by Cenen Reyes Herrera
Writing from Martinez, San Francisco Bay Area
Which would you prefer: a promised value or an expected value?
There seems to be a contradicting premise on the values that both paradigms would suggest. When I read the proceedings on the review of FAS no. 7 on the use of present value accounting, two of the members of the Board issued dissenting views on the use of present value as a measure for estimating fair value.
What could be the main distinction between a promised value and an expected value?
A promised value refers to the nominal cash flows that are indicated in the contractual agreement. The main difficulty of this paradigm is that under the promised value concept, a $100 received today is the same as the $100 received at a future date after considering the implicit interest of the contract. On the other hand, the expected value concept presents the realistic view that future cash flows could vary in terms of amount and timing. The word "expected" connotes a probabilistic view that is aligned with the concept of risk. Risk represents an exposure to an adverse consequence. That adverse consequence, however, could happen anytime depending on a number of variables. The timing of payment and the actual amount of payment could be estimated using a number of porbabilistic models that are available in financial markets.
The main problem in the shift towards the present value accounting is on the impact on liabilities. FAS 7 indicates that diseenting views focused on the fact that it would appear that changes in the effective interest rates of liabilities could impact on equity and that in an environment of rising interest cost of borrowings, there would be a tendency to increase equity. This is something that could create some difficulties in financial reporting. My long years of experience in accounting also point to a need to clarify how the changes in present values of both assets and liabilities could be handled or treated in a transparent manner, i.e., should they be treated as an activity account or a resource account?
Strategy & Stewardship Consultant in International Finance
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Tuesday, June 06, 2006
Monday, June 05, 2006
The Accounting Profession - Emerging Issues
by Cenen Herrera
Writing from Martinez, San Francisco Bay Area
Financial Accounting Concept No. 7
Accounting Measurement Using Cash Flow Information and Present Value
The FASB guideline finally recognizes the importance of the time-value of money in measuring assets or liabilities.
After reading the FASB guide, I am surprised at the length of time that the accounting professionals have come to realize the value of measuring the economic differences that result from changes in the amount and timing of expected cash flows.
Highlights:
OMDA - the use of observable marketplace-determined amount reflects the importance of measuring company assets or liabilities with a view towards integrating the market forces that influence a company's resources.
Expected versus Present Value Cash Flows - The distinction might not be quite clear to all accountants, but again the underlying principle is to recognize that whenever we speak of economic differences, it is not only the timing and the amount that matter, but we also need to consider the probabilistic nature of valuing company assets and liabilities.
3. Accounting Measurements could be classified into three (hccnp):
a. Historical Cost - The cost that is usually reflected in our invoice when we buy a certain asset.
b. Current Cost - The replacement cost of the asset.
c. Current Market Price - The price of the asset in the market today.
d. Net realizable value - The amount that would remain after deducting all selling expenses.
e. Present Value - Expected cash flows discounted at the risk-free interest rate.
The guideline offers a framework for financial accounting and reporting assets and liabilities in the financial statements.
The conceptual framework is expected to lead to consistent standards and that prescribes the nature, function and limits of financial accounting and reporting.
Financial accounting concepts are necessary in (EIA) establishing, interpreting, and applying accounting and reporting standards.
Fair value as defined in this conceptual framework is the amount at which an asset or liability could be bought or sold between willing parties (I find the definition quite simple compare to many definitions elsewhere in the FASB pronouncements).
Fresh-Start Measurement - Pertains to subsequent periods.
It is quite explicit in the guideline that it does not cover recognition principles (while it might be directly related to measurement issues). Further, it says that recognition is the process of formally recording or incorporating an item into the financial statemetns as an asset, liability, revenue or expense.
The conclusions reached in this Statement apply only to measurements at initiail recognition, fres-start-measurements, and amortization techniques based on future cash flows (para 15).
Present value should attempt to capture teh elements that taken together could comprise a market price.
The objective of the present value is to capture the economic difference between sets fo future cash flows.
Present value must represent some observable measurement atttribute of assets or liabilities.
Present value formula is a tool used to incorporate the time value of money in a measurement.
Present value helps to distinguish between unlike items that might otherwise appear similar.
