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Beyond point estimates, financial statements edition

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We need to adopt a corporate performance statement that is transparent and relevant for assessing value. This should include two separate sections: the cash flows the company realised during the reporting period and estimates of the company's future cash flow commitments. The statement begins with revenue and deducts cash outlays for operating expenses and capital investments to arrive at free cash flow. This is the cash available to pay interest and dividends and gives investors a baseline from which they can assess the company's prospects. Clearly stating the individual items that determine free cash flow is the best way to serve investors.
The second section presents estimates of the cash flows that the company anticipates it will need to satisfy future financial commitments, such as pension liabilities. Reporting a single estimate to capture an uncertain amount leaves investors in the dark. This corporate performance statement presents a most likely, an optimistic and a pessimistic estimate for each account. Management's discussion of the factors driving the estimates and the likelihood of each enables investors to form their own expectations in an informed fashion.

The corporate performance statement would have been useful, for instance, in informing the debate over how to value mortgage-backed securities during the subprime lending crisis. Critics argued that forcing banks to write down their long-duration securities to fire-sale prices understated their value and exacerbated the financial meltdown. Other observers maintained that the low prices fairly reflected the poor decisions companies had made, and that investors were entitled to know the unvarnished truth. This type of controversy vanishes when there are three estimates. Fire-sale prices are appropriate for the pessimistic estimate if it is likely that creditors or regulators will force the bank to sell assets to stay afloat.

The optimistic scenario reflects the present value of holding the securities until market prices recover. The most-likely estimate lies in between. This disclosure acknowledges that there is no right answer, only a range of possibilities.
When investors and creditors have the information they need to manage their risks, they lower the rate of return that they demand. A lower cost of capital allows companies to invest profitably in more projects, leading to stronger economic growth.
Investors, managers and accountants are all heavily invested in the current accounting model. But this corporate performance statement offers benefits too great to ignore: not only more useful information, but greater trust in public companies and capital markets.

-- Michael Mauboussin and Alfred Rappaport


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