Copyright
© 2001 American
Institute of Certified Public Accountants, Inc.
Journal
of Accountancy
OCTOBER
2001
1001 J.A. 57
Future Cash Flow Measurements
David
T. Meeting
Randall
W. Luecke
Linda
Garceau
DAVID T. MEETING,
CPA, DBA, is professor of accounting at Cleveland State University, Cleveland,
Ohio. His email address is d.meeting@csuohio.edu. RANDALL W. LUECKE, CPA, CMA,
CFM, is vicepresident, finance, at CSA Group in Toronto, Ontario, Canada. His
email address is randall.luecke@csagroup.org. LINDA GARCEAU, CPA, DBA, is
dean, College of Business, East Tennessee State University, Johnson City. Her email
address is garceaul@access.etsu.edu.
Accountants
use present value and cash flow information as a surrogate for fair value
whenever an entity pays or receives a future stream of cash. Because this
happens frequently in business, CPAs need guidance on using future cash flow as
the basis for accounting measurements at initial recognition when making freshstart
measurements (see box on page 59) and with the interest method of amortization.
To provide them with this guidance, FASB issued Concepts Statement no. 7, Using
Cash Flow Information and Present Value in Accounting Measurements.
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 freshstart measurements are
appropriate. Rather, FASB expects to decide whether a particular situation
requires a freshstart measurement or some other accounting response on a
projectbyproject basis.
Concepts
Statement no. 7 applies only to measurements at initial recognition, to freshstart
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 (see exhibit 1, page 60).
A
CPA who uses accounting measurements at initial recognition and when making
freshstart 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 freshstart 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 objectivitymarket 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 (riskfree 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 computing present value that CPAs
may use to estimate an asset or liability's fair value. The expected cash flow
approach uses a discount rate representing the riskfree rate of interest. It
uses the other factors listed above to adjust expected cash flows in computing
riskadjusted expected cash flows, which are then discounted at the riskfree
rate. The traditional
approach uses the adjustment factors for the last four items above to determine
the discount rate.
The
statement lists these general principles that govern any use of present value
techniques in measuring assets or liabilities:
[] To the extent possible, estimated cash
flows and interest rates should reflect assumptions about future events and
uncertainties that someone would consider in deciding whether to acquire an
asset or group of assets in an arm'slength transaction for cash.
[] Interest rates used to discount cash
flows should reflect assumptions consistent with those inherent in the
estimated cash flows so the assumptions are not double counted or ignored.
[] Estimated cash flows and interest
rates should be free from both bias and factors unrelated to the asset,
liability or group of assets or liabilities in question.
[] Estimated cash flows or interest rates
should reflect the range of possible outcomes rather than a single most likely,
minimum or maximum possible amount.
The
traditional approach to present value uses contractual cash flows when
available. CPAs find the traditional approach useful when measuring assets and
liabilities that have contractual cash flows (financial assets and liabilities)
and when they are able to observe comparable assets and liabilities in the marketplace.
This approach places most of the emphasis on selecting an interest rate by
comparing the asset or liability with a similar one in the marketplace.
When
contractual cash flows are not available other approaches use an estimate of
the single most likely amount or best estimate. The entity discounts the single
set of estimated cash flows using a single interest rate, often described as "the
rate commensurate with the risk." This approach assumes the single
interest rate can reflect all expectations about the appropriate risk premiums
and all expectations about the variability of cash flows.
THE EXPECTED CASH FLOW
APPROACH
FASB says the expected cash flow approach
is a better measurement tool than the traditional approach for complex
measurements such as nonfinancial assets and liabilities for which there is no
market value. To develop asset and liability values when there is no
contractual cash flow, FASB says CPAs should use an expected cash flow
approach, which takes into account all of the things an entity anticipates
happening with regard to all possible cash flows rather than just with the most
likely cash flow.
Example. An entity has potential cash inflows of $ 1,000,
$ 2,000 and $ 4,000. The probability of the entity receiving them is 15%, 55%
and 30%, respectively. Using this information the expected cash flow is:
.15 x $ 1,000 
= 
$ 150 
.55 x $ 2,000 
= 
$ 1,100 
.30 x $ 4,000 
= 
$ 1,200 


