PRESENT VALUE TECHNIQUES: PERTINENT ISSUES AFFECTING THE ACCOUNTING MEASUREMENT PROCESS

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1 49b PRESENT VALUE TECHNIQUES: PERTINENT ISSUES AFFECTING THE ACCOUNTING MEASUREMENT PROCESS José Carlos Lopes Instituto Politécnico de Bragança Campus de Santa Apolonia - Apartado 34; Bragança Fernanda Cristina Pedrosa Alberto Instituto Superior de Contabilidade e Administração de Coimbra Quinta Agrícola - Bencanta Coimbra Área temática: B) Valoración Y Finanzas Keywords: Cash flows estimation; Discount rate; IAS 36; Impairment; Materiality; Value in use

2 PRESENT VALUE TECHNIQUES: PERTINENT ISSUES AFFECTING THE ACCOUNTING MEASUREMENT PROCESS Abstract International Accounting Standards support the use of Present Value Techniques (PVT) for accounting measurements. Particularly, IAS 36 determines the use of PVT and establishes guidelines for it, namely for cash flows estimation and the discount rate calculation. In this paper we present and discuss pertinent issues raised by the use of the mentioned techniques. From a theoretical point of view we believe PVT should be used only in some particular cases. In many situations, its use could introduce biases in the accounting measurement process. This analysis identifies factors that could have a significant effect in the cash flows estimation and in the discount rate estimation, and consequently material variations in the value in use.

3 . Introduction The present value techniques are widely used in finance and accounting fields. They are used for financial instruments assets evaluation, for tangible and intangible assets evaluation or for project evaluation. Their use for accounting measurements has raised discussion and resulted in new guidelines. To issue guidance about the use of present value techniques for accounting measurements Financial Accounting Standards Board (FASB) issued SFAC 7. In 004, International Accounting Standards Board (IASB), following FASB and regarding the impairment matter, also issued regulation about the use of present value techniques (see IAS 36). Concerning assets evaluation (financial, tangible or intangible), the most commonly used methods are based on the market (market approach methods), based on the cost (cost approach methods) and based on income (income approach methods). The present value techniques belong to the latter category. The methodology followed in its use can assume several and distinct assumptions, and consequently lead to different results. The aim of this study is to introduce the basics of present value techniques and its use in the accounting field, namely for accounting measurements (e.g.asset impairment analysis), and to identify and discuss pertinent issues that could have material impact in the measurement process. First, we present the guidance provided by IASB regarding the use of present value in impairment tests, including in IAS 36,and then we discuss pertinent issues related to the use of PVT that could have implications the measurement process.. Financial Accounting Standards and Measurements in Impairment Tests. The use of present value techniques in impairment tests In order to improve the reliability of accounting financial reporting, IASB publishedthe International Accounting Standard (IAS) 36. IAS 36 establishes the guidelines for impairments assets purposes. As any standard, IAS 36 starts indicating its objective and scope, the underlying concepts and its definitions, and then prescribes the procedure. The objective of this standard is to ensure that assets are carried at no more than their recoverable amount and to define how recoverable amount is determined. IAS 36 applies to all assets except inventories, assets arising from construction IAS 36 was published in June 998 and revised in March 004. After that, IAS 36 was amended for Annual Improvements to IFRSs 007 and for Annual Improvements to IFRSs

