash flows is measured using a discounting process that assigns the proper time value to those cash flows. AFTF will replace the cost concept with a value concept. These features are needed to produce shareholder values. 

Note that the AFTF value is not a spot market value, but rather a stabilized value, based on the historic cost of capital, which retains and conveys company information. AFTF values are "fair values" in that they are unbiased, take into account the major contingencies, and use a meaningful coordinated discount rate. 

Traditional accounting is biased toward conservatism. This is sometimes phrased as "Anticipated no profit, but provide for all possible losses." This obviously ignores and distorts values. The corresponding AFTF dictum would be " Anticipate everything". There is an effective leash on conservatism or liberalism with AFTF. The normalization process is a very short leash so that explicit conservatism is not needed to offset liberal tendencies. 

 

Measure of Change 

An accounting system should measure the progress, or lack thereof, of the company. A steady state company will have a constant company valuation. The change in the company valuation will be similar to the change in market valuation. This relative change represents the company's progress and is a growth rate. For example, if the cost of capital (the discount rate) is 15% and the growth rate increases from stable 0% to a stable 10% then the Gordon Growth Model suggests that the price of the stock will triple. AFTF captures and appropriately evaluates this growth dynamic by looking, not at a single past year, but at the entire future. 

The change in the company valuation reflects all factors of change including: the cost of capital, management's plans, emerging experience, the regulatory and tax environment, the investment outlook, model refinements, etc. The Value Added Analysis will provide some detail in accounting for the actual change in the Company Valuation. In addition the Sensitivity Analysis provides information on possible change. 

  

Responsive 

An accounting system should measure the impact of decisions and events in a timely manner. AFTF will respond to every sale, every purchase, every new decision, every change in experience or assumptions, directly and immediately through changes in expected cash flows. This response is measured in stock market terms appropriate for the investor and management.

AFTF will also respond, through the market cost of capital, to changes in the stock price. Will AFTF respond too well? Should the company report on external conditions, on highly variable factors beyond its responsibility or control? Ignoring the question as to whether management can shun responsibility for exposing the company to external factors, the answer is that the impact of external conditions may be as important as, if not more important than, management in determining value. In addition, the historic cost of capital used will exhibit greater stability than the spot cost of capital. This will dampen oscillations in the company valuation.

Consider an example involving inflation which ratchets-down stock prices and ratchets-up the general cost of capital. Should the company valuation fall? Not necessarily. If future expected nominal cash flows increase due to inflation then the net effect may be no loss, or perhaps a gain in value. The stock market will either recognize the fact that some companies will do well under inflation or it won’t recognize that fact. If the market prices the stock too low then management will report a correspondingly high estimate of the shareholders future yield. This information should help push the price up. 

An accounting system should immediately measure and report the effect of the cause. AFTF has immediate recognition of the value of new decisions, assumption changes, and experience gains or losses. AFTF would periodically report those recognized values and their changes so that the capital markets are up-to-date. AFTF also responds with continuous measures, not the all-or-nothing measures of traditional accounting. All effects of current period causes (triggering events) are reported. In this way causes and effects are more completely revealed and more consistently measured. 

The long-term prospective view and the 5-year historic average cost of capital will provide stable valuations to the market and will thereby stabilize the market. Rapid market fluctuations do not represent changes in underlying value; AFTF will respond to the underlying values. 

AFTF is responsive is a broader sense in that it is itself a response to a changing financial accounting environment. This changing environment is characterized by number of trends. Corporate finance has become more critical as limited growth opportunities and competition have eroded margins. AFTF encourages the efficient use of financial resources by implicitly and explicitly recognizing the cost of capital.


 

Inclusive

 "Look beneath the surface, let not the several quality of a thing nor its worth escape thee."

Marcus Aurelius Atoninus

 

An accounting system should include or capture all essential information. From a financial perspective this means risk, expected values and their timing. The net cash flows capture the expected magnitudes and the market cost of capital captures the timing and risk assessment. It is clear that AFTF captures essential information by incorporating, as input, all significant information, in as much as it is known. AFTF also includes most essential information, as output, in as much as it is practical. 

AFTF directly provides a balanced single measure that can be used to guide management decisions and actions. That measure is the company valuation. It is a monetary weighted-average of all factors that contribute to shareholder value. There is no need to maintain a "Balanced Scorecard" in order to incorporate factors other than the traditional bottom line. Customer satisfaction enters directly into the company valuation. If the company takes steps to increase customer satisfaction then it can also factor that into projected cash flows as increased repeat sales, fewer returns, increased referrals, lower warranty costs, higher profit margins, etc. Employee training may translate into a more productive workforce, greater employee satisfaction, and reduced hiring expenses. Research and development capabilities (including existing patents and licenses), management expertise, manufacturing advantages, distribution capabilities, all have value for the future and are incorporated into the company valuation. 

