A PROPOSAL FOR A NEW CONCEPTS STATEMENT
QUESTIONS AND ANSWERS
This article introduces a proposed FASB Concepts Statement, Using Cash Flow Information in Accounting Measurement, in a series of question and answer exchanges. The questions are typical of those that we receive from accountants and the financial press.
FASB Statements of Financial Accounting Concepts are different from other Board pronouncements, and the difference is more than skin deep (the cover is green, rather than the usual brown). A Concepts Statement tries to dig beneath the surface of accounting to examine and explain the foundations. The Board tries to build on those foundations in developing its Standards (the ones with brown covers).
Concepts Statements also provide accountants with a common language. For example, FASB Concepts Statement No. 6, Elements of Financial Statements, defines the concepts asset, liability, revenue, and expense. You might wonder why such apparently simple ideas need precise definition. Don’t accountants know what an asset is? Key ideas need precise definition because they are the foundations; square corners and plumb lines are important in foundations. The definitions in Concepts Statement 6 have proven critical to framing debates on a host of accounting issues, from income taxes to insurance. Indeed, several countries and the International Accounting Standards Committee have copied (with small modifications) the definitions first articulated in FASB Concepts Statements.
Concepts Statements also are different in their level of authority. Unlike an FASB Standard, a Concepts Statement does not establish generally accepted accounting principles. No company need change its accounting because of a new Concepts Statement, and no auditor need modify the opinion. Instead, the Board tries to build on the body of Concepts, and colleagues abroad and constituents at home use them to understand and evaluate Board decisions. Like a foundation, Concepts Statements are the base on which the Board expects to erect future Standards, when and if those Standards prove to be necessary.
Why issue a proposed Concepts Statement on using cash flows in measurements? Why not focus on present value?
Maybe a (very) old story will help to describe the problem. It seems there was a man on his hands and knees, obviously looking for something under a streetlight. A cop came on the scene and, seeing the man, asked what he is doing.
“Looking for my lost wallet,” said the fellow.
“Where did you lose it?” asked the cop.
“Back in the middle of the block,” the fellow replied, “but the light is better here.”
When it comes to measurements that use estimated cash flows, accountants and standard setters around the world have been like the hapless fellow in this shaggy-dog story. We know intuitively that the value of cash flows paid or received in the future are different from the same amount today, but we haven’t agreed on how best to capture that economic difference. We often have looked for answers under the light post, rather than where they might actually be found. Worse still, we often haven’t been clear on what the right answer (the wallet) would look like, even if we found it.
The Board’s proposed Concepts Statement provides a framework for addressing many of the questions surrounding present value. The Board’s objective is to provide a common understanding of the role of present value in accounting measurement and some general principles governing its use. Returning once more to the story, the proposed Concepts Statement is like giving the fellow a flashlight and a general description of the wallet.
So, is the Board proposing to convert all accounting measurements into present values?
Not at all. The issues addressed in this project don’t even come up in most accounting situations. Most accounting measurements are based on transactions or observable marketplace values. The number of cases that require estimated future cash flows is fairly small. However, the amounts involved in those cases are often very significant. For example, a company might estimate that the costs to decommission a power plant will total $100 million. However, those costs will not be paid for 30 years. The present value of $100 million, discounted for 30 years at 5 percent, is about $23.1 million. Differences of that magnitude, 100 against 23, make people take notice.
The Board has excluded recognition issues from the proposed Concepts Statement, limiting the discussion to measurement issues. Recognition questions ask “Should this item be included in the financial statements?” Measurement questions ask “How much” or “How many?” Recognition and measurement are obviously related, but the Board decided it should limit this document to measurement questions and leave recognition for another day.
The Board also decided not to address the question of when the accounting for an existing asset or liability should be abandoned for a fresh-start measurement. Decisions to remeasure (for example, the accounting for impaired long-lived assets addressed in FASB Statement 121) are always difficult and usually controversial. The Board decided that those issues are, for now, best addressed in individual projects.
But why is present value a problem? Don’t accountants understand the time value of money?
Of course accountants understand time value, as an abstraction. Translating that abstraction into accounting measurements is another matter. The FASB staff recently received a letter from a major CPA firm with the following comment:
A best estimate of cash flows, which takes into consideration uncertainty of amounts and timing and applying an appropriate risk adjusted discount rate, with appropriate disclosure of risks and possible ranges, may give the user of financial statements better information.
