Copyright 2001 Gale Group, Inc.
Copyright 2001 National Society of Public Accountants
The National Public Accountant
May 1, 2001
An Analysis of Statement of Financial Accounting Concepts No. 7: Using Cash Flow Information and Present Value in Accounting Measurements; Statistical Data Included
This statement is part of the FASB's Conceptual Framework. As such, it does not represent a new standard that sets forth required accounting or disclosure methods in financial reporting. This statement explains the concepts and techniques that will be used for financial accounting standards to be issued by the FASB in the future. Put another way, this statement should lay the foundation for upcoming FASB standards on accounting and disclosure issues.
In 1988, the FASB began to examine the subject of present valuation as an accounting measure. In 1990, the Board prepared a discussion memorandum on this topic. The Board then issued a special report on the present value project in 1996. An exposure draft of a proposed statement followed in 1997. In 1999, the Board released a second exposure draft after reconsidering the purpose of present valuation in accounting. Finally, Concepts Statement No. 7 was issued early in 2000.
This statement discusses the objective of present valuation in the accounting measurement process and also furnishes procedures for applying this technique. The statement constitutes a guide to application of present valuation in accounting particularly when the future amounts or timing of cash flows are uncertain. The statement stresses measurement rather than recognition issues.
Present valuation can serve to explain the difference between two or more sets of future non-discounted cash flows in a decision situation, and thus can be a relevant tool in decision making. As such, present valuation involves the time value of money in its computations. As the statement asserts: "To provide relevant information in financial reporting, present value must represent some observable measurement attribute of assets or liabilities... [F]or some assets and liabilities, management's estimates may be the only available information. In such cases, the objective is to estimate the price likely to exist in the market place..." Thus, present valuation is useful as a proxy for an observable market value.
The statement provides a detailed analysis of the present value model, the components of which are as follows (p. 15):
a. An estimate of the future cash flow, or in more complex cases, series of future cash flows at different time
b. Expectations about possible variations in the amount or timing of those cash flows
c. The time value of money, represented by the risk-free rate of interest
d. The price for bearing the uncertainty inherent in the asset or liability
Other, sometimes unidentifiable, factors including illiquidity and market imperfections.
Accounting measurements that apply present valuation should incorporate the uncertainties associated with forecasting cash flows. This statement focuses on an "expected cash flow" approach. Only the time value of money in terms of a risk-free interest rate is incorporated into the discount rate in this approach. Adjusting expected cash flows reflects risk. Uncertain cash flows can be adjusted downward to reflect expectations and a risk premium before being discounted.
See Exhibit 1. By contrast, the traditional application of present value uses only one set of cash flows and one discount rate, generally including risk from cash flow changes in amounts and timing, among other factors, in the discount rate. Selecting this rate is most critical in this approach. However, the FASB contends that a single discount rate in the traditional present value model cannot incorporate uncertainty regarding the timing of future cash flows.
This statement considers present valuation of liabilities, as well as assets. The FASB asserts that "the most relevant measurement of an entity's liabilities should always reflect the credit standing of the entity' That determines the interest rate used.
As Concepts Statement 7 observes (pp. 12-13): The best estimate of the present value of cash flows is not necessarily the fair value. Among the reasons that a difference may occur between fair value and present value are the following (pp. 12-13):
a. The entity's managers might intend different use or settlement than that anticipated by others. For example, they might intend to operate a property as a bowling alley, even though others in the marketplace consider its highest and best use to be a parking lot.
b. The entity's managers may prefer to accept risk of a liability (like a product warranty) and manage it internally, rather than transferring that liability to another entity.
c. The entity might hold special preferences, like tax or zoning variances, not available to others.
d. The entity might hold information, trade secrets, or processes that allow it to realize (or avoid paying) cash flows that differ from others' expectations.
e. The entity might be able to realize or pay amounts through use of internal resources. For example, an entity that manufactures materials used in particular processes acquires those materials at cost, rather than the market charged to others. An entity that chooses to satisfy a liability with internal resources may avoid the markup or anticipated profit charged by outside contractors.
The statement recommends that if the timing or amounts of cash flows were to change and the balance sheet item is not given a "fresh start" measurement, an interest method of allocation (e.g., amortization of discount or premium) also should be changed to modify the carrying amount of the item in order to reflect the present value of the revised future cash flows using the original discount rate. The statement does not indicate when fresh-start measurements should be made, deferring that determination to future accounting standards.