4 contracts, deferred tax assets, assets arising from employee benefits, financial assets, investment property carried at fair value, agricultural assets carried at fair value, insurance contract assets and non-current assets held for sale (, IAS 36). The impairment process begins by identifying the possible impaired assets. An asset is considered impaired if the recoverable amount (RA) is lower than the carrying amount (CA). At each reporting date, an entity should assess whether there is any indication that an asset may be impaired. According to the circumstances, impairment analysis should be performed at an asset level or at a cash-generating unit level. The assessment should take into consideration, as a minimum, the following external and internal sources of information (, IAS 36): External sources of information: «(a) during the period, an asset s market value has declined significantly more than would be expected as a result of the passage of time or normal use. (b) significant changes with an adverse effect on the entity have taken place during the period, or will take place in the near future, in the technological, market, economic or legal environment in which the entity operates or in the market to which an asset is dedicated. (c) market interest rates or other market rates of return on investments have increased during the period, and those increases are likely to affect the discount rate used in calculating an asset s value in use and decrease the asset s recoverable amount materially. (d) the carrying amount of the net assets of the entity is more than its market capitalization. Internal sources of information: (e) evidence is available of obsolescence or physical damage of an asset. (f) significant changes with an adverse effect on the entity have taken place during the period, or are expected to take place in the near future, in the extent to which, or manner in which, an asset is used or is expected to be used. These changes include the asset becoming idle, plans to discontinue or restructure the operation to which an asset belongs, plans to dispose of an asset before the previously expected date, and reassessing the useful life of an asset as finite rather than indefinite. Therefore, IAS 36 applies to (among other assets): lands, buildings, machinery and equipment, investment property carried at cost, intangible assets, goodwill, investments in subsidiaries, associates and joint ventures carried at cost and assets carried at revalued amounts under IAS 6 and IAS 38. 4

5 (g) evidence is available from internal reporting that indicates that the economic performance of an asset is, or will be, worse than expected». If evidence exists that an asset may be impaired, a deep impairment analysis, which leads to impairment tests, should be carried out. Otherwise, the impairment procedure ends, without further analysis (and impairment tests). However, three exceptions to the general rule are stated for intangible assets that has an indefinite useful life, intangible assets that is not yet available for use and goodwill, determining a compulsory annually impairment test for that kind of assets. The next step involves the recoverable amount measurement. According to IAS 36, the recoverable amount is «( ) the higher of an asset s or cash-generating unit fair value less costs to sell and its value in use. ( )» ( 6, IAS 36). To compute the recoverable amount, entities can follow two different approaches fair value less costs to sell and value in use. The former is based on market values while the latter is based on the present value techniques. However, IAS 36, paragraph 0, states the primacy of fair value less costs to sell over present value techniques: «It may be possible to determine fair value less costs to sell, even if an asset is not traded in an active market. However, sometimes it will not be possible to determine fair value less costs to sell because there is no basis for making a reliable estimate of the amount obtainable from the sale of the asset in an arm s length transaction between knowledgeable and willing parties. In this case, the entity may use the asset s value in use as its recoverable amount». Furthermore, paragraphs 5-7 indicate as good alternatives to achieve fair value less costs to sell: a) Firstly, «a price in a binding sale agreement in an arm s length transaction, adjusted for incremental costs that would be directly attributable to the disposal of the asset». b) Secondly, if the asset is traded in an active market, «fair value less costs to sell is the asset s market price less the costs of disposal. The appropriate market price is usually the current bid price. When current bid prices are unavailable, the price of the most recent transaction may provide a basis from which to estimate fair value less costs to sell, provided that there has not been a significant change in economic circumstances between the transaction date and the date as at which the estimate is made». c) Thirdly, «If there is no binding sale agreement or active market for an asset, fair value less costs to sell is based on the best information available to reflect the amount that an entity could obtain, at the balance sheet date, from the disposal of 5

6 the asset in an arm s length transaction between knowledgeable, willing parties, after deducting the costs of disposal. In determining this amount, an entity considers the outcome of recent transactions for similar assets within the same industry. Fair value less costs to sell does not reflect a forced sale, unless management is compelled to sell immediately». Only if any of the previously stated alternatives are not feasible should the measurer turn to the value in use approach, which involves the use of present value techniques. The main objective when using the present value techniques for accounting measurements (initial recognition or fresh start measurements) is to find the fair value. Appendix A of IAS 36 provides guidance on the use of present value techniques in measuring value in use. First, the components of present value measurement are identified and some general principles to be followed are stated. Finally, it states guidance about the use of the discount rate.. The value in use A recoverable amount based on value in use, which is in turn based on present value techniques, should be regarded with care. To compute the value in use, it is necessary to take into account the future cash flows which the entity expects to derive from the asset and, on the other hand, an appropriate discount rate. Therefore, without proper regulation and enforcement, a creative accounting could be performed, to manipulate the recoverable amount. Baker (000: 36) denotes, «management may want to overestimate cash flows to avoid write-off. ( ) other times management may believe a significant write-off will benefit the company in the long term». The importance of the propervalue in use is higher when recent studies indicate that the valuation basis most disclosed to calculate impairment loss is the value in use or the higher of the Net Selling Price and value in use - e.g. Andrews (006: 35). To achieve some uniformity in value in use computation and, perhaps, in order to avoid manipulations, IAS 36 establishes guidelines regarding cash flows and discount rates. The last IAS 36 revision (March, 004), was strongly inspired on the FASB SFAC 7 provisions about the issue. For example, the paragraph 30 from IAS 36 seems very similar to paragraph 3 from SFAC 7 and many others are a direct copy of SFAC 7 rules. 6