That seems a reasonable enough comment -- until you start to ask what it means. Then, it seems to raise a whole host of questions. For example, what is a best estimate? Is it the most-likely amount? If so, how does it consider uncertainty? How does one determine an appropriate risk-adjusted discount rate? What is the objective of the measurement? Finally, why discount at all?
OK, why should accountants use present value? Just adding up the cash flows would be simpler.
The first goal of accounting and financial reporting is to provide information that is useful in making decisions. Useful information allows useful discrimination. That is, the information distinguishes things that are different from one another and does not make things that are economically different appear the same.
For example, each of the 4 assets listed below has an undiscounted measurement of $1,000:
a.A riskless cash flow of $1,000 due in 1 day
b.A riskless cash flow of $1,000 due in 10 years
c.A risky cash flow of $1,000 due in 1 day
d.A risky cash flow of $1,000 due in 10 years.
You might willingly give something close to $1,000 for asset (a). After all, it’s risk free and you will only wait 24 hours. Asset (b), on the other hand, is a different matter. It’s still risk free, but with a 10-year wait. Asset (c) is due tomorrow, but you might not get paid. Asset (d) seems the least valuable of the set. You might not get paid, and you have to wait 10 years to find out.
By computing the present value of each cash flow, we can attach different measurements to those four assets, based on time and risk. That ability to discriminate, just as the marketplace discriminates when it gives each of the assets a different price, makes a present value measurement more relevant than a measurement based on the undiscounted sum of cash flows.
But any combination of cash flows and interest rates can be used to compute a present value. Present value is a mathematical construction; it is not an end in itself. To provide relevant information in financial reporting, present value must represent some real-world attribute of an asset or liability. The Board has identified two (and only two) attributes that meet that criterion -- fair value and entity-specific value.
I understand the time value of money, but why bring up risk? Isn’t that an unnecessary complication?
Again, the measurement adjusts for uncertainty and risk so that assets and liabilities that are economically different do not appear the same. If the measurement does not include the effect of risk, asset (a) looks like asset (c) and asset (b) looks like asset (d). The marketplace differentiates risky assets (like low-grade bonds) from less risky assets (like high-grade bonds) and prices the cash flows from each accordingly. An accounting measurement that omits a similar adjustment for uncertainties and risks provides information that is less useful than a measurement that includes that adjustment.
The terms uncertainty and risk, mean slightly different things to a finance theorist, an economist, an actuary, or a statistician. The proposed Concepts Statement uses those terms in their everyday dictionary sense. Risk refers to the chance of injury, damage, or loss. Uncertain refers to that which is not surely or certainly known, is questionable, or is problematic.
I see, including an adjustment for uncertainty and risk is accounting conservatism. You are building in a cushion, right?
Wrong. The Board has long maintained that there is no such thing as a “good misstatement.” Intentional overstatement and understatement are equally misleading, equally harmful to the credibility of financial statements, and equally likely to fail in the long run.
The objective is to imitate the pricing system. Recall the four assets mentioned earlier:
a.A riskless cash flow of $1,000 due in 1 day
b.A riskless cash flow of $1,000 due in 10 years
c.A risky cash flow of $1,000 due in 1 day
d.A risky cash flow of $1,000 due in 10 years.
A simple note receivable, say asset (c), presents the possibility of loss from default. The market’s adjustment for risk results in a measured amount that is less than asset (a), which offers a fixed cash inflow with no possibility of default. The price of asset (c) is probably less than (a), even though both are due tomorrow morning. Asset (d) presents the possibility of loss and a 10-year wait for payment. The price of asset (d) is certainly less than asset (b), which offers the same $1,000 cash flow with no possibility of default.
Accountants usually refer to the interest rate that equates a future cash flow with a current amount as the effective interest rate or the implicit rate in the measurement. A risky asset has a higher interest rate than one with less risk. For example, if the current price of asset (b) is $615, the effective or implicit interest rate in that price is about 5 percent. If the current price of asset (d) is $250, the effective or implicit interest rate in that price is about 15 percent.
And liabilities work the same way. The higher the risk, the higher the effective interest rate, right?
Not exactly. It depends on the nature of the uncertainty and risk.
The holder of a note receivable faces the chance that cash received will be less than promised; asset (d) might only pay $750. A company that sells product warranties, in contrast, faces the chance of cash outflows that are greater, or less, than expected. For example, consider two warranty obligations with an expected present value at the (5 percent) risk-free rate of $26,000 and expected cash flows, one year hence, of $27,300. Both warranties have uncertain cash flows. The ultimate cost of warranty (x) may be as low as $20,000, and in no case will it be more than $30,000. The ultimate cost of warranty (y) may be as low as $20,000, but it has no maximum. There is a 5 percent chance that the ultimate cost of (y) may be as high as $100,000.
