By Jefferson P. Jones
First New Concepts Statement in 15 Years
Statements of financial accounting concepts are issued from time to time as part of a conceptual framework for use by FASB in developing standards for financial accounting and reporting. The framework helps provide consistency and a sense of purpose and direction for new standards.
In June 1997, FASB issued a proposed concepts statement on using cash flow information in accounting measurements. After considering the comments received, FASB changed two of the fundamental conclusions contained in the 1997 ED and decided to issue a new draft. A March 31, 1999, revision, with a comment deadline of August 1, 1999, took the position that the sole purpose of using present value measurements at initial recognition (and for fresh starts) is for determination of fair value. The earlier proposal had given other purposes.
The 1999 proposal, in addition to limiting the purpose of present value measurements at initial recognition, presents the concepts that would apply when calculating present values where there is a range of estimated cash flows. The ED also speaks of the need to adjust cash flows to reflect the uncertainty of the estimates and, in the case of liabilities, the credit standing of the issuer.
FASB would like to issue a final statement in early 2000. Its ultimate impact rests with the subsequent standards that are developed using the concepts.
FASB, in Statement of Financial Accounting Concepts (SFAC) No. 5, set forth fundamental recognition and measurement criteria to be used as guidance in determining what information should be included in financial statements. As part of this project, FASB discussed the use of present valuebased measurements as a measurement attribute, but did not explore the complex issues involved in measuring the present value of future cash flows. Subsequent to the issuance of SFAC No. 5, FASB has advocated estimated cash flows (and, by implication, the use of present value techniques) as a basis for measuring an asset or liability in many accounting standards. However, without a common understanding of the objectives of present valuebased measurements and an explanation of how to employ present value techniques in accounting measurement, current practice has been to solve these issues on a piecemeal basis.
FASB, in an attempt to address these concerns, has issued an exposure draft, Using Cash Flow Information and Present Value in Accounting Measurements. This is a revision of a June 1997 exposure draft, Using Cash Flow Information in Accounting Measurements. As of this writing, FASB is expected to issue either a final concept statement or a revised exposure draft in the first quarter of 2000. If a final document is issued, it would be the first new SFAC since 1985, and FASB would be the first standards setter to incorporate present value techniques into its conceptual framework.
Present Value: Relevance Gained?
The argument behind the use of present value techniques is that more relevant information is produced due to factoring in the uncertainties and risks associated with the amount and timing of cash flows. This form of accounting measurement is designed to capture the economic substance of a set of cash flows in a manner similar to that of how the market behaves. In other words, present value techniques attempt to measure assets (or liabilities) at their fair value.
Opponents of the use of present value in accounting measurements argue that its application results in a decrease in the reliability of accounting information. A present value calculation requires numerous estimates regarding the timing and amount of future cash flows, interest rates, and economic conditions. The use of these estimates is seen as a threat to the reliability of accounting information either through differing opinions as to future conditions (decreased verifiability of estimates), or through the introduction of bias in estimates (decreased neutrality). In the exposure draft, FASB has taken the position that the use of present value techniques should result in more relevant information being provided to financial statement users without sufficiently damaging the reliability of the information.
Fair Value As a Measurement Attribute. FASB has identified fair value as the sole objective when present value techniques are applied in measuring assets or liabilities at the time of initial recognition (or for fresh start measurements). This is the fundamental change that FASB made to its 1997 proposal. That earlier draft conceptualized that present value as a measurement technique could have other objectives for initial recognition purposes. In adopting fair value as the measurement attribute, FASB is attempting to "capture the elements that taken together would comprise a market price if one existed."
The adoption of fair value as a measurement attribute necessitates the use of market-based assumptions about the asset or liability's utility, future cash flows, uncertainties, and risk premium demanded to bear these uncertainties. As set forth in an alternative view section of the 1999 exposure draft, it can be argued that market-based assumptions are not relevant if an entity is engaged in the acquisition or settlement of nonfinancial assets or liabilities in a noncurrent transaction. In such a situation, an alternative approach, such as entity-specific value (the fair value unique to the entity based on entity-specific assumptions of cash flows or risk premium) or cost accumulation may be more relevant and appropriate.
FASB concluded, however, that the fair value estimate resulting from present valuebased measurements using market-based assumptions better captures the economic differences between assets (or liabilities) and provides more relevant information than other possible measurement attributes. FASB does acknowledge that entity-specific assumptions may be used when market assumptions are not available, and there is no evidence indicating that they would differ from the entity's assumptions.
Risk Adjustment. Given the above measurement objective, accounting measurements employing present value techniques should contain an adjustment that reflects the market risks and uncertainties related to the asset or liability being measured. Because the market demands a premium in dealing with risks and uncertainties, any measurement attempting to simulate a market price must do so as well. Additionally, FASB advocates that the credit standing of the entity obligated to pay should always be considered when measuring a liability.
