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Computing Present Value:
What You Need to Know
about the Latest Guidelines
Paul Munter
The FASB recently issued a revised concept statement on present value. The
author reviews the key issues you need to know—and their important implications.
© 1999 John Wiley & Sons, Inc.
O
n June 11, 1997, the Financial Accounting Standards Board (FASB) issued
a proposed Statement of Financial Accounting Concepts entitled Using
Cash Flow Information in Accounting Measurements. The proposed Concepts
Statement represented the work of the FASB on its agenda project on interest
methods. This is a long-lived project, having been on the FASB’s agenda since
1988. In issuing a proposed concepts statement rather than a statement of
financial accounting standards, the FASB is, in essence, attempting to give
practitioners (as well as itself) guidance on the Board’s thinking as it prepares
to examine individual projects which have interest implications. As such, the
proposed concepts statement would not amend or supersede any existing
standard. While the original exposure draft outlined much of the FASB’s
thinking, after considering comments to that document, the FASB has more
recently issued a revised exposure draft on the subject. This article will discuss
both the original conclusions of the FASB as well as the more recent conclusions
as described in the latest exposure draft.
OBJECTIVE OF PRESENT VALUE COMPUTATIONS
The objective of present value computations is to capture the economic
difference between different sets of cash flows. As the original proposal discussed,
those future cash flows can differ with regard to either amount or timing. To
illustrate, consider the following four extreme situations:
Paul Munter, Ph.D., CPA, is a
KPMG Peat Marwick Professor of
Accounting at the University of
Miami. He is editor-in-chief of The
Journal of Corporate Accounting &
Finance.
•
•
•
•
A riskless cash flow of $1,000 due in one day
A riskless cash flow of $1,000 due in ten years
A risky cash flow of $1,000 due in one day
A risky cash flow of $1,000 due in ten years.
CCC 1044-8136/99/1101109-06
© 1999 John Wiley & Sons, Inc.
109
Paul Munter
Clearly, these four future cash flows do not all have the same value. Indeed,
no two of those cash flows has the same value. Thus, the FASB argues that
present value computations should reflect both uncertainty and risk, since the
computation is a function of both amount and timing of future cash flows. To
illustrate further, consider the following example (which is taken from the
FASB’s original proposed Concepts Statement):
Company A loans $1,000 to Company B. B agrees to repay $1,220 in 1 year.
This results in an annual interest rate of 22% and yielding a present value
on the note of $1,000. The 22% interest rate determined as appropriate by
A might have been determined by considering the following factors:
Interest rate of risk-free investments
Thus, A could receive from investing in
risk-free investments
5.00%
$1,050
Assume that there is a pool of borrowers
similar to B
1,000 loans
A expects a default rate of 10.8% on this pool
of borrowers
(108)
Borrowers who will repay and provide A with
a suitable return
892
Additional adjustment by A for other potential defaults
(30)
862
Loans on which returns will be provided
To earn a risk-free rate on all loans ($1,050 per loan),
amount A must charge each lender
([1,000 loans x $1,050]/862 loans)
$1,220 (rounded)
ORIGINAL PROPOSAL
A key component of the
original proposal was the
FASB’s consideration of
different measures of fair
value.
A key component of the original proposal was the FASB’s consideration of
different measures of fair value. In particular, the FASB discussed the distinction
between a fair value present value measure versus an entity-specific value. These
differences are summarized in Exhibit 1.
To amplify, the original proposal examined the application of these
concepts in a variety of situations including the distinction between initial
measurement and fresh-start measurements. Initial measurement of assets
is typically based on some observable measurement attribute (the amount
of cash paid being the best attribute if it is available). If an observable
measure is not available, or if the entity wishes to develop an entity-specific
amount, future cash flow information can then be used. The FASB originally
argued that the following general principles applied to present value
techniques for use in measuring assets:
•
•
110
To the extent possible, the estimated cash flows and interest rates
should reflect assumptions about all future events and uncertainties
that would be considered in deciding whether to acquire an asset or
group of assets in an arm’s-length transaction for cash.