7 The guidance on the use of present value techniques for impairment purposes starts on paragraph 30. To calculate the value in use, the measurer must take into account the following elements: «(a) an estimate of the future cash flows the entity expects to derive from the asset; (b) expectations about possible variations in the amount or timing of those future cash flows; (c) the time value of money, represented by the current market risk-free rate of interest; (d) the price for bearing the uncertainty inherent in the asset; and (e) other factors, such as illiquidity, that market participants would reflect in pricing the future cash flows the entity expects to derive from the asset.» The second, fourth and fifth elements can be reflected in the first or second step. Those elements involve a risk analysis and perhaps are the reason why the CAPM is suggested to determine the appropriate discount rate. According to paragraph 3 of IAS 36, the calculation of the value in use involves two steps: first, estimate the future cash inflows and outflows to be derived from continuing use of the asset and from its ultimate disposal; and, second, apply the appropriate discount rate to those future cash flows. Then, IAS 36 establishes the rules to deal with those components: paragraphs 33 to 54 establish the guidelines to determine the cash flows and paragraphs 55 to 57 the guidelines to determine the discount rate; and also the guidelines of appendix A... The components of present value techniques The main components of the present value formula are the set of cash flows and the discount rate In regards to the components of present value techniques, to «capture the economic differences between assets», appendix A ( A), identifies the following elements: «(a) an estimate of the future cash flow, or in more complex cases, series of future cash flows the entity expects to derive from the asset; (b) expectations about possible variations in the amount or timing of those cash flows; (c) the time value of money, represented by the current market risk free rate of interest; (d) the price for bearing the uncertainty inherent in the asset; and (e) other, sometimes unidentifiable factors (such as illiquidity) that market participants would reflect in pricing the future cash flows the entity expects to derive from the asset». 7

8 Thus, the previously stated takes into account the two main components to compute present value the cash flows and the discount rate, but also issues more specific guidance in order to achieve more accuracy, that is, concerning the cash flows estimation, special attention should be given to the expectations of amount variations and timing. The impact on the present value of those elements is significant. In addition, in point (c) it requires the time value money to be take into account, which can be accomplished through the second main factor the discount rate. Finally, it is necessary to consider the uncertainty and other relevant factors; this can be achieved through cash flows or the discount rate. To accurately capture the preceding elements, paragraph A3 (Appendix A), establishes that the elements taken into account in the cash flows should not be taken into account in the discount rate (see paragraph A3 (a)). If it occurs, the effect will be double counted or ignored. For example, if we take into consideration some measure of uncertainty in cash flow estimation, then we must not take into consideration the same measure of uncertainty through the discount rate. «The estimated cash flow and discount rates should be free from bias and factors unrelated to the asset». This means that the measurer should clearly state the factors related to the asset performance, i.e. cash flows and discount rates should not be underestimated or overestimated (see paragraph A3 (b)). Ultimately, the main components (cash flows and discount rate) «should reflect the range of possible outcomes rather than a single most, likely, minimum or maximum possible amount» (paragraph A3 (c)). This requires the use of probabilities, and like FASB, leading therefore to additional complexity, IASB also distinguishes the two different approaches the traditional one and the expected cash flow. These approaches will be analysedin section The discount rate Concerning the discount rate, IAS 36 ( 55 and appendix A) establishes that the measurer must use a pre-tax rate reflecting the market assessment for the time value money. It also establishes that the discount rate should reflect risks specific to the asset for which the future cash flow estimates have not been adjusted; otherwise, the effect will be double-counted.the previously stated is applied to both, traditional or expected cash flow approaches. As a point of reference, the discount rate can be «the return that investors would require if they were to choose an investment that would generate cash flows of amounts, timing and risk profile equivalent to those that the entity expects to derive from the asset» ( 55). Which means «This rate is estimated from the rate implicit in 8