Expected Cash Flow Approach. Traditionally, the risk adjustment is accomplished by adjusting the discount factor (interest rate). The greater the risk, the higher the interest rate used to discount the cash flows. However, FASB appears to favor incorporating risk and uncertainty by developing a probability-weighted cash flow estimate that utilizes a wider range of information and then discounting these expected cash flows by the risk-free interest rate. In FASB's view, this would be especially appropriate where present value techniques are being used to value assets.
The use of probabilities in this expected cash flow approach, while injecting a measure of imprecision, is expected to have several advantages over using a single estimate of cash flows. First, a broader set of information is utilized in the measurement process because a wide range of possible outcomes is considered rather than a single, best estimate. Second, the use of probabilities should make any assumptions about the uncertainties of the cash flow stream explicit, whereas the traditional approach buries these assumptions within the interest rate. Third, a reliable estimate of the market risk premium may often not be available, making the risk-free interest rate the most reliably determined value. Finally, the use of probability-weighted cash flows allows for an explicit adjustment for uncertainties with regard to the timing of cash flows, in addition to uncertainties with regard to the amount of cash flows.
While both approaches are conceptually consistent, FASB has left the choice as to the method of risk adjustment up to either the entity or to the context of a specific standard. As noted by the American Accounting Association's Financial Accounting Standards Committee, there may be circumstances in which it is easier and more reliable to use a readily available market rate of interest to discount expected cash flows.
Unique Aspects of Liabilities. FASB concluded that the concepts developed for the use of present value measurement in initial recognition of assets also apply to liabilities. Liabilities, however, create the following unique problems:
* The measure of fair value of an entity's notes or bonds is the price other entities are willing to pay to hold those notes or bonds. For example, the proceeds of a loan are the price that the lender is willing to pay and represent fair value for initial measurement.
* The measure of fair value of a liability should always reflect the credit standing of the borrower. This is normally reflected in the market rate of interest that the borrower has to pay. This would be true whether the liability was for bonds, notes payable, or warranties.
Two examples are presented below to illustrate how the proposed concept statement may affect accounting measurement. It should be noted at this point that because the concepts do not establish GAAP, the issuance of a final statement of FASB will not mandate the accounting treatment shown below. Instead, these illustrations are merely applications of the ideas found in the exposure draft. Presumably, FASB will use the concepts in the development of future standards, at which time they would become GAAP.
Example 1: Receivables. Assume that, on January 1, 1998, ABC renders landscaping services to XYZ. In exchange for these services, ABC accepts a $5,000 down payment and a $20,000 zero-interest-bearing note that is payable in two equal annual installments of $10,000 beginning December 31, 1998. The fair value of the services is not readily determinable, and the note is not readily marketable. After considering factors such as credit standing, the absence of collateral, and the prevailing interest rate on similar transactions, ABC determines that 9% is an appropriate interest rate. It is made up of two elements: a risk-free rate of 5% and an adjustment to reflect the uncertainty about the future cash flows. The present value of the note and the imputed fair value of the landscaping services is computed as follows:
Annual payments $10,000
(2 periods @ 9%) 1.75911
|Present value of note
Present value of services
Based on this calculation, ABC would make the following journal entry:
Notes Receivable 20,000
Discount on Notes Receivable (2,409)
Landscape Service Revenue (22,591)
Following the examples in the exposure draft, FASB would make the calculation by reducing the cash flows by an amount representing the estimated uncertainty about the future cash flows to which a risk-free discount rate would be applied. However, when a reliable and readily available market interest rate exists and the cash flows are contractually determined, the uncertainty and risk adjustment is most easily made by selecting a risk-adjusted interest rate. Attempting to adjust future cash flows would require estimates that are impracticable and would introduce an unnecessary and unreliable element in the measurement process. It should be noted that the use of present value techniques, in this context, is consistent with current practice.
Beyond initial recognition, current practice would employ the effective interest method to amortize the discount. As long as the estimates of the amount or timing of the expected cash flows do not change, this will result in the note receivable being carried in the accounting records at its present value. However, it is possible that, over time, the assessment of uncertainty and risk would change, resulting in a change in the underlying cash flows. This would produce an inconsistency between the value of the recorded asset and the present value of future cash flows.
In such a situation, FASB has identified two options: 1) adjust the amortization scheme or 2) remeasure the asset or liability. If the amortization scheme is adjusted, the proposed concept statement advocates the use of a catch-up adjustment that would adjust the carrying amount of the asset to the present value of the future expected cash flows using the original effective interest rate. This catch-up adjustment is favored over prospective or retrospective approaches to maintain consistency with "the present value relationships portrayed by the interest method." FASB has left the issue as to when remeasurement may be appropriate to specific standards.
Example 2: Warranties. In some situations, contractual cash flows do not exist, and the analysis may be more complicated. Assume that LMN offers a two-year warranty on its product, and warranty costs are expected to be 1% of current sales of $1,000,000. Under current GAAP, a contingent warranty liability of $10,000 is established in the period of the sale based on LMN's estimate of future warranty costs associated with current period sales. The estimated warranty costs are not currently discounted nor adjusted for risk.
