The FASB Explores Accounting for Future Cash Flows

Healthcare Financial Management, March, 2001 by Randall W. Luecke, David T. Meeting

The term "fair value" generally refers to the amount at which an asset (or liability) can be bought (or incurred) or sold (or settled) in a current transaction between willing parties. [c] Another term for fair value, "current market value," connotes a market composed of knowledgeable buyers and sellers, each willing and able to assess the value of an available item. In such a market, the forces of supply and demand rule, so no item is bought or sold at more or less than its true worth.

By contrast, the present value of estimated future cash flows is implicit in market prices, including the historical cost recorded when an entity purchases an asset for cash. Present-value measurements represent the amounts an entity demands (or that others demand from it) for money that it will receive (or pay) in the future. The buyer would not pay more than the present value of the future cash flow for the asset, and the seller would not accept less than the future cash flow's present value. In a competitive market, the exchange price should be equal to the present value of the cash flow.

Present values use estimates that are subject to bias and therefore are considered to be less relevant and reliable than fair values that can be observed in the marketplace. The FASB therefore advocates the use of fair value when the requisite information to determine fair value is available, while allowing that present-value analysis can provide a basis for measurements when information on the fair value of an asset or liability is not available, as typically is the case with assets or liabilities that are paid over time.

Present-value calculations incorporate the time value of money in accounting measurements, thereby making it possible to determine the economic difference among sets of future cash flows. Consider, for example, the following assets, each of which involve an undiscounted cash flow of $50,000:

* Asset 1: An interest-free note receivable from a patient unable to settle his bill in full. The note calls for an $833.33 payment at the end of each month for 60 months.

* Asset 2: A note receivable from Imaging, Inc., which purchased the hospital's used radiological equipment. The note calls for a $10,000 payment at the end of each year for five years.

* Asset 3: A note receivable from Conglomerate Corp. for the purchase of excess land from the hospital. The note calls for a single $50,000 payment at the end of five years.

* Asset 4: A pledge receivable from a benefactor of the hospital. The pledge calls for a payment of $10,000 at the end of each year for five years.

* Asset 5: An investment with an expected cash flow of $10,000 each year for the five years. The cash flow could be as low as $8,000 or as high as $12,000 each year.

Although the undiscounted cash flows of these assets are identical, the discounted present values of the assets will differ significantly due to the timing of the cash flows. Thus, for example, under a traditional approach to present-value measurement, the discounted cash flows associated with the five assets (based on an 8 percent annual interest rate) would be as follows: