Viewpoints
Status Report Feature
Using Cash Flow Information and Present Value in Accounting Measurements
by Lindsay K. Nelson and Thomas L. Porter, Financial Accounting Standards Board
On March 31, 1999, the Board issued an Exposure Draft of a proposed Concepts Statement, Using Cash Flow Information and Present Value in Accounting Measurements (Revised Exposure Draft). That Exposure Draft is a revision of a June 1997 FASB Exposure Draft, Using Cash Flow Information in Accounting Measurements (1997 Exposure Draft). Background information on the 1997 Exposure Draft can be found in the Highlights article, “Cash Flows and Present Value: A Proposal for a New Concepts Statement,” that was published in the August 27, 1997 Status Report.
The Revised Exposure Draft reflects changes resulting from constituents’ comments and suggestions on the 1997 Exposure Draft and from further deliberations by the Board on certain issues. There are two fundamental changes: (1) the removal of entity-specific measurement as a measurement objective of present value and (2) the addition of guidance that the relevant measure of a liability should always include an adjustment for the entity’s credit standing. The Board concluded that those changes warrant issuing a second Exposure Draft to allow for further public comment. This article addresses the Board’s rationale for making those changes.
Removal of Entity-Specific Measurements
The 1997 Exposure Draft identified two measurement attributes, fair value and entity-specific measurement, as appropriate measurement objectives when using present value to measure an asset or a liability at fresh-start or initial measurement. During its redeliberations, the Board decided to remove entity-specific measurement as an objective. The Revised Exposure Draft states that “in future standard-setting deliberations, 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” (paragraph 19).
Why the Change?
Confusion of Terms
During its redeliberations, the Board realized that a number of constituents (as well as some staff and Board members) did not agree on the meaning and application of entity-specific measurement. The Board found that much of the confusion arose from misunderstandings about the distinctions between the three unique measurement attributes that were considered during deliberations on the 1997 Exposure Draft: fair value, entity-specific measurement, and cost accumulation.
Fair Value
Fair value is the price that willing market participants would offer (ask) to buy (sell) an asset or liability. Most people understand fair value because they are familiar and comfortable with the notion of an arm’s-length transaction. The basic premise of fair value is that, in arriving at a price, the market incorporates assumptions about how the average market participant would use an asset or settle a liability. In estimating cash flows to arrive at a fair value, an entity would use the amounts that the average market participant would expect to (1) realize as a result of using the asset or (2) pay as a result of settling a liability, along with the premium or discount that an average market participant would demand for the uncertainty inherent in the cash flows.
Entity-Specific Measurement
In contrast to fair value, an entity that uses entity-specific measurement (as contemplated in the 1997 Exposure Draft) would base expected cash flows on its private knowledge about how it intends to use an asset or settle a liability. The price approximated by entity-specific measurement is that which willing market participants would offer (ask) to buy (sell) an asset or liability if they shared the same information about, and could acquire without cost, the entity’s unique options relating to its intentions. The entity, in effect, places a value on any real options that are exclusively available to that entity (e.g., unique technology) and recognizes that value immediately in its cash flow estimates. To illustrate, assume that an entity has a liability for an environmental cleanup and that the entity (1) manufactures one of the products that will be used in the cleanup and (2) plans to use its own labor. If that entity were to use a fair value measurement, it would have to disregard its private knowledge of its intentions as to the use of the asset or liability. The entity would use the price that other market participants would have to pay to obtain the manufactured product and would value the labor at the same rate as the market to arrive at its expected cash flow. If the entity used an entity-specific measurement, it would use the cost of its manufactured product and value the labor at its internal cost to arrive at its expected cash flow.
Cost Accumulation
In contrast to fair value and entity-specific measurements, cost accumulation makes no attempt to arrive at a price. Cost accumulation simply discounts the sum of all of the incremental inflows and outflows that the entity actually expects to realize or pay. Cost accumulation makes no attempt to estimate what premium a market participant might pay for an asset or liability. Some Board members found that they actually preferred the cost accumulation method to entity-specific measurements as an alternative to fair value. Those who held that view disagreed with the idea of a market premium being included in cash flows if an entity has no intention of actually selling an asset or settling a liability in the market.