The variety of interest rate and cash flow conventions used in a number of different accounting standards motivated this new concepts statement. The appendix to this paper gives a list of such existing standards. The FASB has previously been reluctant to extend applications of present valuation to accounting measurement without first developing a conceptual framework on this subject. Now that the Board has formulated such a framework, we can expect to see new accounting standards dealing with present valuation of assets and liabilities. Other standard setters--in the United Kingdom (U.K.), International Accounting Standards Committee (IASC), and the G4 + 1 (i.e., Australia, Canada, New Zealand, UK, US, and IASC) have also recently examined the present value measurement.
List of APB and FASB Standards Involving Present Valuation
1. APB (Accounting Principles Board) Opinion No. 12, "Ommbus Opinion," 196. This opinion deals with amortization of a discount or premium on bonds payable.
2. APB Opinion No. 16, "Business Combinations," 1970. Assets acquired by incurring liabilities should reflect the present value of the debt. Interest accrued should also be based on those present values.
3. APB Opinion No. 21, "Interest on Receivables and Payables," 1971. In a note exchanged for assets other than cash, a fair value interest rate has to be determined to present value of the transaction.
4. APB Opinion No. 26, "Early Extinguishment of Debt," 1972. The exchange of new securities can involve present value analysis.
5. FASB Statement No. 13, "Accounting for Leases," 1976. Capital leases as well as direct-financing and sales-type leases involve present valuation.
6. FASB Statement No. 22, "Changes in die Provisions of Lease Agreements Resulting from Refundings of Tax-Exempt Debt," 1978. Refunding entails computing an effective interest rate on new borrowing.
7. FASB Statement No. 28, "Accounting for Sales with Leasebacks," 1979. Deferred profit on a sales-leaseback assuming an operating lease is the present value of minimum lease payments.
8. FASB Statement No. 60, "Accounting and Reporting by Insurance Enterprises," 1982. Liability for future policyholder benefits involves present valuation.
9. FASB Statement No. 63, "Financial Reporting by Broadcasters," 1982. License payments are measurable for assets and liabilities using present valuation.
10. FASB Statement No. 66, "Accounting for Sales of Real Estate," 1982. Deferred profits are measurable using present values.
11. FASB Statement No. 72, "Accounting for Certain Acquisitions of flanking or Thrift Institutions," 1983. Amortization of intangibles from acquisitions uses a constant rate when applied to carrying value of interest-bearing assets.
12. FASB Statement No. 87, "Employers' Accounting for Pensions," 1985. Pension obligations are based on actuarial present value.
13. FASB Statement No. 90, "Regulated Enterprises -- Accounting for Abandonments and Disallowances of Plant Costs," 1986. Regulatory assets are amortized using a constant effective yield.
14. FASB Statement No. 91, "Accounting for Nonrefundable Fees and Costs Associated with Originating or Acquiring Loans and Initial Direct Costs of Leases," 1986. Origination fees over life of a loan adjust die yield on net investment in the loan.
15. FASB Statement No. 97," Accounting and Reporting by Insurance Enterprises for Certain Long-Duration Contracts and for Realized Gains and Losses from the Sale of Investments," 1987. Amortization of deferred policy acquisition Costs is based on the present value of expected gross profits.
16. FASB Statements No. 106, "Employers' Accounting for Postretirement Benefits Other Than Pensions," 1990. The obligations are actuarial present values.
17. FASB Statement No. 113, "Accounting and Reporting for Reinsurance of Short Duration and Long-Duration Contracts," 1992. Deferred gains are amortized using an effective interest rate when amounts and timing can be reasonably estimated.
18. FASB Statement No. 114, "Accounting by Creditors for impairment of a Loan," 1993. The balance of the net carrying amount of die loan is adjusted to the present value of future cash flows using the initial interest rate.
19. FASB Statement No. 116, "Accounting for Contributions Received and Contributions Made, 1993." Amortization of pledges receivable and payable involves an effective interest rate.
20. FASB Statement No. 121, "Accounting for Impairment of Long-Lived Assets to Be Disposed of," 1995. Present valuation is used to estimate the fair value of such assets.
21. FASB Statement No. 125, "Accounting for Transfers and Servicing of Financial Assets and Extinguishment of Liabilities," 1996. Present valuation can be used to estimate the fair value of assets received and liabilities incurred.
Robert Bloom is a Professor of Accountancy at John Carroll University in Cleveland, Ohio. He is the author of many accounting publications, including articles and books. He has taught at a number of U.S. and Canadian universities.
(**.) This is a very abbreviated version of Appendix B in Concepts Statement 7, pp. 43-54.