Since the determination of an appropriate discount rate may not be feasible, LMN decides to use an expected cash flow approach that incorporates uncertainties with respect to the timing and uncertainties of the cash flows. Although management's "best-guess" of future warranty expense is $10,000 (one percent of $1 million), four probabilities exist with respect to the warranty payments associated with current period sales. These probabilities and their related expected cash flow are shown below, simplified for illustration. In practice, the cash flow estimates may be given as ranges of cash flows with probabilities attached to the ranges. The expected cash flow can then be computed based on an iterative procedure that establishes a probability distribution based on varied combinations of cash flows.
1998 warranty payments:
1999 warranty payments:
Present value at risk-free
interest rate (3%):
(Discount factor) $9,703
This illustration was adapted from "The FASB Project on Present ValueBased Measurements, an Analysis of Deliberations and Techniques," Financial Accounting Series Special Report, February 1996.
The above value, $9,703, represents the probability-weighted expected cash outflow associated with the warranty liability.
This example illustrates three important advantages of the expected cash flow approach. First, when there are non-contractual cash flows and uncertainty exists with respect to the amount and timing of these future cash flows, the use of probability-weighted cash flows allows for an explicit adjustment not present in a "best-guess" estimate. Second, because the determination of the appropriate risk premium may prove intractable, the risk-adjustment is made in the cash flow estimate and the more easily determined risk-free interest rate is used. Third, the use of probabilities allows for the incorporation of a broader set of information in the measurement process. Finally, while there seems to be a broader range of assumptions necessary when the expected cash flow approach is used, it is merely that the use of probabilities makes these assumptions explicit.
The use of present value techniques will affect not only initial measurement of the warranty liability but subsequent accounting as well. For example, since the cash flows were discounted, future expense should include an adjustment for interest expense on the warranty obligation. Additionally, since cash flow and risk estimates are used in the above calculations, there must be some adjustment when the actual warranty expenditures do not equal estimated warranty expenditures. Complicated issues such as these must be resolved by FASB if present value measurement techniques are to be employed in future standards.
This proposed concept statement has four implications for the accounting community. First, it confirms FASB's current focus on fair value accounting. In SFAS 133, Accounting for Derivative and Hedging Activities, FASB, in Paragraph 334 states as follows:
The Board is committed to work diligently toward resolving, in a timely manner, the conceptual and practical issues related to determining the fair values of financial instruments ... and the Board believes that all financial instruments should be carried in the statement of financial position at fair value when the conceptual and measurement issues are resolved.
This concept statement, with its focus on present value measurement techniques, clearly demonstrates FASB's intention to address measurement issues involved in fair value accounting.
The focus on fair value accounting raises the question of whether all accounting measurements will eventually be estimates of fair value. Paragraph 19 of the exposure draft states that "the Board expects to adopt fair value as the measurement attribute when applying present value techniques in the initial and fresh-start measurement of assets and liabilities." This statement indicates that FASB, which has previously shown no interest in taking fair value measurements beyond financial instruments, may be changing its tune. This exposure draft certainly establishes the foundation for fair value estimates of assets or liabilities for which reasonable cash flow estimates can be made. These ideas can already be easily applied to the measurement of monetary assets and liabilities with contractually determined cash flows; however, the application of these ideas to other assets and liabilities (e.g. contingent liabilities) will require future guidance.
Second, it is significant that FASB decided to focus on measurement issues only and to decide on recognition issues and fresh start measurement questions on a project-by-project basis. Specifics of classes of individual transactions make a general determination of recognition issues nearly impossible. Additionally, recognition issues are more politically contentious than measurement issues. Therefore, FASB has left these issues to its due process procedures of future standards. However, the specification of these measurement concepts has made the introduction of fair value in future standards much easier. Instead of having to determine when and how the fair value of an asset or liability should be measured, the concept statement has allowed FASB to focus mainly on when fair value measurement is appropriate. Also, the addition of present value to the conceptual framework has more clearly defined and solidified fair value as an appropriate measurement attribute.
Third, reliability concerns and the possibility of bias in the application of the present value techniques seems to indicate that increased disclosure of the assumptions made in the cash flow, interest rate, and risk estimates will be necessary. Without the increased disclosure, reliability concerns may outweigh any possible increase in relevance.
Finally, the ideas discussed in this concept statement refer to the measurement of assets and liabilities. If present value techniques are to be used in situations beyond initial measurement (e.g., effective interest amortization) and articulation is to be maintained, the measurement must have an effect on either earnings or comprehensive income. The effect of using present value techniques in both initial and subsequent measurements will almost certainly result in increased volatility of reported income. The effect of such a measurement and the method of presentation will certainly be a point of discussion in future standards. *
Jefferson P. Jones, PhD, CPA, is an assistant professor of accounting at Auburn University. He can be reached at firstname.lastname@example.org.
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