06/18/2015

Extended Yield methods:Part 4

Where's the Sunshine? 

To sum up, extended yield methods were designed to deal with complex cash flows (cash flows wherein the rolling sum of the flows change signs more than once). they go from negative to positive and back to negative then to positive again such that their rolling forward sums give rise to yield curves that cross the zero rate axis more than once. The intent was and is to eliminate the wild swings in cash flows so as to limit the sign changes to only one.  Doing so eliminates the potential for other positive rates existing in the modified flow.  Any method that does not eliminate the multiple yield potential from the cash flows is not doing its' job. It leaves us with a transaction that can't be represented by rate of return, as many or more than one rate may exist. To pick one rate ignores the rest.  It also facilitates  the manipulation of rate by making it easy to move cash flows around the term as long the total flows remain the same. Many yield rates can be sought and landed on for many different adjusted flows using the "Pick Your Rate" method. This makes the model entirely arbitrary and hence unacceptable. It is not logically computed and does not provide a unique computation of rate inherent to the flow. It is just one of many rates that performs a mathematical function of resolving the present value to zero and nothing more.

We have tried to relate in this discussion how and why rate analysis must adhere to the mathematical principles espoused by Descartes' rule of signs.  The genesis of extended yield methods was created for the sole purpose of making it possible to adhere  to Descartes rule of signs.

PAMS-DCF's yield engine checks for adherence to Descartes' rule of signs in both the initially presented unmodified flow and the modified flow, giving appropriate warnings when necessary. If someone wishes to use  a non-unique rate to distribute income over the transaction term,  then they can do so. It may be a misrepresentation of the return on the transaction, and it may give rise to violations of good accounting principles that call for using a distribution that matches costs against revenues, full disclosure, a non-arbitrary basis for computation, etc., but so be it. The Investment Tax Credit  (does anyone remember the ITC ?) was taken into income all in the year of acquisition and not amortized over the life of the asset as good accounting demanded. The accounting profession objected loudly but with little success.  Congress said it was OK. 

Similar to the MISFM (Legacy), the ITC accounting served as an immediate economic incentive resulting in increased earnings per share in the early years. Rules are broken all day long, and principals are violated over and over again, but one should be aware of the what and wherefore of these issues so that they are not misapplied to other situations. I repeat, the MISFM-Legacy had and may have a place, but not as representing a good example of yield analysis techniques.

We intend to demonstrate  that new investment is a non-starter in building cash flow models and using discounted cash flow analysis. We will be using examples of FASB13 in the next installment of this discussion on "Extended Yield Methods" because it is a well known example and easily available for study. It will clearly show that the modified cash flow generated by the MISFM-Legacy results in arbitrarily adjusted cash flows distribution of income and is not the only rate that , once given the freedom to introduce "new Capital",  that will discount other adjusted flows  to zero within the confines of the transactions net income.  We will then proceed to review one or two methods that do work to eliminate the multiple yield issue and what their impact is on the timing of profit recognition within the transaction. 

The entire purpose of this exercise is to demonstrate that Descartes  Rule of Signs must be adhered to and that "Extended Methods" were created to for the sole purpose of making this possible. To have created a method such as the MISFM-Legacy that only partially adheres to the " rule of signs" by providing for only the first few negative flow and ignoring  the remaining negative flows is at best obscuring the technically correct approach, demonstrating incorrect concepts and principals and causing confusion about the techniques used in DCF analysis. It is an example of  obfuscation at its' best. That is perhaps one reason it is being abandoned, except that the current thought is to abandon all after tax accounting recognition done using good DCF techniques or bad ones. On the positive side the MISFM-Legacy added incentive to do these transactions. I do not see why EPS has to be tied to good DCF techniques! Let the EPS issue be whatever the parties agree to, but the mathematical truisms should always be honored.

As an aside, FASB13 is a great publication and it broke new ground in accounting in many areas.  The concepts as noted in our book that accompanies PAMS-DCF, should not be discarded. They included the "Economic Reality" concept, and substance over form concepts that FASB13 dealt with. That FASB13 did not land on a proper method for use in distributing  leveraged lease income is a minor flaw in the overall achievement, and can be easily fixed by simply clarifying the need to adhere to Descartes Rule of Signs. Any method that results in an inherent unique yield should be acceptable to spread income with. Yes, changes can be made that will improve FASB13 in several areas, but discarding after tax analysis and reporting is not necessarily one of them.

An argument can be made that leveraged leases are less needed in today's tax environment as companies are paying much lower effective tax rates than in the past, but that can change quickly. Further, leveraged lease accounting may be more trouble than it is worth from some peoples perspective, however, it was the segue into areas of finance that accounting types such as myself never had cause to look at. Perhaps it is simply to complex to deal with from a practical standpoint. The economic analysis of a leveraged lease or a leveraged real estate transaction, or business acquisitions, etc..will always require good DCF understanding and techniques regardless of what happens to FASB13.

   Congress would not allow accounting firms to write an exception when ITC was taken in year one. I don't know of any firms that did. The Financial Accounting Standards Board may not allow pretax income to be distributed on an after tax proportional basis as conceived of when the deal is done, but that does not change the reality of why it was done and how it will be earning real cash. It is a step backwards for the accounting profession to throw it all out ( in my humble opinion).

(to be continued using examples as Part 5 " A Picture is Worth 1,000 Words")