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Statements of Financian Accounting Concepts No. 7 (SFAC7) has been formulated by the Financial Accounting Standard's Board (FASB) as a starter step for present values to replace the current method of reporting under historical cost, which is called an observable marketplace-determined amount in SFAC7. The reason why the historical cost method is used over present values, is due to the difficulty of estimating the future cash flows of an asset or liability, where as an observable marketplace-determined amount is more reliable and more efficiently determined. What the FASB is trying to do with the SFAC7 is creating a general framework that will allow financial reporting to occur with present values instead of using historical cost.
SFAC7's main objective with present values is to estimate a 'fair value' when dealing with the initial recognition of assets and liabilities. What this framework is trying to explain is that present value should be used to create a market price when one is indeterminable, and consider that to be the 'fair value'.
Present Value is trying to provide assets and liabilities with a fair value if the marketplace and its participants are unable to determine one. The exchange of assets need to be recognized at fair value, but if neither parties have determined one, this is where measurement issues come to the forefront. This is why FASB is pushing to use present value to measure the value of the assets with their future cash flows.
The main problem with present value is the fact that it is going to be based on an estimate, which will not be very reliable depending on what basis the estimate is being formulated. This occurs with initial recognition and fresh-start measurement situations, because the interest rate used and the expected future cash flows are very important factors that must be estimated when trying to calculate the present value of an asset or liability. Leaving the estimation up to the entity may lead to a bias that will encourage a lower estimate, when they know the future cash flows should be more, so in the future, the cash inflows would exceed the past expectations. This give the entity an advantage relative to others in the marketplace and in doing so, diminishes the reliablity of the information.
Other measurements have been suggested, such as management's best estimate of future cash flows which are a better measurement method for assets and liabilities than fair value. The only issue with management's best estimate is the lack of uncertainty in regards to the estimation of the future cash flows.
When estimating a present value for an asset or liability, there are different components that contribute to estimation: (FASB, SFAC 7, Para. 23)
a. "An estimate of the future cash flow, or in more complex cases, series of future cash flows at different times"
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"
e. "Other, sometimes unidentifiable, factors including illiquidity, and market imperfections"
When it comes to estimating the future cash flows and interest rates for an asset or liability, there are many different situations that must be factored in, depending on the circumstances of the asset or liability in question. There have been principles that govern the application of a present value for the measurement of assets or liabilities: (FASB, SFAC 7, Para. 41)
a. "To the extent possible, estimated cash flows and interest rates should reflect assumptions about the 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."
b. "Interest rates used to discount cash flows should reflect assumptions that are consistent with those inherent in the estimated cash flows. Otherwise, the effect of some assumptions will be double counted or ignored. For example, an interest rate of 12 percent might be applied to contractual cash flows of a loan. That rate reflects expectations about future defaults from loans with particular characteristics. That same 12 percent rate should not be used to discount expected cash flows because those cash flows already reflect assumptions about future defaults."
c. "Estimated cash flows and interest rates should be free from both bias and factors unrelated to the asset, liability, or group of assets or liabilities in question. For example, deliberately understating estimated net cash flows to enhance the apparent future profitability of an asset introduces a bias into the measurement."
d. "Estimated cash flows or interest rates should reflect the range of possible outcomes rather than a single most-likely, minimum, or maximum possible amount."
Difficulty arises when it comes to estimating the present value for non-financial assets or liabilities, where comparable items and a market are non-existent. If there isn't a comparable item, where would this market interest rate estimation come from? There is a need for observable market that has a similar item where an adeuqate interest rate can be inferred from. The similar item must also share similar cash flows for the interest rate to be used. When the measurer is making the estimation, the measurer must do the following: (FASB, SFAC 7, Para. 44)
a. "Identify the set of cash flows that will be discounted."
b. "Identify another asset or liability in the marketplace that appears to have similar cash flow characteristics."
c. "Compare the cash flow sets from the two items to ensure that they are similar. (For
example, are both sets contractual cash flows, or is one contractual and the other an
estimated cash flow?)"
d. "Evaluate whether there is an element in one item that is not present in the other. (For
example, is one less liquid than the other?)"
e. "Evaluate whether both sets of cash flows are likely to behave (vary) in a similar fashion
under changing economic conditions."
By calculating the present value of an asset or liability, there is a level of uncertainty due to the estimation of future cash flows and the interest rate the cash flows are discounted at. For this reason alone, it is difficult to to establish a reliable estimate of the market-risk premium, based on a potential measurement error in the estimated cash flows. The main reason why the present value measurement is calculated under uncertainty is because the cash flows are mere estimates, and not known amounts. Due to the uncertainty involved with present value estimates, entities who use this estimation measurement method, put their financial position at risk until the uncertainties become resolved. The issue with using an estimation of cash flows when calculating a present value, in regards to risk is the fact that the marketplace participants favour an asset with a return that has no uncertainty, rather than an asset with uncertain cash flows.
The Ionica article that we referenced for this report brought up a very good point when Ionica notes that the issue becomes too simple and one-dimensional when it comes to debating the merits of historical costs versus that of fair value. Ionica argues that this becomes an either-or debate when really there is an existence of other current value methods. Having said this, Ionica still belives that the overall relevancy with the historical cost method is greatly diminished by a greater margin than the spike in reliability. He attributes this claim by mentioning that even at the time of the purchase of an asset, the buyer may not pay market price so at the time of the purchase, the cost may not only be irrelevant, but also not be reliable. (Ionica, 3)
Another downfall with the historical cost method of financial reporting as evidenced by Ionica is that it reduces the comparability of similar assets on the balance sheet of a firm. He mentions that the same or similar asset may be bought at two different periods of time, and if the entity is utilizing the historical cost method, both assets will have different valuations on the balance sheet, thereby making it impossible to compare the financial backing of both assets. (Ionica, 3) Had the present value approach been implemented, both assets would be valued at their current or fair market values, which would allow the users of the statements to compare the costs of both assets accurately and with a relative degree of precision.
In the article by Jones, he mentions that one of the benefits of the expected cash flow approach is that the entity and the measurer takes into account all the relevent and possible probabilities of various outcomes. (Jones, 30) This helps the entity in identifying every likely scenario and assigning it a subjective, yet reasonable probability. In doing so, the relevancy of the information relayed to the public is at a very high level and the information that is relayed to the public is one which may help them make useful, intelligent and well-informed decisions. This again asserts the confidence in the use of the expected cash flow method that was outlined in SFAC7.
The Financial Accounting Standards Board will continue to encourage the use of observable amounts from the marketplace when they are available, but many assets and liabilities do not have readily available observable amounts from marketplace transactions. The reliability of an estimate is very low, which is understood, because it is not a real value, it is being estimated which is only an approximation. Present value calculations with expected cash flows will be more relevant to marketplace participants than historical cost, but lacks the reliability factor that is held by observable marketplace amounts. The reason why reliability is low with a estimated present value calculation is because the expected outcome is usually incorrect due to inaccurate estimates of future cash flows. Relevance and reliability need to be weighted against each other depending on the situation of the transaction.
In conclusion, we believe that the shift towards present value accoutning, specifically it's utilization of an expected cash flow approach is beneficial for the future of the profession. The benefits far exceed the costs in relation to the relavance-reliability tradeoff making way for an improved climate of financial reporting, moreso than the previously used historical cost method. However, it is crucial that those responsible for implementing these measurement technqiues and carrying on the measurement, are using subjective probabilities that are formulated based upon edcuated assumptions and increased likeliness.