Demo Briefing – EarningsPower Accounting™

The demonstration starts with the formation of a hypothetical company on December 31, 2010, with shareholders contributing a five-year zero-coupon government bond worth $1000.00 that yields 5%. Both the principal and interest are repaid on December 31, 2015, totaling $1276.28.

The December 31, 2010, balance sheet is shown in Columns B and E at the top of the demo screen.

This demonstration concerns generating financial statements for the year 2011.

The Default Case is initially presented. Some users may experience the Default Case as somewhat purposeless, but it demonstrates the structure and operations of EarningsPower Accounting. After considering the Default Case, the reader is invited to experiment with different interest rates to witness the separation between recurring income and windfalls.

5% Default Case

Assuming the 5% interest rate remains constant, by the middle of 2011, the value of the bond will have increased to $1024.70. Marking-to-market triggers a debit to the bond asset account and a credit to a new type of income statement account, called the windfall account. The windfall posting is shown on the EarningsPower Accounting Income Statement 2011 of the demo screen (Cell B10).

In the Default Case, the interest rate remains at 5% at the end of 2011, and the value of the bond increases to $1050.00, triggering a $25.30 debit to the asset account and a credit to the same windfall account, as shown in Cell C10 of the demo screen. At this point, the balance sheet entry of the government bond is complete, reflecting current market values as championed by fair-value advocates, and as shown in Cell C1 of the balance sheet at the top of the demo screen.

Now, at the close of 2011, the Ex Ante Equation™ is applied using the $1050.00 bond value and the current 5% yield, yielding a $50.00 Ex Ante Income. This $50.00 is the amount of capital base ($1050.00) that can be consumed on December 31, 2011, with the expectation that the remaining value will appreciate to the December 31, 2011 value of $1050.00 by December 31, 2012. This is graphically shown in the middle of the demo screen where, at the start of 2012, the retained-bond–portion value drops by the Ex Ante income of $50.00 (because of presumed consumption), and then appreciates and reaches the $1050.00 value by the end of 2012.

The $50.00 Ex Ante Income is posted as a debit to the windfall account and as a credit to a second new type of income statement account, called the asset income account, as shown in Column D of the income statement.

Tallying asset income in Column E of the income statement yields a net income of $50.00. This is recurring and permanent income because if the status quo holds, then $50.00 could be paid as dividends perpetually. In other words, $50.00 is earnings power. This is the type of net income championed by fair-value opponents, i.e., opponents grounded in traditional revenue and expense and historic costing.

The value of Cell E10 is analogous to Stern-Stewards’ Economic Value Added (EVA) calculation. Both represent deviations from expectations, with EVA applicable to a business unit and the cell value here (Cell E10) applicable to a single asset.

If the bond performs as expected, the net result is a zero windfall account balance, as shown. If the bond performs better than expected, the net result is a positive windfall account balance, representing a capital gain. If the bond underperforms, the net result is a negative windfall account balance, representing a capital loss.

User Cases

The user is invited to experiment with different interest rates as of the end of the bond’s first year, 2011.

If the user specifies that the four-year risk-free rate is 10%, the user will see that the bond decreases in value to $871.72 from the mid-year value of $1024.70, resulting in a comprehensive income loss of $128.28 (Cell E11, EarningsPower Accounting™ Income Statement 2011 of the demo screen). However, the net income has increased to $79.25. While the value of the bond has decreased, owning the bond still yields an expected positive return. While it is perhaps counterintuitive that the bond-asset income increases, the increased net income is the result of the Ex Ante Equation, yielding the amount that can be consumed on December 31, 2011, with the expectation that the capital base will return to the $871.72 value on December 31, 2012 (see graph).

While interest rates are not empirically constant, using the current interest yields an unbiased estimate of Ex Ante Income, because, on average, the current rate is the best estimate of the future rate.

For all four-year risk-free rates, EarningsPower Accounting isolates and separates net income earnings power and windfalls. With EarningsPower Accounting, the balance sheet is simultaneously based upon fair market values—serving fair-value advocates; the income statement yields an improved recurring permanent net income—also serving fair-value opponents. Thus, with EarningsPower Accounting, you get the best of both worlds.

Prior-Method Comparisons

Below the graph on the demo screen are balance sheets and income statements generated according to the revenue-and-expense and fair-value accounting methods. As can be seen, by changing the four-year risk-free rate, the revenue-and-expense financial statements are impervious to market changes. Fair-value accounting tracks the market, yielding an accurate, valid, and useful balance sheet, but fails to provide any measurement of recurring income.

These prior methods are pure-form, meaning that each makes no consideration or allowance for the other. In other words, they represent strict orthodox implementations. In today’s practice, the two prior methods are confounded, essentially as compromises, reflecting a lack of an agreed conceptual framework.

The comprehensive income loss of $128.28 introduced above is the reported net income under pure-form fair-value accounting, as the accounting boards, according to their ideal, would calculate. The problem, however, is that the $128.28 figure has little significance for going forward; it is unsuitable for dividend determination or price-to-earnings ratio analysis since it is a “loss.” It says nothing regarding what can be consumed, with the expectation that the capital base is preserved. It says nothing regarding what the income for the next period, the year 2012, will be. In short, to quote Nobel laureate economist J.R. Hicks, “On the general principle of ‘bygones are bygones’, it [fair-value net income; comprehensive income] can have no relevance to present decisions” (Hicks, J. R. (1946). Value and Capital, 2nd ed, p. 172).

Notes

1. While this demo entails only a single asset, multiple assets and liabilities are handled analogously.
   
   
2. Revenues and expenses are posted as they are currently posted in today’s practice, except that asset and liability mark-to-market postings are made to windfall accounts.