Interest rates should reflect assumptions that are consistent with
those inherent in the estimated cash flows. Otherwise, the effect of
The Journal of Corporate Accounting and Finance/Autumn 1999
Computing Present Value: What You Need to Know about the Latest Guidelines
Exhibit 1. Distinctions between Fair Value and Entity-Specific Value
General statement
Fair Value
Entity-Specific Value
The amount at which an
asset (liability)could be
bought (incurred) or sold
(settled) in a current
transaction between
willing parties
The amount at which
independent willing
parties that share the
same information and
assumptions about the
entity’s estimated future
cash flows would agree
to a transaction
Assumed cash flows Those that the market
would assume based on
the market’s expectation
of an asset’s use or a
liability’s settlement
Those that the entity
expects from its use of
an asset or settlement
of a liability over the
item’s expected life and
that reflect the role of
the entity’s proprietary
skills in that use or
settlement
Adjustment for risk
An adjustment that the
market would demand
for cash flows with
similar risk, applied to
the entity’s expectation
of cash flows
•
•
An adjustment that the
market would demand
for cash flows with
similar risk, applied to the
market’s expectation of
cash flows
some assumptions will either be double-counted or ignored. For
example, an interest rate normally applied to contractual cash flows
will reflect exceptions about future defaults (as shown in the previous
illustration). That same rate should not be used to discount expected
cash flows since they are reflected in the assumptions about future
defaults.
Estimated cash flows and interest rates should be free from both bias
and factors unrelated to the asset or group of assets to be measured. For
example, deliberately understating estimated net cash flows to enhance
the reported profitability of the asset in the future introduces bias into
the measurement.
Estimated cash flows or interest rates should reflect the range of
possible outcomes rather than a single most likely, minimum, or
maximum possible amount.
The Journal of Corporate Accounting and Finance/Autumn 1999
111
Paul Munter
While that discussion is applicable to assets, obviously, present-value-based
measurements are applied to liabilities as well. Thus, it would seem that these
concepts should apply equally to valuing liabilities (a point which the FASB
more clearly addresses in the revised exposure draft).
REVISED PROPOSAL
To provide relevant
information in financial
reporting, the FASB has
concluded that the present
value must represent
some observable
measurement attribute of
assets or liabilities.
112
After considering responses to that exposure draft, the FASB has determined
that a revised exposure draft needed to be issued. Thus, on March 31, 1999, the
FASB issued its revised proposed Concepts Statement entitled Using Cash Flow
Information and Present Value in Accounting Measurements (the exposure draft
can be downloaded from the FASB’s Web site at http://www.rutgers.edu/
Accounting/raw/fasb/new/index.html).
Most accounting measurements use an observable marketplace measure
such as cash exchanged, current cost, or current market value. However,
frequently accountants are forced to use estimated future cash flows as a
basis for measuring an asset or a liability. The latest proposed Concepts
Statement attempts to provide a framework for using future cash flows as
the basis for an accounting measurement. It provides general principles
governing the use of present value—particularly when either the amount or
timing (or both) of future cash flows are uncertain. Additionally, the
exposure draft provides additional discussion of the objective of present
value in accounting measurements.
The FASB concluded that it would be appropriate to limit the standard to
measurement issues and not to address recognition questions. Additionally, the
FASB determined that the standard should not specify when fresh-start
measurements would be applied. Subsequently, the FASB expects to address the
question of when fresh-start accounting would be appropriate on a project-byproject basis.
According to the exposure draft, the objective of using present value in an
accounting measurement is to capture the economic difference between sets of
estimate future cash flows. As noted earlier, there is clearly a difference between
a $1,000 cash flow due tomorrow and a $1,000 cash flow due in ten years.
Without present value, these two amounts would appear to be the same. Thus,
a measurement based on the present value of estimated future cash flows
provides more relevant information than a measurement based on the
undiscounted sum of the cash flows.
To provide relevant information in financial reporting, the FASB has
concluded that the present value must represent some observable measurement
attribute of assets or liabilities. It is important to note that in future standardsetting deliberations, the FASB expects to adopt fair value as the measurement
attribute when applying present value techniques in both the initial and freshstart measurements of financial assets and financial liabilities.
An accounting measurement that uses present value should reflect the
uncertainties inherent in the estimated cash flows. If the entity fails to do so,
items with different risks could be reported at similar amounts. The proposed
Concepts Statement describes the effect of uncertainties about the amount and
timing of estimated future cash flows on the measurement of an asset or liability.
A major concern of the FASB is that in the past, accounting applications of
present value have usually used a single set of estimated cash flows and a single
The Journal of Corporate Accounting and Finance/Autumn 1999
Computing Present Value: What You Need to Know about the Latest Guidelines
interest rate. The proposed Concepts Statement introduces the idea of the
expected cash flow approach. This approach differs from the traditional approach
by focusing on explicit assumptions about the range of possible estimated cash
flows and their respective probabilities. According to the FASB, this approach
better accommodates the use of present value techniques when the timing of
cash flows is uncertain.
