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:
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
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 (
·David
T. Meeting et al., “Future
Cash Flow Measurements,” Journal of Accountancy (
(www.fasb.org).
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
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). |