The Future of Accounting For The Future
By Humphrey Nash
Accounting For the Future (AFTF) is the title of a draft proposal written by Humphrey Nash (published March 1998). The proposal suggests that accounting should become more broadly relevant and proposes feasible and reliable structures and technologies to help make this possible. It is time to explain why AFTF or a similar system provides a uniquesolution to the problem of accounting relevance for publicly traded corporations. At this time, we will not repeat why and how AFTF is feasible, reliable and auditable.
Relevance
Relevance must be defined and judged by the current users of accounting information. Relevance cannot be defined or judged by traditional accounting standards. Traditional accounting standards and practices have not kept pace with changing business and financial environments. Traditional accounting information does not adequately support decisions. The accounting profession is painfully aware of this but has not "discovered" a workable solution.
Ironically, the solution is familiar to many practicing accountants. Whenever accountants have been called upon to support decisions they employ the same methods. They use forward-looking information based on valuations scaled to the capital markets. This takes the form of present values of expected cash flows, whether the decision is pricing, dividend policy, financing, capital expenditure, external investment, merger or acquisition. This technology is also familiar to most financial decision-makers outside the accounting profession. It is a proven relevant technology.
A Solution
Relevance (decision utility) is the ultimate goal of accounting. Adherence to the traditional cost-based accounting model, in a changing environment, has made accounting increasing irrelevant. The accounting profession realizes that it must look forward but it doesn’t know how to begin. It is difficult, especially for accountants experienced in auditing the past, to see how a forward looking value-based model could be made feasible, let alone reliable or auditable. The AFTF accounting model provides feasible structures and explicit technology that can make prospective accounting relevant and reliable. A solution is available.
A Unique Solution
More importantly: Any accounting model relevant to the decision process will be similar to AFTF.
First, we note that AFTF was patterned after, indeed adopts, existing financial decision technologies. It provides forward-looking information based on valuations scaled to the capital markets. This is useful high-level information ideal for financial reporting. Appropriately scaled measures promote the effective and efficient use of capital, a goal shared by shareholders, management, regulators, creditors, analysts and others interested in the success of the enterprise. Any accounting model, such as the current cost-based model, which is not scaled to capital market values, cannot be as relevant.
Not only is the current accounting scale different, it is unpredictable. Accounting values can range from a small fraction to a large multiple of capital market values. Do capital market values invariably represent underlying values? No, but they are much, much closer to the mark than accounting values. Furthermore, those cases where capital market values deviate from underlying values generally result from inadequate accounting and disclosure. Clearly, if accounting wants to be relevant it should at least attempt to measure and report underlying values
The AFTF model is a value-based accounting model. It explicitly takes into account the time value of money ... shareholder money. It measures the progress (value-added) and the value (PVECF) of the enterprise taking into account the shareholders’ cost of capital and it measures that cost using capital market prices for that enterprise. These prices are the only means of properly scaling the cost to the capital markets. Any accounting model, such as the current cost-based model, which does not use an appropriately scaled cost of capital cannot be as relevant.
The AFTF model coordinates projected cash flows with the discount rate (cost of capital) to which the discount rate is applied. The mechanism for doing this is the dual validation. Without such coordination it is impossible to reliably scale valuations to the capital market. It is the end result of projecting cash flows and discounting which is the gold standard. Any accounting model, which does not coordinate the discount rate with projected cash flows, using the dual validation or something equivalent, cannot produce values scaled to the capital markets.
The AFTF model uses management decisions and assumptions in modeling the future. Making decisions and judgments about the future is management’s job, its exclusive prerogative and its exclusive responsibility. The AFTF model makes the working assumptionthat management is best able to assess the company’s future. This may not always be true; hence, AFTF doesn’t depend completely on management. AFTF also depends on the independent judgment of the capital markets. It is assumed that the capital markets have assimilated past information and performance and have correctly valued the company. One important exception is new decisions or assumptions not yet communicated to and processed by the capital markets. The dual validation separates old from new information and reports the expected capital market value change resulting from that new information. Any accounting model, which does not make use of management’s decisions and expectations, cannot be expected to produce a complete or current valuation. AFTF uses management expectations, as restrained by capital market valuations and other disciplines, to produce reliable accounting values.
AFTF values management decisions and then holds management accountable for those decisions. Management decisions depend on explicitly stated management expectations (otherwise they will not be valued in the AFTF model). These expectations enter the cash flows models and are expressed as present values. A prominent feature of AFTF is the periodic reporting of actual-to-expected results. This is done within a defined and disciplined financial reporting model using unequivocal cash flows. Any accounting model which does not continuously track management expectations and performance in a meaningful manner cannot guarantee management accountability.
AFTF models and values the entire enterprise in a coordinated manner. No matter how financial values are decomposed or recombined, the AFTF valuation will be the same capital market value. There can be no missing values (such as intangibles) since the unfolding future includes all relevant factors. There can be no capitalization of current expenses (as with Worldcom) since there is no capitalization. There can be no double counting of assets (as with Enron) since the models are based on normalized cash flows not accounting treatments, adjustments, or allocations. Any accounting system that recognizes revenue other than cash flows is subject to abuse. Cash flows are unequivocal whether they are past cash flows in the books of account or expected cash flows within a prospective accounting model.
Intangibles values are real even if they don’t have a current existence or manifestation. They are realized in the fullness of time. AFTF is complete in that it captures all values including intangibles. How? An intangible has value if and only if it affects the future. By measuring the future (PVECF) we simultaneously capture and value intangibles. An accounting model is complete if and only if it captures all values, including current intangibles. An incomplete model lacks relevance.
The fair value of a publicly traded company is its market capitalization. This means that the attribute of fair value must be capital market value. No system of financial measurement that fails to scale measures to capital market values can be consistent with fair value. The sum of the pieces will not match the whole.
Decisions must be made taking into account the future and only the future. The past is irrelevant. For example, it is well known that past or sunk costs are not relevant to the decision process and will produce sub-optimal results if used. A relevant (decision-useful) accounting model must look forward and must not look backwards. The current cost-based accounting model is "sunk accounting" and cannot adequately support decisions. AFTF is a prospectivevalue-based system in which all values reside in the future. AFTF is designed to support and optimize current decisions.
Financial reports are designed to represent past, present or future realities. Financial reports are simplified representations designed to be feasible, to be understandable, and to distill essential information. Models are simplified representations designed to be feasible, understandable and to convey essential information. With AFTF we model and recognize future cash flows and measure them as present values. This is accounting. This is the future of accounting.
Conclusion
AFTF is an expression of existing decision technologies and existing trends and developments within accounting. It provides a simple workable accounting model. Any relevant accounting model must be equivalent to AFTF.
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