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. …