$ 2,450 
The
result$ 2,450takes into account the probability distribution of the
expected cash flows. CPAs can modify it based on the timing of the cash flows
when they occur over several periods, such as over several months. Probability
is an essential element in the expected cash flow approach.
The
traditional approach would use the most likely cash flow$ 2,000 (55% chance
of receipt) and adjust the interest rate to indirectly take into account the
risk of a change from the most likely amount. This approach requires many of
the same probability estimates as the expected cash flow approach, but without
the computational transparency.
TRADITIONAL AND EXPECTED
CASH FLOW APPROACHES
Present value calculations include the
time value of money in accounting measurements and make it possible to
determine the economic differences between groups of future cash flows. This
example demonstrates the differences between undiscounted cash flows,
discounted cash flows using the traditional approach and discounted expected cash
flows according to the concepts statement.
Example. The assets listed below each involve an
undiscounted cash flow of $ 60,000.
[] Asset A has a fixed contractual cash
flow of $ 60,000 due in one day. The cash flow is certain. The expected cash
flow is $ 60,000.
[] Asset B has a fixed contractual cash
flow of $ 60,000 due in one day. The amount actually received may be less than
$ 60,000. The probability distribution is: a 10% probability of collecting
zero, a 20% probability of collecting $ 40,000 and a 70% probability of
collecting $ 60,000. The expected cash flow is:
.10 x $ 0 
= 
$ 0 
.20 x $ 40,000 
= 
$ 8,000 
.70 x $ 60,000 
= 
$ 42,000 


$ 50,000 
[] Asset C has a fixed contractual cash
flow of $ 60,000 due at the end of six years. The cash flow is certain. The
expected cash flow is $ 60,000.
[] Asset D has a fixed contractual cash
flow of $ 60,000 due at the end of six years. The probability distribution is: a
15% probability of collecting zero, a 25% probability of collecting $ 40,000 and a 60% probability of
collecting $ 60,000. The expected cash flow is:
.15 x $ 0 
= 
$ 0 
.25 x $ 40,000 
= 
$ 10,000 
.60 x $ 60,000 
= 
$ 36,000 


$ 46,000 
[] Asset E has a fixed contractual cash
flow of $ 10,000 to be received at the end of each year for the next six years.
The cash flow is certain. The expected cash flow is $ 60,000.
[] Asset F has a fixed contractual cash
flow of $ 10,000 to be received at the end of each year for the next six years.
The cash flow is uncertain. The probability of collecting each amount in each
year is as follows. In year 1, for example, there is a 10% chance of collecting
only $ 8,000 and a 90% chance of collecting $ 10,000.
Year 1 
.10 
$ 8,000 
= 
$ 800 

.90 
$ 10,000 
= 
$ 9,000 
Year 2 
.15 
$ 7,000 
= 
$ 1,050 

.85 
$ 10,000 
= 
$ 8,500 
Year 3 
.20 
$ 7,000 
= 
$ 1,400 

.80 
$ 10,000 
= 
$ 8,000 
Year 4 
.23 
$ 6,500 
= 
$ 1,495 

.77 
$ 10,000 
= 
$ 7,700 
Year 5 
.25 
$ 6,000 
= 
$ 1,500 

.75 
$ 10,000 
= 
$ 7,500 
Year 6 
.30 
$ 5,000 
= 
$ 1,500 

.70 
$ 10,000 
= 
$ 7,000 




$ 55,445 
The
expected cash flow is $ 55,445, determined by multiplying each expected cash
flow by its probability and adding the results.
Each
asset's undiscounted cash flow is $ 60,000. Undiscounted cash flow makes the
six assets appear to have equal economic values because this method ignores
timing and uncertainty. Traditional present value would discount the
contractual cash flows using a discount rate that is commensurate with the risk.
Certain cash flows would be discounted at the riskfree rate and uncertain ones
at a higher rate. The traditional discounted present values of the assets would
each be different due to the timing of the cash flows. Assets A, C and E, for
which receipt is certain, should be discounted at the riskfree rateassumed
to be 6% in this example. Assets B, D and F, where receipt is not certain,
should use the rate commensurate with the riskassumed to be 9% in this
example.
When
using the traditional approach to present value measurement, a CPA would
calculate discounted cash flows for the six assets as follows:
Asset A 
$ 60,000 
($ 60,000 x 1.0) 
Asset B 
$ 60,000 
($ 60,000 x 1.0) 
Asset C 
$ 42,300 
($ 60,000 x .705) 
Asset D 
$ 35,760 
($ 60,000 x .596) 
Asset E 
$ 49,170 
($ 10,000 x 4.917) 
Asset F 
$ 44,860 
($ 10,000 x 4.486) 
Traditional
present value provides more relevant measurements than undiscounted cash flows
because it takes into account the time value of money. The 9% rate is supposed
to include the time value of money at the riskfree rate plus the uncertainty
of collecting the contractual cash flows. The rate is often set with little or no
formal examination of the uncertainty of cash flows of individual assets; often
accountants use a factor for risk without examining the uncertainty of each
individual asset's cash flow. However, using probabilities requires accountants
to more formally recognize the uncertainty in a group of cash flows than does
the traditional method. The statement requires CPAs to consider assumptions
about cash flow uncertainty when determining cash flows used in value
computations.
Concepts
Statement no. 7 lists five elements that present value measures should include
to fully represent the economic differences between assets or liabilities,
described earlier. Fair value includes all five using the expectations and
estimates marketplace participants would employ to determine the amount at
which an asset (liability) could be bought (or incurred) or sold (or settled) in
a current transaction.
Undiscounted
cash flows fail to differentiate between the economic differences of the six
assets. Traditional discounted cash flows would not discount assets A and B, as
the cash flows are due the next day. They would use $ 60,000 as asset B's value
since it is the single most likely amount and ignore the fact the cash flow is
uncertain. Traditional discounted cash flows make assets A and B appear to be
of equal value when they are not; asset A's cash flow is certain and asset B's
is not.
All
six assets carry different degrees of cash flow uncertainty the traditional
approach ignores or takes into account indirectly in the discount rate. The
statement says CPAs should incorporate the probability distribution of possible
cash flows in determining the expected cash flow, which is then discounted at
the riskfree rate.
Exhibit
2, at left, summarizes cash flows for the six assets above. Exhibit 3, below,
uses the statement's concepts to calculate the present value of the expected
cash flows for the six assets. Exhibit 4, page 64, is a subschedule of exhibit
3.
Exhibit 2: Cash Flows
for Assets 





