Although "derivatives" have been a hot issue recently in financial accounting and other issues are somewhat overshadowed by it, the FASB's Exposure Draft issued on June 11, 1997 is, I believe, certainly more important because of its potentially much more impact on financial accounting. Here is my recent paper on the issue. Your comments are welcomed!

Introduction

The Financial Accounting Standards Board (FASB) in the Proposed Statement of Financial Accounting Concepts: Using Cash Flow Information in Accounting Measurements, is proposing a framework for using future cash flows as the basis for an accounting measurement.¹ The framework provides (1) general principles governing the use of present value, especially when the amount of future cash flows, their timing, or both are uncertain, and (2) a common understanding of the objectives of present value in accounting measurements, in particular, for estimating either fair value or an entity-specific measurement.² Objectives of this paper are to analyze the implications of the proposal, evaluate how it better serves the FASB's conceptual framework as a whole on which consistent accounting standards are built, and support the board's position.

The FASB has issued more than a dozen of standards requiring recognition and measurement issues in the 1990's and most of them have addressed the use of present value techniques but with considerable variations among those applications.³ Therefore, there has been a need to explore the basic characteristics of those techniques and the underlying concepts before implementing fair value accounting on a more comprehensive basis.⁴

Better Serving the Objectives of Financial Reporting?

The very first question that has to be asked is whether or not the present value-based measurements using future cash flows better serve the objectives of financial reporting. Unlike current cash flows, future cash flows generally entail uncertainty and risk. The present value formula is essentially composed of cash flows and interest rates, and it is a tool used to incorporate the time value of money into a measurement, by which the present value distinguishes between unlike items that might otherwise appear similar.⁵

Since the present value measures what an entity owns and owes at a certain measurement date based on the discounted future cash flows rather than on the undiscounted sum of those cash flows, it better reflects more likely cash flows, thus provides better assessments of cash flow prospects to which investors and creditors pay close attention. It also better represents enterprise resources, claims to resources, and changes in them. Moreover, the present value-based measurements could solve, to some extent, the additivity problem resulting from various measurement attributes currently used in the balance sheet. Therefore, the FASB proposal would lay a foundation on which accounting standards provide information that is more useful in investment and credit decisions. Some of these aspects with respect to qualitative characteristics of accounting information will be discussed later in more detail.

Broader Implications

Primary Elements, Comprehensive Income, and the Asset/Liability Approach

The FASB's conceptual framework defines the two primary elements of accounting information, i.e., asset and liability and defines the other elements in terms of these two elements.⁶ In other words, income is defined, recognized, and measured as a by-product of asset and liability measurement.

Because of the reason discussed earlier, present value-based measurements using future cash flows are more in line with the definition of an asset and a liability than the undiscounted sum of those cash flows are. They better represent probable future economic benefits and probable future sacrifices of economic benefits, both of which essentially affect net cash flows in the future. Better representation of assets and liabilities inevitably leads to better representation of stockholders' equity since it is defined as net assets or residual.

Changes in net assets are comprehensive income which was recently issued as a new standard, and it includes all changes in net assets during a period. It means that dirty surplus items in the balance sheet will be eliminated and only net dividends (dividend minus capital contributions) run through equity.⁷ This results in making the income statement simply a way of classifying and reporting changes in net assets.⁸

It appears natural and reasonable that the present value-based measurements came out soon after the comprehensive income concept because these two work complementarily each other for the purpose of reinforcing usefulness of financial reporting, and also can be viewed as the FASB's one major step toward the asset/liability approach.

Balance Between Relevance and Reliability

It was addressed earlier that the FASB's proposal would result in providing information that is more useful to investors and creditors. Then, how would the components of usefulness, i.e., relevance and reliability work for the betterment of financial reporting? Would reliability be at the expense of relevance?

While present value-based measurements generally capture the economic difference such as risk and uncertainty between sets of estimated future cash flows, and distinguish a $ 1,000 cash flow due tomorrow from a $ 1,000 cash flow due in 10 years, the undiscounted sum of future cash flows do not.⁹ The former, therefore, serves better assessments of cash flow prospects, and improves both predictive value and feedback value, resulting in more relevance. As for reliability, representational faithfulness would be certainly enhanced because the present value-based accounting information better represents economic realities.