If there is no observable market price, use estimates of future cash flows in measuring assts or liabilities.
3 Objectives of Financial Statements:
a. Usefulness
b. Assesses amounts, timing and uncertainty of cash flows
c. Resource Information
Marketplace is the final arbiter of asset & liability values.
Conclusion: Expected Cash Flow Approach is a more effective measurement than the traditional approach because of the computational limitations of the traditional approach. The expected cash flow approach offers computational transparency which makes the measurement issue clear to users of Financial statements. It further argues that developing cash flow scenarios is critical for present value applications.
I find this financial accounting concept paper of FASB to be reader-friendly despite its very technical subject matter. The subject has become a point of contention between accountants and economists, and I have come across several instances where such differences could lead to a clarification note by the external auditor. The guideline certainly helped in threshing out any differences that long existed in measuring the financial resources of an organization.
5 June 2006 USA
Writing from Martinez, San Francisco Bay Area
Financial Accounting Concept No. 7
Accounting Measurement Using Cash Flow Information and Present Value
The FASB guideline finally recognizes the importance of the time-value of money in measuring assets or liabilities.
After reading the FASB guide, I am surprised at the length of time that the accounting professionals have come to realize the value of measuring the economic differences that result from changes in the amount and timing of expected cash flows.
Highlights:
OMDA - the use of observable marketplace-determined amount reflects the importance of measuring company assets or liabilities with a view towards integrating the market forces that influence a company's resources.
Expected versus Present Value Cash Flows - The distinction might not be quite clear to all accountants, but again the underlying principle is to recognize that whenever we speak of economic differences, it is not only the timing and the amount that matter, but we also need to consider the probabilistic nature of valuing company assets and liabilities.
3. Accounting Measurements could be classified into three (hccnp):
a. Historical Cost - The cost that is usually reflected in our invoice when we buy a certain asset.
b. Current Cost - The replacement cost of the asset.
c. Current Market Price - The price of the asset in the market today.
d. Net realizable value - The amount that would remain after deducting all selling expenses.
e. Present Value - Expected cash flows discounted at the risk-free interest rate.
The guideline offers a framework for financial accounting and reporting assets and liabilities in the financial statements.
The conceptual framework is expected to lead to consistent standards and that prescribes the nature, function and limits of financial accounting and reporting.
Financial accounting concepts are necessary in (EIA) establishing, interpreting, and applying accounting and reporting standards.
Fair value as defined in this conceptual framework is the amount at which an asset or liability could be bought or sold between willing parties (I find the definition quite simple compare to many definitions elsewhere in the FASB pronouncements).
Fresh-Start Measurement - Pertains to subsequent periods.
It is quite explicit in the guideline that it does not cover recognition principles (while it might be directly related to measurement issues). Further, it says that recognition is the process of formally recording or incorporating an item into the financial statemetns as an asset, liability, revenue or expense.
The conclusions reached in this Statement apply only to measurements at initiail recognition, fres-start-measurements, and amortization techniques based on future cash flows (para 15).
Present value should attempt to capture teh elements that taken together could comprise a market price.
The objective of the present value is to capture the economic difference between sets fo future cash flows.
Present value must represent some observable measurement atttribute of assets or liabilities.
Present value formula is a tool used to incorporate the time value of money in a measurement.
Present value helps to distinguish between unlike items that might otherwise appear similar.
If there is no observable market price, use estimates of future cash flows in measuring assts or liabilities.
3 Objectives of Financial Statements:
a. Usefulness
b. Assesses amounts, timing and uncertainty of cash flows
c. Resource Information
Marketplace is the final arbiter of asset & liability values.
Conclusion: Expected Cash Flow Approach is a more effective measurement than the traditional approach because of the computational limitations of the traditional approach. The expected cash flow approach offers computational transparency which makes the measurement issue clear to users of Financial statements. It further argues that developing cash flow scenarios is critical for present value applications.
I find this financial accounting concept paper of FASB to be reader-friendly despite its very technical subject matter. The subject has become a point of contention between accountants and economists, and I have come across several instances where such differences could lead to a clarification note by the external auditor. The guideline certainly helped in threshing out any differences that long existed in measuring the financial resources of an organization.
5 June 2006 USA
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