A New Approach to Income Valuation: 

The Financial Accounting Standards Board’s

Statement of Financial Accounting Concepts No. 7: 

Using Cash Flow Information and Present Value in Accounting Measurements

The discounted cash flow (DCF) approach described in chapter 1 forms the core methodology of the income approach to valuation.Recently, the Financial Accounting Standards Board (FASB) has recommended an alternative approach in its Concepts Statement No. 7.

As we have seen, the DCF methodology utilizes a single set of estimated cash flows and a single discount rate, which attempts to adjust the estimate of future results to reflect the many varied inherent risks and uncertainty.The FASB thinks this approach is overly simplistic.The traditional approach does not adequately capture the uncertainties associated with the projected cash flows themselves.Higher or lower expenses, new competition, government regulation and numerous other factors may affect the project favorably or unfavorably.The number of possible outcomes is virtually limitless.Reducing all of these possibilities to a single projection of cash flows, and then applying a single discount rate, is conducive to serious inaccuracies in present value determinations according to FASB.

Concepts Statement No. 7 introduces the “expected cash flow approach.”It differs from the traditional approach by focusing on explicit assumptions about the range of possible estimated cash flows and their respective probabilities.The following is an excerpt from the Statement which explains the fundaments of the proposed methodology:

 

FASB – Statement of Financial Accounting Concepts No. 7

February 2000

[Excerpt (¶¶ 43-53)]


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 most-likely 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.

Present value of $1,000 in 1 year at 5%$952.38

Probability10.00%$95.24

Present value of $1,000 in 2 years at 5.25%$902.73

Probability60.00%$ 541.64

Present value of $1,000 in 3 years at 5.50%$851.61

Probability30.00%$ 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 long-lived 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 cost-benefit 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.

For discussion and analysis of Concepts Statement No. 7, see:

·Edward W. Trott and Wayne S. Upton, “Expected Cash Flows,” Understanding the Issues (May 2001) (a FASB newsletter).

·      Robert Bloom, “An Analysis of Statement of Financial Accounting Concepts No. 7: Using Cash Flow Information and Present Value in Accounting Measurements,” The National Public Accountant (May 1, 2001).

·David T. Meeting et al., “Future Cash Flow Measurements,” Journal of Accountancy (Oct. 1, 2001)


(www.fasb.org).


 
Example

General Electric Corporation faces the likelihood of having to pay an uncertain amount in five years in connection with an EPA ordered cleanup of Hudson River PCB contamination downstream from two of its factories in upstate New York.The future loss estimate is in the range of $100 million to $300 million with the following estimated probabilities:

 

Loss Amount
Probability
$100 million
10%
$200 million
60%
$300 million
30%

Using the Concepts Statement No. 7 (Expected Cash Flow) approach, calculate General Electric’s current liability for the cleanup.


Answer: 

First, calculate the expected cash flow:

$100 x 10% = $10

$200 x 60% = $120

$300 x 30% = $90

Expected cash flow = $220 million

Assuming the risk-free rate of interest is 5%, the present value of the expected outflow can be easily calculated:

PV = $220,000,000/ (1 + 0.05)^5

Therefore, General Electric should report a liability of $172,373,266.50 (the present value of the expected outflow).