Cash Flow and Present Value in Accounting Measurement

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In 2000, Financial Accounting Standards Board (FASB) issued Statement of Financial Accounting Concepts #7 (SFAC). SFAC 7 states that the present value of cash flow should be used to estimate the fair value. SFAC7 presented a framework for accounting measurements of present value of financial items (assets and liabilities) from future estimated cash flows at initial recognition. It deals only with the measurement issues, not the recognition issues. Measurement methods for liabilities are different for different entities and require factors like credit position of their creditors to be included in the computation of present value. It also provides the principles of how to compute present value amount when the amount and the timing of the future cash flow is uncertain. According to SFAC7, uncertainty and riskiness of the cash flow should be considered for the computation of present value. The method of computation is different than the traditional or prior method in a sense that it considers the range of estimated cash flows, not just a single amount for the cash flow and also their respective probabilities is taken into account. All these factors help to determine the discount rate unlike prior method which had only a fixed discount rate. This helped reduce the variations in prior methods of having different methods for calculating fair value with no controlled direction from generally accepted accounting principles (GAAP). It also deals with the subject concerning the interest method of amortization. Hence, this new framework of present value computation helps to clarify the difference between various sets of cash flows for decision makers in making a more relevant decision.

The Financial Accounting Standards Board (FASB) as standard setter therefore provided SFAC # 7 as guidance to the issues of financial measurement and recognition using the cash flow Information and present value concepts in financial reporting. The FASB proposes a present-value method that takes into account the degree of uncertainty associated with future cash flows among different assets and liabilities. It suggests, rather than use estimated cash flows (in which a single set of cash flows and a single interest rate is used to reflect the risk associated with an asset or liability), accountants should use expected cash flows (in which all expectations about possible cash flows are used) in calculating present values.

The essence of this development stem from the fact that for nearly three decades, the FASB has been questioning the most relevant measurement attribute for financial instruments. A measurement based on the present value of estimated future cash flows is considered to provide more relevant information than a measurement based on the undiscounted sum of those cash flows. The traditional method to cash flow measurements has proven to be less effective though still may be appropriate under certain circumstances, such as assets and liabilities with contractual cash flows e.g., bonds and notes payable or receivable. Accounting applications of present value have traditionally used a single set of most likely estimated cash flows and a single interest rate, often described as "the rate commensurate with the risk." The higher the risk of the expected future cash flows, the higher the interest rate used to determine the present value of the cash flows. Therefore, the traditional approach assumes that a single interest rate convention can reflect all of the expectations about the future cash flows and the appropriate risk premium. The reporting of assets and liabilities at fair value on the financial statements can be aberrant, since organizations are usually composed of different kinds of assets and liabilities. It is possible that some asset’s fair value cannot be determined readily.

SFAC 7 sustains that measuring the expected cash flow is more efficient than the traditional approach also in circumstances such as the measurement of nonfinancial liabilities and assets. Reviewing expected cash flows is different from the traditional approach because it takes into account all expectations about possible cash flows as a replacement for only taking the most possible cash flow. The measurement objective is to use a valuation technique which is correct for the conditions but also at the same time which makes the best use of the use of market inputs. Fair value measurement assumes the highest and best use of an asset from the perspective of market participants, regardless of how the company actually intends to use it.

The SFAC 7 statement is not a declaration and also it does not directly affect existing accounting standards. It provides the standard setter with a basis upon which to build consistent GAAP. SFAC 7 Statement deals with measurement issues and was not prepared to look at other areas of accounting. It clearly states that it was created to address measurement only, using cash flow and present value information which is and will become a very important concept as we move towards fair value accounting and IFRS. SFAC 7 indicates positions that the accounting boards are likely to take in future declarations and that is why it provides a basis for evaluating both existing and future accounting standards and practices.

SFAC 7 conclude that fair value should be set by discounting future, expected cash flows using some rate of interest that gives reflection to the differences in timing and risk. If we knew with any accuracy what the differences would work out to be or if we knew what other consumers expected those differences to be, we could be able to determine a fair value for those assets, but in reality that is not the case. Buyers and sellers in an open market are privy to information because it helps them make decisions. Because of that information, they bring expectations to the marketplace and, based on those expectations, they make estimates.