Would a company that sells warranties charge customers the same price for (x) and (y)? Probably not. The company would demand a higher price for (y) as compensation for the greater risk, even though the two warranties have the same expected cash outflow of $27,300. The market’s adjustment for risk results in a measured amount that is greater than (or has a lower effective interest rate than) a liability with a fixed series of cash outflows. The company might charge $26,500 for warranty (x) and $27,000 for warranty (y). Those prices result in effective interest rates of about 3 percent for (x) and about 1 percent for (y). Note that the effective rate is less than the risk-free rate in both cases.
Whether for assets or liabilities, the important questions are “Risk of what?” and “Compared to what?”
A lender knows that some loans will default, but is uncertain about how many and to what extent (some borrowers might pay part of the balance). The lender prices the loans (sets the interest rate) to reflect its expectations about defaults. The risk is that the lender’s estimated default rates will prove to be too low, and a market interest rate includes the lender’s charge for bearing that risk.
In the warranty example, the company is uncertain about the number of warranty claims and the average cost per claim. The risk is that the company’s estimate of the probable claims is too low (there was really a 15 percent chance of $100,000) or that the extreme event occurs (the 5 percent estimate was fine, and it happened). The company demands a premium for accepting that risk.
In both cases, the company seeks payment for assuming risk. Remember, the term risk is used to refer to the possibility of loss. There are situations, like state lotteries, in which players pay to take risk in the hope of a large payoff. While they exist, those situations are not typical of the measurement problems found in financial reporting.
Do I have to put the risk adjustment in the interest rate, or can I adjust the cash flows?
You can do either, but not both. The measurement may reflect uncertainty and risk by discounting cash flows at a rate commensurate with the risk or by adjusting the cash flows and discounting the result at a risk-free rate. Both techniques have the same objective. Most accountants are used to thinking about risk as a component of the interest rate because the effective interest rate is a handy tool for comparing assets or liabilities against one another. However, adjusting the expected cash flows may give the accountant a clearer picture of how risk affects the measurement.
You talked about expected cash flows in your last answer. Are expected cash flows different from estimated or contractual cash flows?
Yes. An accountant who uses cash flows in a measurement must decide which set of cash flows to use. For asset (d), the risky $1,000 due in 10 years, there are several possibilities:
- The accountant might use the contractual promise ($1,000). For this illustration, assume that the probability of receiving $1,000 is 30 percent.
- The accountant might use the best or most-likely estimate of cash flows ($750), which reflects the fact that some loans default, at least in part. For this illustration, assume that the probability of receiving $750 is 60 percent.
- The accountant might use a worst-case estimate ($400). For this illustration, assume that the probability of receiving $400 is 10 percent.
- The accountant might use the expected cash flow. The expected cash flow is the average of the various possibilities, weighted by their respective probabilities. In this case, expected cash flow is ($1,000 x .3) + ($750 x .6) + ($400 x .1) or $790.
Traditional accounting measurements, including some FASB Standards, use contractual cash flows or best estimates -- the first two bullets above. In developing the proposed Concepts Statement, the Board found that an expected cash flow approach has several advantages over traditional approaches. An expected cash flow approach uses explicit assumptions about possible outcomes. Those explicit assumptions can be examined, questioned, and modified individually. In contrast, the traditional methods are implicit approaches. They use a single cash flow estimate and assume that uncertainty and risk are completely captured in an interest rate.
An expected cash flow approach also allows accountants to use present value when the timing of estimated future cash flows is uncertain. The problem of uncertain timing has been a major impediment to accounting use of present value. For example, APB Opinion No. 21, Interest on Receivables and Payables, is “applicable to receivables and payables which represent contractual rights to receive money or contractual obligations to pay money on fixed or determinable dates” (emphasis added). Traditional approaches place a single cash flow in each period and discount that cash flow at an interest rate. Those approaches simply cannot address the problem of a fixed cash flow that might fall in period 10 or period 15 or period 20.
In an expected cash flow approach, uncertain timing is no more troublesome than uncertain amounts. For example, a cash flow of $1,000 may be received in 1 year, 2 years, or 3 years with probabilities of 10 percent, 60 percent, and 30 percent, respectively. The example below shows the computation of expected present value. Again, the expected present value differs from the traditional notion of a best estimate, $907.03 (the 60 percent probability) in this example.