These advantages are likely, unless an arbitrary interest rate is applied to a series of cash flows, in which case present value method would provide only limited information to financial statement users and may mislead rather than assist.¹⁰ Therefore, it is important to have an explicit statement of the assumptions used in the measurements such as amounts and timing of future cash flows and their variations as well as any adjustment for uncertainty and risk.

Verifiability may be reduced; more specifically verifiability with respect to an accounting measure itself ("direct verification")¹¹would be lower especially in case of entity-specific measurements¹² due to specific situation pertaining to the entity as well as potential manipulation by management. However, more disclosures as mentioned above could still minimize measurer bias¹³ by enhancing verifiability with respect to the procedures used to obtain the measure ("indirect verification")¹⁴. Such disclosures could also contribute to imposing discipline on preparers of financial statements, resulting in maintaining reliability to some extent.

Considering these, the proposed concepts statement would bring more relevance and still maintain sufficient reliability, thus be more useful in terms of investment and credit decision making.

Potential Revision in the Existing Conceptual Framework

Statements of Financial Accounting Concepts describe concepts and relations that will underlie future financial accounting standards and practices as well as serve as a basis for evaluating existing standards and practices.¹⁵ Therefore, any inconsistency or inappropriateness among those statements would impair integrity of the conceptual framework.

Descriptions of measurement attributes in Statement of Financial Accounting Concepts (SFAC) No.5, Recognition and Measurement in Financial Statements of Business Enterprises, are nothing more than a collection of present practices.¹⁶ Since the SFAC No. 5 presented nothing new and was silent on any conceptual way to justify one choice of accounting treatment over another, it has not been useful to either the FASB or practitioners in resolving complex accounting issues.¹⁷

Now that the new concepts statement is proposed in addition to the recent issuance of the standard on comprehensive income, it is undoubtedly about time for the FASB to do major revisions in measurement part in SFAC No.5 so that it can be more consistent and prescriptive in terms of when and how a specific measurement attribute is used. This would be a major leap in the development of the conceptual framework.

Potential Effects on Other FASB Standards

Although the proposed concepts statement itself does not intend to amend or modify any existing accounting standard,¹⁸ its consequences would be very broad since it lays a foundation against which each accounting standard should be evaluated. The FASB recognizes, if does not specify any, that in certain respects current generally accepted accounting principles may be inconsistent with those that may derive from the objectives and concepts set forth in Statements in this series.¹⁹

The treatment of deferred tax assets/liabilities, Accounting for Income Taxes (Statement of Financial Accounting Standards: SFAS No. 109), would be an example that should be reviewed. They are currently not discounted, thus do not indicate the appropriate future economic benefit or future sacrifices of economic benefit.²⁰

Another examples would be Accounting for the Impairment of Long-Lived Assets and for Long-Lived Assets to Be Disposed of (SFAS No. 121). In performing the review for recoverability of long-lived assets and certain identifiable intangibles to be held and used by an entity, the entity should estimate the future cash flows expected to result from the use of the asset and its eventual disposition on the undiscounted basis.²¹ It is also arguably problematic in terms of relevance.

Other examples for review would include, but not limited to, convertible bond debt described in the Accounting Principles Board (APB) Opinion No. 14 and an estimated liability for product warranty costs.²² Appropriate amendments of these standards would improve usefulness of accounting information.

Conclusion: Yes to Better Conceptual Framework

As discussed above, the proposed concepts statement would work as prescriptive accounting measurements if the inconsistencies in troublesome SFAC No.5 were appropriately revised. This makes the FASB's conceptual framework as a whole a more coherent and integrated system. Accordingly, the improved framework can allow some of the existing accounting standards to be reviewed and modified, and also serve as the foundation which leads to consistent accounting standards and prescribe the nature, function, and limits of financial accounting as well as financial statements. Furthermore, the proposed statement can be a crucial milestone toward the FASB's next move to address recognition issues. So let the FASB move on.