Accounting functions of present value have conventional used a single set of estimated cash flows and a single interest rate which is related to risk. The higher the risk of the expected future cash flows, the higher the interest rate used to determine the present value of the cash flows. The traditional approach assumes a single interest rate convention, which can reflect all of the expectations about the future cash flows and the appropriate risk premium. Accountants throughout the years have and will continue to use the traditional approach for some assets and liabilities because the traditional approach may be relatively easy to apply or may be consistent with the manner in which the market values such assets and liabilities. However, the SFAC 7 states that the traditional approach does not provide the tools needed to address some complex measurement problems. The SFAC 7 tells us that the traditional method will not work when the asset or liability does not have contractual cash flows, or when there is uncertainty about the timing of cash flows, because it cannot incorporate enough economic variables needed to sufficiently estimate market values. SFAC 7 proposes a present value method that takes into account the degree of uncertainty associated with future cash flows among different assets and liabilities. SFAC 7 also recommends that rather than using estimated cash flows, where a single set of cash flows and a single interest rate is used to reflect the risk associated with an asset or liability, accountants should use expected cash flows in calculating present values, as it takes into account all the expectations about the possible cash flows which are to be used. The present value of estimated future cash flows is implicit in market prices, including the historical cost recorded when an entity purchases an asset for cash. 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.  Present values use estimates that are subject to bias and therefore are considered to be less relevant and reliable than fair values that can be observed in the marketplace. SFAC 7 states that the present values of assets should be adjusted to account for the relative degree of uncertainty associated with the future cash flows. It therefore, suggests that the present values of each asset should be adjusted to account for such differences in degree of uncertainty. Using estimated cash flow means that a broader set of information is utilized in the present value measurement process because a wide range of possible outcomes is considered rather than a single, best estimate of a period's cash flow.

Implementing the techniques used to estimate future cash flows and interest rates will vary from one situation to another depending on the circumstances surrounding the asset or liability in question. The fact that fair value is the key objective of present value measurements normally requires the use of market based assumptions about the magnitude, timing and uncertainty of an asset's or liability's future cash flows, as well as the risk premiums required by the market. Fair value estimates resulting from present value calculations made with market-based assumptions better capture the economic differences between assets or liabilities and provide more relevant information than other possible measurement attributes. The SFAC 7 therefore advocates the use of fair value when the requisite information to determine fair value is available, while allowing that present-value analysis can provide a basis for measurements when information on the fair value of an asset or liability is not available, which is typically the case with assets or liabilities that are paid over time. Furthermore, it can it can be argued that market-based assumptions are not relevant if an entity is considering the acquisition of non-financial fixed asset or the settlement of a non-financial warranty or contingent liability. In these situations, entity-specific values may be more appropriate.

SFAC 7 addresses measurement issues rather than recognition issues, it does not specify when fresh start measurements are appropriate. It applies to measurements at initial recognition and fresh start recognition based on future cash flows. It does not apply to measurements based on the amount of assets or on observation of fair values in the market place. If these types of observations are available, the measurement would be based on them rather than the future cash flows which can lead to bias on the financial statements.

The fair value of an entity's liabilities, such as its notes and bonds payable, represent the prices that other entities are willing to pay, which are normally reflected in the market rates of interest that the borrower has to pay. For liabilities such as these, which involve contractual cash flows for which reliable and readily available market interest rates exist, the risk adjustment for uncertain cash flows is easily made by selecting a risk-adjusted interest rate to be used in the present value calculations and applying the traditional present value approach. On the other hand, attempting to estimate probability-weighted cash flows in these situations based on present value measurement would require estimates that are impracticable and would introduce an unnecessary and unreliable element in the present value measurement process.

The use of present value in accounting measurements results in a decrease in the reliability of accounting information. A present value calculation requires numerous estimates regarding the timing, uncertainty, and amounts 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 which also means decreased verifiability of estimates, or through the introduction of bias in estimates which also represents decreased neutrality.

The origin of the disagreement over a shift to fairvalue measurement is the philosophical debate over relevance versus reliability. Fair value accounting argues that historical cost financial statements are not relevant because they do not provide information about current values. Whereas it can be argue that the information provided by fair value financial statements is unreliable because it is not based on arm's length transactions, so if the information is unreliable it should not be used to make financial decisions. This trade-off should be at the core of any discussion about the use of fair value in financial statements.