The Board’s Decision to Remove Entity-Specific Measurement
The main difference between fair value and entity-specific measurement is what cash flows (the market’s or the entity’s) are being measured. The main difference between entity-specific measurement and cost accumulation is who is measuring those cash flows (the market or the entity). (The example in paragraph 103 of the Revised Exposure Draft gives a numerical illustration that compares computations involved in each measurement approach.) The Board rejected cost accumulation as a measurement objective and proposed fair value measurement and entity-specific measurement in the 1997 Exposure Draft. Constituents’ responses to that Exposure Draft indicated some concern over when to apply entity-specific measurement. In its reevaluation of entity-specific measurement, the Board focused on the “real option” portion of that measurement. The Board considered whether incorporating the value of those options into measurements results in recording internally generated intangibles and accelerates the recognition of any comparative advantage or disadvantage into earnings.
Internally Generated Intangibles
Some Board members observed that placing a value on one entity’s advantage over another entity is similar to valuing internally generated intangibles (such as a patent that is generated internally rather than acquired in a purchase). While arguments have been made for the recognition of internally generated intangibles in some circumstances, that practice is not currently permitted under GAAP. In the Board’s view, questions about the recognition of internally generated intangibles are both complex and important enough to warrant their own discussion and should not be decided in this project through a measurement decision.
Realization of Expected Advantage or Disadvantage
Another factor in the Board’s decision to remove entity-specific measurement from the proposed Concepts Statement involved the question of whether an entity’s relative advantage or disadvantage over another entity should affect earnings. Using entity-specific measurement, any comparative advantage or disadvantage that an entity might have over other market participants is recognized in earnings at initial measurement. Fair value recognizes those advantages or disadvantages in earnings at the culmination of the transaction. The Board was persuaded that earnings should not be affected until the comparative advantage or disadvantage is actually realized (thereby “proving” the advantage or disadvantage actually existed) rather than when the comparative advantage or disadvantage is only expected to be realized.
Scope of Fair Value Application
The Board’s decision to remove entity-specific measurement as an objective of present value measurements will likely resurrect a concern that has existed throughout the life of this project. The concern is whether the FASB intends to measure all assets and liabilities at fair value. The scope of this project deals only with those measurement situations that rely on estimates of future cash flows. It also applies only to initial or fresh-start measurements. With those scope limitations, the guidance in the Revised Concepts Statement will apply only to a small percentage of assets or liabilities.
Credit Standing and Liability Measurements
The second significant change from the 1997 Exposure Draft is the Board’s conclusion that the most relevant measure of an entity’s obligation on initial recognition or in fresh-start measurements should include the effect of the entity’s credit standing. In the 1997 Exposure Draft, the Board concluded that an entity’s credit risk should be taken into account if the objective is to measure the fair value of the liability to others who hold it as an asset (paragraph 55). That logic is fairly easy to follow. If Entity A loans money to Entity B, Entity B’s credit standing affects the amount and the price at which Entity A is willing to lend. The recorded value of Entity A’s asset and Entity B’s liability clearly depends on Entity B’s credit standing.
The Board considered an alternative measure of the fair value of a liability as the value of the assets (cash) that one entity must pay another to induce that other entity to assume an obligation, an objective known as “fair value in settlement.” The Board concluded in the 1997 Exposure Draft that if the objective is to measure the liability at fair value in settlement, an entity’s credit standing should not be reflected in that measurement. In reaching that conclusion, the Board was persuaded by the argument that an entity’s credit standing, or ability to pay, has an insignificant effect on the price that a third party would demand to assume the entity’s obligation. The entity assuming the liability would derive a price based on its own credit standing, discounting the expected cash flows at their own internal borrowing rate (thereby approximating the amount they could obtain in a straightforward loan).