With AFTF intangibles are translated into tangible future cash flows and become part of the company valuation. Often the intangibles are the largest component of value and it is a mistake to ignore them. Conversely, value goals and measures can be translated into intangibles more directly meaningful to the manager. For example, a company valuation sensitivity analysis may reveal value drivers not readily apparent without the valuation process. These value drivers are most often not directly value measures, but may be such things as degree of automation, creative advertising, advanced training, number of customers contacted, etc. 

 

 Contingent 

An accounting system should not ignore likely events simply because they are not certain. AFTF takes all future contingencies into account. An accounting system that includes contingencies permits us to measure, assume and manage risk, and thereby reap rewards.

AFTF neatly solves the troublesome problem of inflation accounting. First, historic cost has no meaning or application within AFTF. AFTF is prospective and makes use of expected future cash flows. It also applies the cost of capital as a discount rate to future expected cash flows. The discount rate implicitly includes a provision for inflation. In time of high inflation the cost of capital will increase. The more distant the cash flow the more it will be discounted by the cost of capital. Looking back, prior period values are accumulated, implicitly providing for the higher prior dollar value. For example, value added is the difference between the current company valuation and the prior period value increased for inflation, among other things (see Equation 5.3). 

AFTF also solves the problem of providing for risk. The historic cost of capital incorporates a timely market assessment of the risk premium for the particular company. This risk premium is the capital market’s assessment of the compensation it requires (price) for the risk it perceives. This free market price can’t be wrong and can be used in discounting expected cash flows since the purpose of the discounting is to compensate the shareholder. The risks provided for may include: the company’s relative stock price volatility (Beta), the general nature of the company’s business (industry risk), the particular characteristics of the company’s business such as diversification or economic sensitivity, quality of management, debt leverage. The inflation risk is also factored in, as discussed above. It is assumed that the risk of adverse outcome (worse than expected) is exactly balanced by the risk of positive outcome (better than expected). This balance follows if an (unbiased) expected value is employed. The capital market bases its prices on expectations and the use of expected values is coordinated, i.e., there is no gap or overlap in the discounting functions of expected values and discount rates. The separate roles of expected values and discount rate are clarified in the following simplified example,

 

Holistic 

An accounting system should be placed in proper context. It should deal with the totality not the piece. AFTF works holistically at all levels. It works at the company or corporate level in particular. It values liabilities and assets simultaneously and consistently, so that risk and reward can be appropriately balanced. It produces an appropriate enterprise sensitivity, for example, to events and decisions. By taking into account the future, all components of company value are included. For example, the value of the sales or marketing assets will emerge through time. AFTF takes into account both the company operations (cash flows) and its financial environment (capital costs). It measures risks at the company level. It unifies all accounting systems. 

Last, and most important, an accounting system should be forward looking.

 

Forward Looking 

Traditional accounting captures only the past effects of past actions. This is not where the principal values lie. It is not where our opportunities lie. An accounting system should look to the future where change and value are created. The greatest values involve the long-term future. An accounting system, which fails to fully recognize this, fails to the same degree. 

AFTF measures the value of the company; whether it is profitable long-term. If it is not, then it is, or will become, insolvent. In addition, the expected future cash flows of AFTF will reveal if a temporary cash crunch will occur. Knowing this in advance can avoid the problem through timely external financing. With traditional retrospective accounting, it may be too late by the time a problem is recognized. Bankruptcy should be less likely to occur because of AFTF’s anticipatory nature and because shareholders would have to knowingly and willingly permit their value to evaporate.

  

Conclusions 

AFTF solves many of the problems that bedevil traditional retrospective accounting. Many of these problems are reporting problems. Reporting problems include relevance, rationality, completeness, comparability and problems with analysis. AFTF is relevant in that it reports shareholder values to the shareholder. AFTF is more rational because it is a consistent system based on real rather than the artificial elements; it is based on real management decisions rather than on the arbitrary accounting decisions. It is more complete since it includes all value components. AFTF enhances comparability because all companies’ values are expressed in capital market value units; a single yardstick is used. AFTF was designed with financial reporting in mind, and it shows.

   

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