9 current market transactions for similar assets or from the weighted average cost of capital of a listed entity that has a single asset (or a portfolio of assets) similar in terms of service potential and risks to the asset under review» ( 55). Thus, according to the formerly stated, the measurer can use the similar entity s WACC as a discount rate. However, it raises an important issue - to avoid an effect of being double-counted the measurer should know what effects were included in the similar entity s WACC, which is not trouble-free. If an assessment by the market is not possible, then the measurer must use surrogates, providing appendix A more details for such circumstances. Paragraph A7 of IAS 36 refers to cases where no similar assets and marketplace can be observed. In those cases, an entity should use surrogates to estimate the discount rate in order to, approximately, calculate a market assessment. «The purpose is to estimate, as far as possible, a market assessment of: (a) the time value of money for the periods until the end of the asset s useful life;and (b) factors (b), (d) and (e) described in paragraph A, to the extent those factors have not caused adjustments in arriving at estimated cash flows.» The above mentioned seems to be applied to the expected cash flow approach, because the traditional approach is recommended for cases where similar assets and a marketplace can be observed. However, the main important aspect is that we can embed the expectations about possible variations in the amount or timing of cash flows, the risks and some other factors that the market participants would reflect in pricing the future cash flows, within the discount rate. Afterwards, paragraph A7 of IAS 36 indicates that some interest rates can be taken into account as a starting point to estimate the discount rate: the WACC determined using techniques such as CAPM, the entity s incremental borrowing rate and other market borrowing rates. The first one raises concerns. According to FASB (SFAC 7), CAPM, in some circumstances, is not proper, and consequently should not be used. This brings forth the following question: should we trust the CAPM to be used in the process of accounting measurement?. The changes in the discount rate could lead to significant differences in the present value, that is, in the value in use. Appendix A (IAS 36) recommends adjustments to the previous discount rates. It states: «A8. However, these rates must be adjusted: (a) to reflect the way that the market would assess the specific risks associated with the asset s estimated cash flows;and 9

10 (b) to exclude risks that are not relevant to the asset s estimated cash flows or for which the estimated cash flows have been adjusted. Consideration should be given to risks such as country risk, currency risk and price risk. A9. The discount rate is independent of the entity s capital structure 3 and the way the entity financed the purchase of the asset, because the future cash flows expected to arise from an asset do not depend on the way in which the entity financed the purchase of the asset. A0. Paragraph 55 requires the discount rate used to be a pre-tax rate. Therefore, when the basis used to estimate the discount rate is post-tax, that basis is adjusted to reflect a pre-tax rate. A. An entity normally uses a single discount rate for the estimate of an asset s value in use. However, an entity uses separate discount rates for different future periods where value in use is sensitive to a difference in risks for different periods or to the term structure of interest rates».... The cash flows Regarding the future cash flows, IAS 36 provides information concerning the: (i) basis for estimates and (ii) composition of estimates. The guidelines on the basis for estimates are based on management predictions and responsibility. The most important aspects in relation to cash flow projections are as follows: «In measuring value in use an entity shall: (a) base cash flow projections on reasonable and supportable assumptions that represent management s best estimate of the range of economic conditions that will exist over the remaining useful life of the asset. Greater weight shall be given to external evidence. (b) base cash flow projections on the most recent financial budgets/forecasts approved by management, but shall exclude any estimated future cash inflows or outflows expected to arise from future restructurings or from improving or enhancing the asset s performance. Projections based on these budgets/forecasts shall cover a maximum period of five years, unless a longer period can be justified. (c) estimate cash flow projections beyond the period covered by the most recent budgets/forecasts by extrapolating the projections based on the budgets/forecasts using a steady or declining growth rate for subsequent years, unless an increasing rate 3 Therefore it seems inconsistent with CAPM, as the CAPM component beta captures the financial risk. 0