Discounted 




Traditional 
expected 



Undiscounted 
discounted 
cash flows at 



cash flows 
cash flows 
riskfree rate 


Asset A 
$ 60,000 
$ 60,000 
$ 60,000 


Asset B 
$ 60,000 
$ 60,000 
$ 49,800 


Asset C 
$ 60,000 
$ 42,300 
$ 42,300 


Asset D 
$ 60,000 
$ 35,760 
$ 31,372 


Asset E 
$ 60,000 
$ 49,170 
$ 49,170 


Asset F 
$ 60,000 
$ 44,860 
$ 44,314 


Exhibit 3: Discounted
Expected Cash Flows Per Concepts Statement no. 7 


Asset A 
Asset B 

Contractual (promised)
cash flow 
$ 60,000 
$ 60,000 

Expected cash flow 
$ 60,000 
$ 50,000 

Adjustments to reflect
risk premium 

$ 200 

Adjusted cash flows 
$ 60,000 
$ 49,800 

Present value at 6% (riskfree
rate) 
$ 60,000 
$ 49,800 

Exhibit 3: Discounted
Expected Cash Flows Per Concepts Statement no. 7 


Asset C 
Asset D 

Contractual (promised)
cash flow 
$ 60,000 
$ 60,000 

Expected cash flow 
$ 60,000 
$ 46,000 

Adjustments to reflect
risk premium 

$ 1,500 

Adjusted cash flows 
$ 60,000 
$ 44,500 

Present value at 6% (riskfree
rate) 
+ $ 42,300 
++ $ 31,372 





Exhibit 3: Discounted
Expected Cash Flows Per Concepts Statement no. 7 


Asset E 
Asset F 

Contractual (promised)
cash flow 
$ 60,000 
$ 60,000 

Expected cash flow 
$ 60,000 
* $ 55,445


Adjustments to reflect
risk premium 

$ 1,400 

Adjusted cash flows 
$ 60,000 
* $ 54,045


Present value at 6% (riskfree
rate) 
$ 49,170 §

* $ 44,314


* See exhibit 4, page 64.
+ $ 60,000 x .705
++ $ 44,500 x .705
§ $ 10,000 x 4.917
Exhibit 4: Present
Value Adjusted for Uncertainty for Asset F 




Probabilityadjusted 


Cash flow 
Probability 
cash flow 

Year 1 
$ 8,000 
0.10 
$ 800 


$ 10,000 
0.90 
9,000 




$ 9,800 

Adjustment to reflect
risk premium. 
(1,400) 





$ 8,400 




Year 2 
$ 7,000 
0.15 
$ 1,050 


$ 10,000 
0.85 
8,500 




$ 9,550 




Year 3 
$ 7,000 
0.20 
$ 1,400 


$ 10,000 
0.80 
8,000 




$ 9,400 




Year 4 
$ 6,500 
0.23 
$ 1,495 


$ 10,000 
0.77 
7,700 




$ 9,195 




Year 5 
$ 6,000 
0.25 
$ 1,500 


$ 10,000 
0.75 
7,500 




$ 9,000 




Year 6 
$ 5,000 
0.30 
$ 1,500 


$ 10,000 
0.70 
7,000 




$ 8,500 




Total 


$ 54,045 

Exhibit 4: Present
Value Adjusted for Uncertainty for Asset F 



Cash flow 
Discount factor 6% 
Present value 


Year 1 
$ 8,000 



$ 10,000 


Adjustment to reflect
risk premium. 




