Coffee Shop Discussion: EarningsPower Accounting™

Sometimes innovations are best understood in a casual setting. Below is the reconstruction of a conversation between JJ, the founder of Silicon Economics, and MC, a medical technician, which occurred in a coffee shop in Silicon Valley. JJ and MC frequently bump into each other in the coffee shop and discuss current events of the day. MC, who is new to financial accounting, brings directness, simplicity, and freshness of inquiry to the table.

MC: You mentioned a project. What’s it about?

JJ: Financial accounting. The problem, as I see it, is that for the past 100 years, accountants have been in a dilemma believing that either the balance sheet or the income statement can be accurate, valid, and useful—but not both. I’ve solved this problem.

MC: Wow!

JJ: Naturally, you want the balance sheet to have current and accurate asset and liability values, as dated information is not as useful.

MC: For example?

JJ: Let us assume that you are a bank considering to make a loan. You first want to be sure that if the borrower runs into trouble, you know about the collateral assets that can cover the loan.

MC: True.

JJ: And from the income statement, you want to know about recurring income. There are two concepts of income. The first, dating from the 19th century, sees income as a change in net assets. Here, you value all assets and liabilities, based on current market values, and take the net change in assets minus liabilities as your income.

MC: What’s the second income concept?

JJ: Recurring income, which is an estimate of the income that you can spend this month, with the expectation that the same income will be available next month. In other words, the focus is on determining what you can spend while preserving your capital base, so that you can spend the same amount again.

MC: What if your expectations are not met, say by stocks going down by 50%, rather than up, as you expected?

JJ: If your stocks plunge by 50%, then your capital base is smaller, so in order to preserve your capital base, you have to reduce spending. Conversely, an unexpected inheritance or other positive windfall increases your capital base and the amount that you can spend while still expecting to preserve your capital base.

MC: Then, your net income adjusts?

JJ: Yes. In fact, it constantly adjusts to your capital base. The problem with the first income concept is that it includes one-time windfall gains or losses—for example, receiving an inheritance or stocks dropping 50% in one day. So, for instance, given that your house has appreciated $100,000 in the last year, do you include that amount in your estimate of what you can spend this year, with the expectation that you’ll get the same income next year?

MC: No way. Given what has happened in real estate, everyone in the Valley now knows you cannot include one-time windfall gains as part of your income.

JJ: Because of this problem—sometimes referred to as the volatility problem—the second income concept, recurring income, was developed about a century ago, and was the basis for accounting in the 20th century. But the problem since then has been that accounting theorists have been unable to determine accurate, valid, and useful recurring net income on the income statement, while also generating a balance sheet that is accurate, valid, and useful.

MC: And both the balance sheets and income statements need to be accurate, valid, and useful.

JJ: Right. As I mentioned, the bank needs to know the financial capacity of its borrowers. But you also need to know the recurring income to avoid using up your capital base, as has happened when people assumed that the $100,000 appreciation of their house in the past year would recur.

When you make an investment, what is your primary concern?

MC: What I’ll get out of the investment.

JJ: This is where you particularly need to know about recurring income because it tells you what an investment will, or can, do for you. You know about price-to-earnings ratio analysis, don’t you?

MC: Yes.

JJ: PE-ratio analysis is probably the most basic type of financial analysis; it essentially indicates returns. PE-ratio analysis requires recurring income, because inclusion of one-time windfalls distorts the valuation. So, for example, if a company owns land that has unusually and significantly appreciated—that is, a positive windfall—the inclusion of such a windfall in the net income would suggest that the company will repeatedly have such a windfall and that, consequently, the company is worth more than it really is. It’s the same as the homeowner assuming that the $100,000 home value increase will repeat.

MC: How big of a problem is this?

JJ: Who knows? Because of this problem, however, some assets are kept off the books, and asset value changes (windfalls) are smoothed and spread across multiple periods. So, for example, a $500 increase in pension liabilities might be spread across five years, with each year’s net income reduced by $100. This is only a stopgap measure, really, the type of thing that has been occurring in accounting for decades.

MC: So then you are fooling yourself?

JJ: Yes. Historically, in the 1950s and 1960s, academic accountants started giving up on resolving the dilemma and started misunderstanding J.R. Hicks, an Oxford economics professor and Nobel laureate economist, as favoring the first type of income. As a consequence, accounting standard-setters have been backpedaling to the first income concept—that is, the 19th-century income concept and methodology where income is the change in net assets.

MC: Really? You know, I believe there is always a time for revolution in any field.

JJ: I agree with you. That’s why I’ve developed a method so that both the balance sheet and income statement are accurate, valid, and useful on a real-time, continuous basis. The present value is arguably the most fundamental concept in finance. My new method uses a formula derived from the present value formula to calculate what might be called instantaneous income.

MC: What do you mean by “instantaneous?”

JJ: It’s an idea of calculus. At the end of an accounting period—an instant—an asset has a certain value. Whether the asset value increases or decreases immediately before that instant or across the whole accounting period is irrelevant. What is relevant, looking forward, is how much of the asset can be consumed, with the expectation that the residual value will appreciate to the current end-of-period value during the next period.

MC: Calculus is a phenomenal discovery. Hasn’t it already been used in accounting?

JJ: Surprisingly no. Using the formula, called the Ex Ante Equation™, recurring income and windfalls can be identified and separated. That’s because, going back to the house appreciation example, you want to determine your recurring income. In the process, windfall values are essentially a side result. The reason the dilemma was never solved was because accounting theorists assumed discrete quantities and assumed that those quantities represented income. So, for example, if an asset increased in value, that increase represented income, which somehow had to be recorded as income.

MC: But isn’t an increase in asset value income?

JJ: An increase in asset value has both components: recurring income and windfall.

MC: Yes. I’m still with you.

JJ: In my new method, assets and liabilities are marked-to-market by posting credits and debits to the asset and liability accounts.

MC: Continue….

JJ: Asset values change because of market conditions. Marked-to to-market entails updating balance sheet accounts to reflect current asset market values. As I mentioned, this lets the bank know how financially secure the borrower is.
In this method, rather than posting the offset marked-to-market values to a revenue or expense account, thus including windfalls in net income, the offset account is new and called the windfall account.

MC: So, right away, you’re beginning to isolate windfalls.

JJ: Yes. The Ex Ante Equation calculates instantaneous income, which is moved from the windfall accounts to what are called asset income accounts. So in the income statement, the first part covers traditional operations, with revenues and expenses. The second part shows asset- and liability-holding incomes. The sum of operating income and asset- and liability-holding incomes yields the net income.

MC: So how does this recur?

JJ: Implicitly, operations are assumed repeatable; in other words, the company can sell the same goods and services in subsequent periods for the same prices and at the same expense. Assets possibly yield holding income and, if so, the Ex Ante Equation yields the associated recurring income.

MC: So where are the windfalls?

JJ: Below the net income line. When totaled with net income, the result yields comprehensive income, the net change in asset value, exclusive of equity transactions. So the result is that both the balance sheet and income statement are accurate, valid, and useful, answering both sides of the debate and resolving a century-old dilemma.

MC: Makes sense. Your method provides both income numbers, particularly the recurring income number, which seems important to me.

JJ: Yes, and Fischer Black, the developer of the Black-Scholes options valuation formula, would agree with you. Accountants are very traditionally bound, and arguably appropriately so. However, I think that it’s time for the revolution you suggested.