11 can be justified. This growth rate shall not exceed the long-term average growth rate for the products, industries, or country or countries in which the entity operates, or for the market in which the asset is used, unless a higher rate can be justified» (paragraph 33); That is, the cash flow projections involve management s judgment and responsibility connected with the financial budgets/forecasts; the cash flows resulting from restructurings and enhancements must not be considered, unless an entity is committed (see paragraphs 47 4, 48 5 ). Generally, only five years should be used for projections; if more than five years are used, normally, only a steady or declining growth rate should be used. For periods longer than five years, paragraphs 34, 35 and 36 give details about cash flows projections. Concerning the composition of estimates, IAS 36 states the following: (i) Inflows, outflows and net cash flows «Estimates of future cash flows shall include: (a) projections of cash inflows from the continuing use of the asset; (b) projections of cash outflows that are necessarily incurred to generate the cash inflows from continuing use of the asset (including cash outflows to prepare the asset for use) and can be directly attributed, or allocated on a reasonable and consistent basis, to the asset; and (c) net cash flows, if any, to be received (or paid) for the disposal of the asset at the end of its useful life.» ( 39). (ii)inflation If the inflation adjustment is included in the discount rate, it must not be included in the cash flows ( 40). (iii) Day-to-day servicing and use/disposal The outflows related to day-to-day servicing of the asset as well as the future overheads that can be attributed directly and those necessary to be incurred to use or sell the asset ( 4, 4) should be included. (iv)future enhancements and restructuring 4 «When an entity becomes committed to a restructuring, some assets are likely to be affected by this restructuring. Once the entity is committed to the restructuring: (a) its estimates of future cash inflows and cash outflows for the purpose of determining value in use reflect the cost savings and other benefits from the restructuring (based on the most recent financial budgets/forecasts approved by management); and (b) its estimates of future cash outflows for the restructuring are included in a restructuring provision in accordance with IAS 37». Illustrative Example 5 shows the effect of a future restructuring on a value in use calculation. 5 «Until an entity incurs cash outflows that improve or enhance the asset s performance, estimates of future cash flows do not include the estimated future cash inflows that are expected to arise from the increase in economic benefits associated with the cash outflow (see Illustrative Example 6)».

12 For estimates of future cash flows, the measurer should only take into account the actual asset s condition and not future enhancements or entity restructuring to which it is not committed. Nevertheless, if the entity is committed to a restructuring, the estimates of future cash flows must include the subsequent benefits. In the same way, for the future enhancements, the entity can take into consideration the future inflows if the related outflows occurred ( 44, 45, 46, 47 and 48). (v) Cash flows from taxation and financing activities The estimates of future cash flows must not include inflows or outflows from income tax receipts/payments and from financing activities ( 50). (vi)disposal value at the end of asset useful life To estimate the future cash flow related with the asset s disposal, the arm s length principle should be taken into consideration and the costs of disposal deducted ( 5)... The traditional approach vs expected cash flow approach These approaches have important differences and both can be used, depending on the circumstances. Usually, the traditional approach considers only one set of cash flows and one discount rate. It is a proper approach for the measurement of some financial assets because comparable assets can be observed in the marketplace. Therefore, if a comparable asset exists in the marketplace, according to paragraph A6 of IAS 36 the measurer must do the same established in SFAC 7: a) Identify the set of cash flows that will be discounted. b) Identify another asset or liability in the marketplace that appears to have similar cash flow characteristics. c) Compare the cash flow sets from the two items to ensure that they are similar. (For example, are both sets contractual cash flows, or is one contractual and the other an estimated cash flow?) d) Evaluate whether there is an element in one item that is not present in the other. (For example, is one less liquid than the other?) e) Evaluate whether both sets of cash flows are likely to behave (vary) in a similar fashion under changing economic conditions. In doing that, the measurer can use the comparable discount rate (discount rate from the similar asset) to compute the present value of the set of cash flows and, consequently, acquires the value in use.the expectations regarding cash flows (e.g. amount and timing) and risks can be embedded in the discount rate.

