Four steps to useful present values.

Financial statements that include flawed present value measurements will be far less helpful to users.

The concept of present value is increasingly important in financial accounting. More and more, generally accepted accounting principles use present value techniques to assign amounts to specific assets and liabilities. Yet all of these applications have at least one material defect, creating suspicion in our minds that present values are not widely understood by CPAs and others. One hope for change is the Financial Accounting Standards Board present value measurement project. However, a February 1996 FASB special report as well as several recent standards and exposure drafts suggest the project may not greatly improve the use of present values. This article describes present value measurement and some of the defects in GAAP in applying it and suggests changes that will increase the usefulness of financial statements.

ORIGINS OF PRESENT VALUE MEASUREMENT

Present value techniques are accepted so completely they have become unquestioned accounting dogma. As a result, many have forgotten (or never knew) their origins and limitations, The four diagrams here describe these origins and two basic applications.

Diagram A in the chart above shows the origins lie in a search to understand the relationship between two observed facts:

1. The expected amounts and timing of a set of future cash flows that constitutes an asset or a liability, such as those from a bond.

2. The market's valuation of the asset or liability.

The goal is to understand the unknown market mechanism that uses predicted future cash flows to create the observed market value.

As diagram B shows, the best explanation is the present value mechanism based on the time value theory of money concept from economics, which asserts that cash flows are more valuable when they occur more quickly, are larger and are more certain. In effect, the relationship between the market value of an asset or liability and its cash flows can be described by saying market value equals the consensus present value of those future cash flows. The present value mechanism is broadly accepted because it has been tested and verified in a variety of settings.

Diagram C illustrates how the mechanism has been applied to create an imputation model that estimates the discount rate the market appears to be using to produce the observed value. In effect, two known inputs (predicted future cash flows and observed market value) are used to impute the apparent consensus market rate of return on the asset or liability. For example, the imputation model is used to find the yield on marketable bonds.

Diagram D reverses the direction of two arrows in diagram C to show how present value can be used to estimate an unknown market value for an asset or liability, that has predictable future cash flows and a known market-based discount rate. This discounting model can be used to estimate the market value.

Different forms of the discounting model include refinements based on levels of understanding of the market mechanism. The present value formula below is that most commonly used for accounting measurements.

[MATHEMATICAL EXPRESSION OMITTED]

It sums the present values of a series of individual discrete future cash flows. The present value of each cash flow in the series ([f.sub.i]) is found by dividing it by the factor of one plus the discount rate (r) raised to a power (i), where i is equal to the number of time periods that are expected to pass before the cash flow occurs.

This formula's simplicity allows its ready use both to impute the market discount rate and find a present value of a set of future cash flows; however, its simplifying assumptions limit its precision. More sophisticated forms use multiple discount rates and probability-based predictions to reflect differing preferences for short- and long-term cash flows. In general, their complexity makes them less suitable for financial reporting; however, the FASB appears to be moving in this direction despite the uncertainties these forms must deal with.

Given its origin, and the constraints arising from reliability,, we believe the only useful financial accounting application of present value is for estimating a current market value that cannot be observed by any other method. Although a present value can be computed by applying any discount rate to any set of future cash flows, the result has relevance (and helps financial statement users) only if the discount rate is an observed market rate and only if the cash flows can be reliably predicted.

PRESENT VALUE MEASUREMENT IN FINANCIAL REPORTING

This limited applicability suggests present value measurements for financial reporting are useful only if they follow the four steps shown in exhibit 1, above, and described below.

Step 1. The CPA must estimate the unknown market value of an asset or liability. If its value can be observed directly, present value measurement is unnecessary. If cash flows cannot be predicted reliably because they are not contractual or subject to actuarial prediction, there is no point in continuing because the result will be unreliable.

Step 2. Present value is useful only if information about cash flows of similar assets or liabilities and their market values is available. For this step to be useful, there must be a fundamental similarity between the set of future cash flows that has an observable market value and the set that does not. The two assets or liabilities must produce cash flows similar in timing and risk. For example, differences in risk make the market value of one of the company's assets unsuitable for imputing the rate for one of its liabilities, and vice versa. A current market rate for a specific asset or liability cannot be found by averaging the market rates for large groups of assets or liabilities or by using historical rates. If these conditions are not met, present value measurement is not useful and there is no benefit to continuing.