The measurement of liabilities, however, involves a different problem from
the measurement of assets. Nonetheless, the underlying objective is the same.
Thus, the proposed Concepts Statement describes the techniques that would be
useful in estimating the fair value of liabilities.
Additionally, the proposed Concepts Statement discusses the role of the
entity’s credit standing in the measurement of its liabilities at initial recognition
and fresh-start measurements (thus, directly incorporating credit risk into the
present value computation). Consistent with this conclusion, the proposal
explains the FASB’s conclusions that the most relevant measurement of an
entity’s liabilities should always reflect the credit standing of the entity.
Another consideration is the application of the interest method to the
measurement. The proposed Concepts Statement describes factors that would
typically suggest that the interest method of allocation would be appropriate. It
also discusses the additional factors that would need to be considered in
implementing the amortization method.
As noted earlier, the proposal does not discuss when fresh-start accounting
is appropriate. It does, however, address the accounting for a change in the
estimate amount or timing of future cash flows. If either the amount or timing
of estimate future cash flows changes and the item is not subject to fresh-start
accounting, the interest method of allocation should be altered by a catch-up
approach that adjusts the carrying amount to the present value of the revised
estimated future cash flows, discounted at the original effective interest rate.
Since this is a proposed
Concepts Statement, it will
not necessarily
immediately impact
financial reporting
practices. Nonetheless,
practitioners should be
aware of the FASB’s
progress on this project
because it contains
important implications for
other current agenda
projects, such as
measuring at fair value.
IMPLICATIONS OF THE PROPOSAL
Since this is a proposed Concepts Statement, it will not necessarily
immediately impact financial reporting practices. Nonetheless, practitioners
should be aware of the FASB’s progress on this project because it contains
important implications for other current agenda projects, such as measuring at
fair value. To illustrate the potential implications of this project, consider the
current accounting for contingencies.
Based on the provisions of FAS No. 5, Accounting for Contingencies, a
loss contingency s accrued in the period in which the loss is both probable
and reasonably estimable. However, if the estimated amount is portrayed as
a range (such as if the amount of the loss will be somewhere between
$50,000 and $300,000) with no amount in the range deemed to be “the most
likely outcome,” FASB Interpretation No 14, Reasonable Estimation of the
Amount of a Loss, specifies that the bottom end of the range—$50,000 in
this case—should be accrued. Interpretation No. 14 argues that the amount
of the loss is at least $50,000, thus it is inappropriate to further delay the
recognition of the loss.
However, consider the question of the “expected” cash flows. Is $50,000 the
expected cash flow? The answer, of course, is no. The expected cash flow would
be the weighted average of all possible cash flows. If no amount in the range is
The Journal of Corporate Accounting and Finance/Autumn 1999
113
Paul Munter
deemed to be more likely than any other amount, the expected cash flow would
be the midpoint of the range (or $175,000 in this instance).
Notice how this proposed Concepts Statement would then make a subtle
but important change in the accounting for loss contingencies. Under the
existing literature, if the amount of a loss is specified in terms of a range with no
“most likely outcome,” the top of the range does not impact the accounting for
the contingent loss (although it does need to be disclosed). For example, if the
estimate range is from $50,000 to $300,000, a $50,000 loss would be accrued. If
the estimate range is from $50,000 to $1,000,000, $50,000 would still be the
amount accrued (again, assuming no amount is deemed to be the most likely
outcome). However, using the expected cash flow model, the first range would
result in an accrual of $175,000 while the second range would result in an accrual
of $525,000!
The example of loss
contingencies is one of
many in which estimated
cash flows form the basis
for the accounting
measure.
114
FAR-REACHING IMPLICATIONS
The example of loss contingencies is one of many in which estimated
cash flows form the basis for the accounting measure. Thus, this proposed
Concepts Statement has far-reaching implications for practitioners. Granted,
not immediately; however, as the FASB pursues other specific projects
(notably, the FASB’s current project to establish fair-value accounting for
all financial instruments) with cash flow measures, it is highly likely that the
existing measurement bases currently in use will need revision. Furthermore,
as factors change (such as the estimated timing of the future cash flows or
the appropriate discount rate), entities would need to remeasure the financial
component. This process could introduce both additional complexity and
additional volatility into the financial reporting process. As such,
practitioners should carefully monitor the FASB’s ongoing deliberations
regarding present value-based measures. ♦
The Journal of Corporate Accounting and Finance/Autumn 1999
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