FASB –
Statement of Financial Accounting Concepts No.
7
February 2000
[Excerpt (¶¶ 4353)]
43. Accounting applications of present value
have traditionally used a single set of estimated
cash flows and a single interest rate, often described
as “the rate commensurate with the risk.”In
effect, although not always by conscious design,
the traditional approach assumes that a single
interest rate convention can reflect all the expectations
about the future cash flows and appropriate risk
premium. The Board expects that accountants will
continue to use the traditional approach for some
measurements. In some circumstances, a traditional
approach is relatively easy to apply. For assets
and liabilities with contractual cash flows, it
is consistent with the manner in which marketplace
participants describe assets and liabilities,
as in “a 12 percent bond.”
44. The traditional approach is useful for many
measurements, especially those in which comparable
assets and liabilities can be observed in the
marketplace. However, the board found that the
traditional approach does not provide the tools
needed to address some complex measurement problems,
including the measurement of nonfinancial assets
and liabilities for which no market for the item
exists. The traditional approach places most of
the emphasis on selection of an interest rate.
A proper search for “the rate commensurate
with the risk” requires analysis of 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. Consequently,
the measurer must do the following:
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.
45. The Board found the expected cash flow approach
to be a more effective measurement tool than the
traditional approach in many situations.In developing
a measurement, the expected cash flow approach
uses all expectations about possible cash flows
instead of the single mostlikely cash flow.For
example, a cash flow might be $100, $200, or $300
with probabilities of 10 percent, 60 percent,
and 30 percent, respectively. The expected cash
flow is $220. The expected cash flow approach
thus differs from the traditional approach by
focusing on direct analysis of the cash flows
in question and on more explicit statements of
the assumptions used in the measurement.
46. The expected cash flow approach also allows
use of present value techniques when the timing
of cash flows is uncertain. For example, a cash
flow of $1,000 may be received in 1 year, 2 years,
or 3 years with probabilities of 10 percent, 60
percent, and 30 percent respectively. The example
below shows the computation of expected present
value in that situation. Again, the expected present
value of $892.36 differs from the traditional
notion of a best estimate of $902.73 (the 60 percent
probability) in this example.
PV of $1,000 in 1 year at 5.00% 
$952.38 

Probability 
10.00% 
$95.24 
PV of $1,000 in 2 years at 5.25% 
$902.73 

Probability 
60.00% 
$541.64 
PV of $1,000 in 3 years at 5.50% 
$851.61 

Probability 
30.00% 
$255.48 
Expected present value 

$892.36 
47. In the past, accounting standard setters
have been reluctant to permit use of present value
techniques beyond the narrow case of “contractual
rights to receive money or contractual obligations
to pay money on fixed or determinable dates.”That
phrase, which first appeared in accounting standards
in paragraph 2 of Opinion 21, reflects the computational
limitations of the traditional approach—a
single set of cash flows that can be assigned
to specific future dates. The Accounting Principles
Board recognized that the amount of cash flows
is almost always uncertain and incorporated that
uncertainty in the interest rate. However, an
interest rate in a traditional present value computation
cannot reflect uncertainties in timing. A traditional
present value computation, applied to the example
above, would require a decision about which of
the possible timings of cash flows to use and,
accordingly, would not reflect the probabilities
of other timings.
48. While many accountants do not routinely
use the expected cash flow approach, expected
cash flows are inherent in the techniques used
in some accounting measurements, like pensions,
other postretirement benefits, and some insurance
obligations. They are currently allowed, but not
required, when measuring the impairment of longlived
assets and estimating the fair value of financial
instruments. The use of probabilities is an essential
element of the expected cash flow approach, and
one that may trouble some accountants. They may
question whether assigning probabilities to highly
subjective estimates suggests greater precision
than, in fact, exists. However, the proper application
of the traditional approach (as described in paragraph
44) requires the same estimates and subjectivity
without providing the computational transparency
of the expected cash flow approach.
49. Many estimates developed in current practice
already incorporate the elements of expected cash
flows informally. In addition, accountants often
face the need to measure an asset or liability
using limited information about the probabilities
of possible cash flows. For example, an accountant
might be confronted with the following situations:
a. The estimated amount falls somewhere between
$50 and $250, but no amount in the range is
more likely than any other amount. Based on
that limited information, the estimated expected
cash flow is $150[ (50 + 250)/2].
b. The estimated amount falls somewhere between
$50 and $250, and the most likely amount is
$100.However, the probabilities attached to
each amount are unknown. Based on that limited
information, the estimated expected cash flow
is $133.33[(50 + 100 + 250)/3].
c. The estimated amount will be $50 (10 percent
probability), $250 (30 percent probability),
or $100 (60 percent probability).Based on that
limited information, the estimated expected
cash flow is $140[(50 * .10) + (250 * .30) +
(100 * .60)].
50. Those familiar with statistical analysis
may recognize the cases above as simple descriptions
of (a) uniform, (b) triangular, and (c) discrete
distributions. In each case, the estimated expected
cash flow is likely to provide a better estimate
of fair value than the minimum, most likely, or
maximum amount taken alone.
51. Like any accounting measurement, the application
of an expected cash flow approach is subject to
a costbenefit constraint. In some cases, an entity
may have access to considerable data and may be
able to develop many cash flow scenarios. In other
cases, an entity may not be able to develop more
general statements about the variability of cash
flows without incurring considerable cost. The
accounting problem is to balance the cost of obtaining
additional information against the additional
reliability that information will bring to the
measurement. The Board recognizes that judgments
about relative costs and benefits vary from one
situation to the next and involve financial statement
preparers, their auditors, and the needs of financial
statement users.
52. Some maintain that expected cash flow techniques
are inappropriate for measuring a single item
or an item with a limited number of possible outcomes.
They offer an example of an asset or liability
with two possible outcomes: a 90 percent probability
that the cash flow will be $10 and a 10 percent
probability that the cash flow will be $1,000.
They observe that the expected cash flow in that
example is $109 and criticize that result as not
representing either of the amounts that may be
ultimately paid.
53. Assertions like the one just outlined reflect
underlying disagreement with the measurement objective.
If the objective is accumulation of costs to be
incurred, expected cash flows may not produce
a representationally faithful estimate of the
expected cost. However, this Statement adopts
fair value as the measurement objective. The fair
value of the asset or liability in this example
is not likely to be $10, even though that is the
most likely cash flow. Instead, one would expect
the fair value to be closer to $109 than to either
$10 or $1,000.While this example is a difficult
measurement situation, a measurement of $10 does
not incorporate the uncertainty of the cash flow
in the measurement of the asset or liability.
Instead, the uncertain cash flow is presented
as if it were a certain cash flow. No rational
marketplace participant would sell an asset (or
assume a liability) with these characteristics
for $10.