Step 3. The third step does nothing more than calculate a present value to be used as an estimated market value for the asset or liability at a specific point in time. The estimate's reliability and usefulness are limited by the reliability of its inputs. Exhibit 2, below, shows how steps 2 and 3 combine the imputation and discounting models. The diagram shows that the market discount rate used in step 3 must come from applying the imputation model to similar cash flows in step 2. If the discount rate is found by another process, a present value can still be calculated, but the amount is unlikely to be a useful description of the asset or liability.

Step 4. The last step is a feedback loop to ensure the process continues to provide useful information over time. Failing to complete step 4 simply means the company's statements present outdated numbers that won't help users reach rational decisions. The step involves three activities:

1. Monitoring the situation to see whether it is now feasible to observe the market value of the asset or liability. If so, present value should be abandoned because it is no longer needed.

2. Determining whether the predicted cash flows should be revised to reflect new conditions. For example, if the issuer of a note later faces financial difficulties, the anticipated amounts and timing of cash flows from the note should be changed to reflect the new reality.

3. Observing similar assets or liabilities to determine whether the market discount rate has changed. Market conditions and values vary even if future cash flows do not. As a result, continuing to apply the original rate will no longer produce a useful estimate of current market value.

OBSERVED INADEQUACIES OF GAAP

Once we determined this process was essential for present value measurement, we analyzed these key authoritative pronouncements to assess whether they were likely to produce useful measures.

* Accounting Principles Board Opinion no. 21, Interest on Receivables and Payables.

* FASB Statement no. 15, Accounting by Debtors and Creditors for Troubled Debt Restructurings.

* Statement no. 114, Accounting by Creditors for Impairment of a Loan.

* Statement no. 87, Employers' Accounting for Pensions.

* Statement no. 106, Employers' Accounting for Postretirement Benefits Other Than Pensions.

* Statement no. 109, Accounting for Income Taxes.

* Emerging Issues Task Force Issue no. 87-11, Allocation of Purchase Price of Assets to Be Sold.

The results are summarized in exhibit 3, below, which uses check marks to identify properly implemented steps: omitted or improperly executed steps are described in yellow shaded boxes. As discussed below, each application has at least one major defect.

Opinion no. 21. This watershed pronouncement helped move present value measurement into the GAAP mainstream. It requires companies to produce an initial measure of a nonmarketable long-term receivable or payable by properly executing steps 1, 2 and 3. However, the opinion does not allow the company to execute step 4. Instead, it must continue using the original discount rate to allocate interest and calculate the balance of the receivable or payable. Although subsequent balances are present values of future cash flows, they do not have relevance unless the current market discount rate coincidentally equals the original discount rate.

Statement nos. 15 and 114. These standards deal with impaired debt situations. Statement no. 15 is inconsistent with useful present value measurement because not one of the four steps is completed. The creditor and debtor misapply step 1 when they predict future cash flows for the troubled debt without first trying to find its current market value. Both parties skip step 2 because they do not try to find a current market rate for similar assets or liabilities. They also omit step 3 by simply carrying forward the debt's book value unless it exceeds the sum of the undiscounted future cash flows, in which case it is written down to that amount. And both omit step 4 because the debt's later balances and interest are calculated with a rate that does not reflect current expectations and market conditions.

Statement no. 114 was issued to upgrade practice but falls short because it requires a creditor to discount restructured cash flows at the original rate when the note was issued instead of the current rate when its impaired status is acknowledged. Even though the standard causes creditors to implement step 3, it requires them to omit steps 1 and 2 because they do not try to find an observable market value for the debt and must use an irrelevant historical rate. While step 3's output admittedly is a present value, it is not useful because it is not the present value that approximates the note's market value. In addition, step 4 is not executed.

Statement no. 87. This standard was controversial because it tried to bring uniformity' to a complex practice area. In fact, our analysis shows it conforms with the four-step process:

* It applies to actuarially predicted future cash flows that do not have a market value.

* The employer's discount rate is the current settlement rate for similar pension liabilities.

* The employer estimates the current market value of the pension liability by finding the present value of the future cash flows discounted with this current market rate.

* The employer continually updates its predictions of future cash flows and discounts them with the current settlement rate.