13 For some accounting measurements, SFAC 7 encourages the use of the traditional approach, for instance, when contractual cash flows are available. This approach is also encouraged when comparable assets and liabilities can be observed in the marketplace. In this case, the discount rate should be adjusted analyzing «at least two items one asset or liability that exists in the marketplace and has an observed interest rate and the asset or liability being measured. The appropriate rate of interest for the cash flows being measured must be inferred from the observable rate of interest in some other asset or liability and, to draw that inference, the characteristics of the cash flows must be similar to those of the asset being measured. However, the use of the traditional approach is not proper to address more complex measurement problems, such as non-financial asset measurements, without similar assets observed in a marketplace. Thus, appendix A establishes a new approach the expected cash flow. The expected cash flow approach «uses all expectations about possible cash instead of single most likely cash flow» ( A7) and still works «when the timing of cash flow is uncertain»( A8). To do that, it uses probabilities. Appendix A provides some examples, on how to use probabilities and shows the superiority of expected cash flow approach over traditional approach. The use of this approach is subject to a cost benefit constraint, so that its use depends on the circumstances, sometimes easy (inexpensive) to get the necessary inputs, sometimes not (i.e., they are not available or are expensive), thus, a case-bycase analysis should be taken. As IAS 36, also SFAC 7 ( 45) considers, for many situations, the expected cash flow approach as the best alternative. Nonetheless, it establishes some principles to be followed: «a. To the extent possible, estimated cash flows and interest rates should reflect assumptions about the future events and uncertainties that would be considered in deciding whether to acquire an asset or group of assets in an arm s-length transaction for cash. b. Interest rates used to discount cash flows should reflect assumptions that are consistent with those inherent in the estimated cash flows. Otherwise, the effect of some assumptions will be double counted or ignored. ( ) c. Estimated cash flows and interest rates should be free from both bias and factors unrelated to the asset, liability, or group of assets or liabilities in question. For example, deliberately understating estimated net cash flows to enhance the apparent future profitability of an asset introduces a bias into the measurement. 3

14 d. Estimated cash flows or interest rates should reflect the range of possible outcomes rather than a single most-likely, minimum, or maximum possible amount». The principles stated above will be useful to any application of present value techniques in measuring assets or liabilities. approach. Table shows the main differences between traditional and expected cash flow Table : The traditional approach versus the expected cash flow approach Traditional approach Expected cash flow approach Single set of estimated cash flows Complex set of estimated cash flows Do not use probabilities Use statistical methods, mainly probabilities, to estimate the future cash flows Estimated cash flows or interest rates reflect a single most-likely, minimum, or maximum possible amount Estimated cash flows or interest rates should reflect the range of possible outcomes Is encouraged when comparable assets and liabilities can be observed in the marketplace Single discount rate The expectations regarding cash flows (e.g. amount and timing) and risks can be embedded in the discount rate Is useful when comparable assets and liabilities cannot be observed in the marketplace Single discount rate might be equal to the risk-free asset Discount rate does not reflect the expectations about cash flows amount, timing and risks. The risks could be adjusted through cash flows According to the differences between the two approaches, the expected cash flow approach seems to have more advantages than the traditional approach because of the use of statistics, although more complex. The use of a discount rate equal to the risk-free asset is another important difference that could lead to precise results if the risks are treated properly via cash flows. At first sight the main advantages of using a risk-free rate are: (i) Slight discount rate variations have a greater impact over present value (that is, value in use ); it is an exponentialfunction. (ii) A discount rate based on a risk-free rate cannot be manipulated (e.g. a Treasury bond yield. (iii) Slight variations in cash flows have a small impact over the present value. (iv) Manipulation over cash flows is more detectable; users can analyze the historic cash flows predictions, compare it with the real cash flows, and decide on the quality predictions. Regarding discount rates, the analysts cannot assess the quality of predictions. (v) Future risk-free rates can be reliably predicted and adjusted based on theterm structure of interest rates. In contrast, if a company uses a different discount rate for each cash flow (i.e. a complex set of discount rates), the impact on the 4

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