Another argument the Board considered was that the entity’s obligation, which is what is measured in a liability, is not decreased by the possible inability of the entity to fulfill that obligation. Under this view, the relevant information would be the present value of the amount the entity is obligated to pay without regard to credit risk. Changes in an entity’s credit-worthiness would not change the carrying amount of that entity’s liabilities. Some maintain that that approach is more representationally faithful.
The Effect of Credit Standing on Liability Measurements
In further deliberating this issue, the Board redirected its focus away from the amount at which an originating entity would value a liability to the amount the originating entity might have to pay to induce another entity to assume the liability. The Board found that considering the transaction from that perspective brought new insights. For example:
Facts: Entity A has an obligation to pay $500 to Entity B, 3 years hence. Entity A has an average credit standing and can borrow at 8 percent. Hypothetically, Entity A has the option to transfer that obligation to one of the following three entities, each with differing credit characteristics.
Transfer to C / Transfer to D / Transfer to EEntity Characteristics / Poor credit standing with a 12% borrowing rate. / Same credit standing and borrowing rate as Entity A. / Good credit standing and a 6% borrowing rate.
Results / The creditor (Entity B) would not consent to replace Entity A with an entity of lower credit standing. / Entity D would demand $396 to assume the liability from Entity A. (The present value of $500 for three periods at8%.) / Entity E would demand $420 to assume the liability from Entity A because it could borrow that much in the market by incurring the same obligation. (The present value of $500 for three periods at 6% is $420.)
The transaction would not occur. / Paying $396 (or borrowing the money to pay it) would put Entity A in no worse position. / If Entity A had to borrow the money to pay Entity E, Entity A would have to promise $529. (The future value of $420 for three periods at 8% is $529.)
The transaction between Entity A and Entity C would not occur because Entity B would not consent to replace Entity A with an entity of lower credit standing. If Entity D agrees to assume Entity A’s liability, the transaction is a straightforward purchase of debt, with no gain or loss to Entity A. Entity A is neither better nor worse off after the transaction. In contrast, Entity A is unlikely to pay $420 to Entity E if all that Entity A receives in return is relief from its recorded liability. After all, Entity A could achieve the same result by paying only $396 to an entity of similar credit standing. The premium demanded by Entity E is the price of a credit upgrade for the benefit of Entity B (the original creditor). If Entity A did pay the price demanded by Entity E, Entity A would essentially be making two separate transactions: extinguishing its liability to Entity B and providing a credit upgrade to Entity B. Because the credit upgrade is supplemental to the transaction, it should not be included in the fair value of the liability recorded by Entity A. To generalize, fair value is determined under the assumption that entities settle with entities of similar credit risk.
The Board’s Decision to Include Credit Risk in Liability
Measurement
When an entity receives cash and incurs a liability by promising to pay a fixed amount in the future, the entity’s credit risk is implicit in the liability valuation. The entity’s credit risk directly affects the amount of cash it initially receives. There are cases in which an entity incurs a liability, but does not receive cash. If the amount of cash that it would receive in exchange for similar promises is readily observable in the marketplace, again, the entity’s credit risk becomes implicit in the liability valuation. There may be cases in which the amount of cash that the entity would receive for similar promises is not readily observable in the marketplace. There also may be cases in which a liability is settled by incurring some other cost. The Board concludes that there is no basis for ignoring the effect of the entity’s credit standing when deriving fair values of some liabilities and not others. Thus, in all initial and fresh-start measurements, the Board concludes that the most relevant measurement should include the effect of the entity’s credit standing.
The deadline for submitting comments on the Exposure Draft is August 1, 1999.
Lindsay K. Nelson is a postgraduate technical assistant and Thomas L. Porter is an assistant project manager at the FASB. The views expressed in this article are those of Ms. Nelson and Mr. Porter. Official positions of the FASB are determined only after extensive due process and deliberations.