Fair value accounting argues that it is more relevant to decision makers even if it is less reliable because fair value accounting would produce balance sheets that are more representative of a company's value. Particularly, unless the values of fixed assets are assumed to remain the same over time, historical cost information is relevant only upon obtaining the asset. In addition, because historical cost measures remain unchanged over time, users do not get valuable feedback about depreciation or appreciation following the purchase of the asset. Whereas, it can also be argued that fair value accounting is not reliable because relevant information that is unreliable is useless to an investor, as it leads to inaccurate decisions because of bias on the financial statements.

One advantage of historical cost financial information over fair value accounting is that it produces earnings numbers that are not based on appraisals or other valuation techniques. Therefore, the income statement is less likely to be subject to manipulation by management compared to fair value accounting. Also, historical balance sheet figures contain actual purchase prices, not estimates of current values that can be altered to improve various financial information and ratios. Because historical cost statements rely less on estimates and more on factual numbers historical cost financial statements are more reliable than fair value financial statements.

SFAC 7 stresses the use of market inputs to value assets and liabilities. Because some market inputs may be more reliable than others, SFAC 7 lists three levels of market inputs that can be utilized in the valuation of an asset. Level one inputs include of quoted prices; they can be found for more liquid assets and are the most reliable type of market inputs. Level two inputs, the second most reliable type, are based on market observables. Finally, level three inputs are the least reliable input used in determining fair value, relying on non observable assumptions, including management's internal assumptions regarding the value of the asset. The issue regarding market inputs is where the tradeoff between relevance and reliability comes into consideration. Level one inputs result in fair values that are equally reliable to historical cost figures while providing more up to date figures for financial statement users. Level two and level three inputs leave room for opinion and bias, which in accounting related situations, do not mesh well for reliability. Also, fair value accounting assumes that the discount rate used to calculate the present value of the cash flows will stay the same, as in reality interest rates keep changing all the time due to changing economic conditions of the market.

The reporting of assets and liabilities at fair value on the financial statements can be aberrant, since organizations are usually composed of different kinds of assets and liabilities. It is possible that some asset’s fair value cannot be determined readily. For instance, a software customised for a specific company cannot be appraised in a market. In such predicament, present value of future cash flows can be determined. Despite the presence of uncertain future cash flows and interest rate, present value of future cash flow is relatively easier to determine than fair market value. However, unique method of valuation for each assets increase unreliability, not to mention high cost implementing fair value.

Applying the principle of conservatism, the selling price is usually different from purchasing price. The FASB section 157 magnify the selling price of the asset and settlement value of liabilities. Using this fair value method of valuation, a professional cannot suggest a resolute value to an asset or a liability because of degree of objectivity. A major dilemma arise when different values are determined for one particular asset, it will leave the accountants in perplexity to determine the most appropriate value. The non ideal conditions of the real world, where uncertainty of interest rates and future cash flows is inevitable, fair value may not be the best method of valuation. An identical asset may be valued differently in different markets where factors like elasticity and supply and demand. The discrepancies in the fair value caused by multiple factors can be used by the management to divert the financial statements for their own interest. For instance, a company with loan covenant to maintain certain current ratio will tend to use the highest value of assets and lower value of liabilities. In reality the liabilities may be settled at a cost more than stated fair value. Therefore, this paradox of fair value can lead to substantial misstatement and thus misguide the financial statement users.

A wide range of estimates have to be made regarding future cash flows and discount rate, thus this measurement method is highly unreliable and inconsistent. The measurement of assets and liabilities are now contingent upon the market, judgment about future cash flows and interest rates by the management and accountants. Considering these elements, comparability of financial statements will be implausible with other companies and competitors. One of the other drawbacks of present value is likelihood of manipulation by the management in their own interest as estimates are made. The section SFAC 7 suggests that higher discount rate should be used when uncertainty exists or when future cash flows are not readily determinable. The subjective nature of this method can cause substantial disparities in measurement. This method of measurement is very useful to compute present value, where a wide variety of cash flows and discount rates are considered, however items on the financial statements should not be measured using this technique as it would distort verifiability and comparability.