Copyright: 1997 by Tetsuya Morikawa

¹ Financial Accounting Standards Board (FASB), Exposure Draft (ED). Proposed Statement of Financial Accounting Concepts, "Using Cash Flow Information in Accounting Measurements" (Norwalk, CT. June 11, 1997), par. 9.

² Ibid.

³ Ibid., pars. 2 and 3.

⁴ Mary E. Barth and Wayne R. Landsman, "Fundamental Issues Related to Using Fair Value Accounting for Financial Reporting," Accounting Horizons (December 1995), p. 97.

⁵ FASB, ED, pars. 13-15.

⁶ Paul B.W. Miller, "The Conceptual Framework as Reformation and Counterreformation," in Stephen A. Zeff and Bala G. Dharan, Readings and Notes on Financial Accounting 5^th ed. (McGraw-Hill, Inc. NY. 1997), p. 97. [Original source: Accounting Horizons (June 1992), pp. 23-32.]

⁷ American Accounting Association (AAA), "An Issue Paper on Comprehensive Income," Accounting Horizons, (June 1997), pp. 120, 124.

⁸ Harry I. Wolk and Michael G. Tearney, Accounting Theory: A Conceptual and Institutional Approach, 4^th ed. (Cincinnati, OH. South-western College Publishing, 1997), pp. 293-295.

⁹ FASB, ED, par. 14.

¹⁰ Ibid., par. 16.

¹¹ FASB. Statements of Financial Accounting Concepts (SFACs), 1994/95 ed. (Burr Ridge, IL. Irwin, 1994), p. 58 [SFAC No.2], par. 87.

¹² FASB, ED, par. 43.

¹³ FASB, SFACs, p. 58[SFAC No.2], par.87.

¹⁴ Ibid.

¹⁵ FASB, ED, Highlights, p. 3.

¹⁶ FASB. SFACs, pp. 151-152 [SFAC No.5], pars. 66 and 67.

¹⁷ Norma Nussbaumer, "Does the FASB's Conceptual Framework Help Solve Real Accoounting Issues?" in Stephen A. Zeff and Bala G. Dharan, Readings and Notes on Financial Accounting 5^th ed. (McGraw-Hill, Inc. NY. 1997), p. 91. [Original: Journal of Accounting Education (Spring 1992), p. 235-242.]

¹⁸ FASB, ED, Highlights, p. 3.

¹⁹ Ibid.

²⁰ Donald. E. Kieso and Jerry J. Weygandt, Intermediate Accounting 8^th ed. (New York, NY. John Wiley & Sons, Inc. 1995), p. 1021.

²¹ FASB. Current Text 1996/97 ed., vol.1, (NY, John Wiley & Sons, Inc.,1996), p. I08.126, par. 125. [SFAS No. 121, par. 6]

²² Roman L. Weil, "Role of the Time Value of Money in Financial Reporting," Accounting Horizons (December 1990), pp. 49-51 and 53-56.

American Accounting Association. "Response to the FASB Discussion Memorandum 'Present Value-Based Measurements in Accounting." Accounting Horizons, vol. 8, no. 1 (March 1994): pp.114-118.

^_______. "Response to the FASB Exposure Draft, Proposed Statement of Financial Accounting Standards: 'Reporting Comprehensive Income." Accounting Horizons, vol. 11, no. 2 (June 1997): pp. 117-119.

Gamble, George. O, and Joe J. Cramer, Jr. "The Role of Present Value in the Measurement and Recording of Nonmonetary Financial Assets and Liabilities: An Examination." Accounting Horizons, vol. 6, no. 4 (December 1992): pp. 32-41.

Johnson, Todd L., Barry P. Robbins, Robert J. Swieringa, and Roman L. Weil. "Expected Values in Financial Reporting." Accounting Horizons, vol. 7, no. 4 (December 1993): pp. 77-90.

Tetsuya Morikawa
San Francisco State University
Master of Science in Business Administration Program
[Accounting and Tax Concentration]

Updated: Dec. 11, 1997 Email: Tetsuya (Tet) Morikawa

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