Despite its use of all four steps, Statement no. 87 is flawed because the employer must modify the present value estimates to defer recognizing various gains and losses. (To its credit, the FASB knew these compromises robbed the statements of their usefulness and warned users to read the footnotes if they wanted the most current information.)

Statement no. 106. To avoid controversy, the FASB tried to make this standard on other postemployment benefits similar to Statement no. 87. The effort fell short with a subtle compromise for step 2. In some cases, the standard requires employers to discount the expected liability cash outflows for benefits with an imputed rate based on high-quality investment assets. This result always overstates the market value of the liability because the rate of return on the low-risk assets is always less than the market rate for the high-risk cash flows from the liability. This present value is unlikely to be a useful measure of the liability. As a result, the estimated annual cost also may not be useful.

Statement no. 109. This standard came out of the FASB's controversial income tax project. Instead of requiring companies to discount future tax cash flows, the standard requires them to report deferred tax assets or liabilities at an amount equal to the undiscounted cash flows for the income tax effects of temporary differences. In effect, a company executes step 1 by predicting future cash flows for income taxes. It omits steps 2 and 3 because it does not try to find a market discount rate and thus cannot discount the cash flows. At least part of step 4 is completed each year by creating new estimates of the future tax effects of the differences, especially for tax law changes. However, the market value of the tax liability or asset is not estimated or reported.

EITF Issue no. 87-11. Even though the specific procedure was not included in this consensus, the early debates on the issue revealed a minimal understanding of the usefulness of present value. Specifically, the EITF proposed estimating the current market value of assets expected to be sold by first predicting a future market value and then discounting it back to a present value. We believe this proposal is contrary to step 1 because we cannot imagine a real situation in which a future selling price could be predicted more reliably than a current selling price could be observed. The proposal also failed to identify a discount rate and would have disallowed substituting a later market value for the initial prediction.

RECOMMENDATIONS

Although compliance with these pronouncements is required, all CPAs must be cautious about calling a present value of some predicted future cash flow useful. Our analysis shows this number is useful only under limited conditions:

1. The market value is unobservable.

2. Future cash flow predictions are reliable because of actuarial methods or a firm contract.

3. The discount rate is imputed from facts about similar assets or liabilities.

4. The results of the process are reevaluated over time.

Unless these four conditions exist, there is no reason to expect the outcome to be useful. Future efforts by standard setters and other policy makers to expand discounting as a measurement technique should meet the described conditions.

In simple terms, present value measurement is not a magic wand that produces useful information in every situation. In fact, it should be a technique of last resort in financial accounting because it works only temporarily in very limited situations when nothing better is available.

Because of these misunderstandings, the FASB should issue a concepts statement identifying the limited usefulness of present value measures and describing when and how that usefulness can be achieved. The board should not create any additional defective uses of present value in new standards; it should eliminate misapplications in existing standards. This task will be difficult because of its wide scope and the acceptability of old practices. However, progress in financial reporting demands that financial statements contain more useful information and this effort is needed to ensure the statements are as useful as they can and ought to be.

EXECUTIVE SUMMARY

* GENERALLY ACCEPTED ACCOUNTING PRINCIPLES include many present value measurements that assign amounts to specific assets and liabilities. These techniques have become so widely accepted that many have forgotten (or never knew) their origins and limitations.

* PRESENT VALUE MEASUREMENT originated in the search for the relationship between future cash flows and their market value. As a result, its only potentially useful financial accounting application is to estimate a current market value that cannot be observed by any other feasible method.

* IN FINANCIAL REPORTING, USEFUL present value measurements are achieved only when four essential steps are completed. Analyzing several key authoritative pronouncements reveals that each of the resulting measures of present value has at least one major defect.

* CPAs MUST BE CAUTIOUS ABOUT CALCULATING the present value of predicted future cash flows and calling the result useful. The number is useful only if the market value is unobservable, future cash flow predictions are reliable, the discount rate is imputed from facts about similar assets or liabilities and the results of the process are reevaluated over time.

PAUL B. W. MILLER, CPA, PhD, is professor of accounting at the University of Colorado at Colorado Springs. PAUL R. BAHNSON, CPA, PhD, is associate professor of accounting at the University of Montana, Missoula.