Concepts Statement No 7

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SCOPE OF THE STATEMENT Concepts Statement no. 7 includes general principles that govern accountants’ use of present value, especially when the amount of future cash flows, their timing, or both, are uncertain. This might happen when a business sells an asset and receives payments over time. The statement is limited to measurement issues (how much) and does not address recognition issues (when or if). It does not specify when fresh-start measurements are appropriate. Rather, FASB expects to decide whether a particular situation requires a fresh-start measurement or some other accounting response on a project-by-project basis. Concepts Statement no. 7 applies only to measurements at initial recognition, to fresh-start measurements and to amortization techniques based on future cash flows. CPAs should not apply it to measurements based on the amount of cash or other assets an entity pays or receives or on observations of fair values in the marketplace. If such transactions or observations exist, CPAs should base measurements on them, not on future cash flows.A CPA who uses accounting measurements at initial recognition and when making fresh-start measurements should try to capture the elements that would make up a market price (fair value) if one existed. The marketplace is the final arbiter of asset and liability values. The objective of using present value is to estimate the likely market price if one existed. The statement introduces an expected cash flow approach focusing on the explicit assumptions about the range of possible cash flows and their respective probabilities. This means a business would evaluate the cash flows it expected to receive from a particular asset and assign a probability to each one. Concepts Statement no. 7 describes techniques for estimating the fair value of liabilities, taking into account the entity’s credit standing at initial recognition and when making fresh-start measurements, as required under GAAP. The statement also describes the factors that, if present, suggest CPAs should consider using the interest method of allocation. FAIR VALUE In accounting, fair value is the objective for most measurements at initial recognition and for fresh start measurements in subsequent periods. At initial recognition, the cash or equivalent amount a willing buyer and seller pays or receives (historical cost or proceeds) in an open market is usually assumed to represent fair value. Both current cost and current market value fall within this definition. Fair value is the most reliable measure of a transaction because it represents the epitome of objectivity—market forces set the amount and it is not subject to bias or measurement problems. When CPAs can determine fair value they must use it; they need not analyze present value or expected cash flow. However, when they can’t find a fair value, accountants must use some of the other techniques described here. PRESENT VALUE AT INITIAL RECOGNITION When CPAs observe an essentially similar asset or liability in the marketplace, they don’t need present value measurements to determine a price. The market price represents the present value of the estimated cash flows. This same present value is implicit in all market prices (including historical cost) and is most apparent in financial assets such as loans and bonds. Fair value provides CPAs with the most complete and representationally faithful measurement of the economic characteristics of an asset or liability. A present value measurement that estimates fair value would include * An estimate of future cash flows or a series of cash flows. * Expectations about possible variations in the timing or amount of those cash flows. * The time value of money (risk-free rate of interest). * The price of bearing uncertainty that is inherent in the asset or liability. * Other, sometimes unidentifiable, factors, including illiquidity and market imperfections. Concepts Statement no. 7 contrasts two approaches to...
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