0.943 
$ 7,921 





Year 2 
$ 7,000 



$ 10,000 




0.890 
$ 8,500 





Year 3 
$ 7,000 



$ 10,000 




0,840 
$ 7,896 





Year 4 
$ 6,500 



$ 10,000 




0.792 
$ 7,282 





Year 5 
$ 6,000 



$ 10,000 




0.747 
$ 6,723 





Year 6 
$ 5,000 



$ 10,000 




0.705 
$ 5,992 





Total 


$ 44,314 


The
traditional method of measuring present value for assets B, D and Fwhich have
uncertain cash flowsonly indirectly incorporates uncertainty of cash flows by
including an adjustment to reflect risk through the use of a higher discount
rate. The expected cash flow approach requires CPAs to make explicit
assumptions about the uncertainty of cash flows. When using this approach, a
CPA examines the probability distribution of each asset's cash flow and
subtracts an adjustment to reflect premiums the market demands for bearing risk.
The expected cash flow is then discounted at the riskfree rate. A CPA uses the
riskfree rate to discount the expected cash flow to avoid double counting
uncertainty. Discounted expected cash flows can give different results from the
traditional discounted cash flows for assets with uncertain cash flows.
PRESENT VALUE AND
LIABILITY MEASUREMENT
The concepts in the FASB statement apply
to both liabilities and assets, though measuring liabilities involves problems
different from measuring assets. When using present value to estimate a
liability's fair value, the objective is to estimate the value of the assets
currently required to settle the liability with the holder, or to transfer it
to an entity of comparable credit standing. For example, the fair value of a
bond payable is its market price, and the fair value of an entity's notes or
bonds payable is the price other entities are willing to pay to hold those
liabilities as assets. There is no active market for liabilities such as
warranties and environmental cleanup so an estimate of their value would be the
price one entity would have to pay another to assume the liability.
CPAs
should ensure that a liability's measurement reflects the credit standing of
the entity obligated to pay. The purchaser of the liability as an asset will
take the credit standing into account when deciding how much to pay. For
example, a bond purchaser takes into account the credit standing of the issuing
entity when determining bonds' purchase price. An entity with good credit will,
for any promise to pay, receive more proceeds than an entity with poor credit. The
liability is recorded at the amount of the proceeds receivedits fair value.
ACCOUNTING ALLOCATIONS
USING PRESENT VALUES
A business often does present value
analyses in conjunction with a periodic reporting of its assets and liabilities.
Companies use allocations or amortizations to systematically adjust the book
value of assets and liabilities over time; the diminished or increased values
of these assets or liabilities reflect their consumption or growth. Common
examples include allocating premiums or discounts on bonds outstanding,
depreciating an asset over its life and amortizing administrative costs over
the term of a lease. Frequently "interest method of allocation" refers
to these adjustments to assets and liabilities that are determined using
present value.
Concepts
Statement no. 7 does not prescribe when entities must use an interest method of
allocationFASB will continue to decide this question on a projectbyproject
basis. However, the statement does provide a framework for using the method. It
indicates that an interest method of allocation is more relevant than other
methods when it is applied to assets and liabilities that exhibit one or more of the
following characteristics:
[] The transaction is commonly viewed as
a borrowing and lending.
[] A periodtoperiod allocation of
similar assets or liabilities also employs an interest method.
[] A particular set of estimated future
cash flows is closely associated with the asset or liability.
[] The measurement at initial recognition
was based on present value.
When
an entity uses the interest method, the statement requires a careful
description of
[] The cash flows to be used (promised
cash flows, expected cash flows or some other estimate).
[] The convention
governing the choice of an interest method (effective rate or some other rate).
[] How the rate is
applied (constant effective rate or a series of annual rates).
[] How the entity will
report changes in the amount or timing of estimated cash flows.
Actual
cash flows often differ from estimated cash flows in terms of timing or amounts.
In these cases, CPAs must determine the new estimated cash flows, typically
using one of three techniques.
[] A prospective
approach that computes a new effective interest rate based on the carrying
amount and the remaining cash flows.
[] A catchup approach that adjusts the
carrying amount to the present value of the revised estimated cash flows,
discounted at the original effective interest rate.
[] A retrospective approach that computes
a new effective interest rate based on the original carrying amount, actual
cash flows to date and remaining estimated cash flows. The CPA would use the
new effective interest rate to adjust the carrying amount to the present value
of the revised estimated cash flows, discounted at the new effective interest
rate.
FASB
prefers the catchup approach because it is consistent with present value
relationships portrayed by the interest method and a business can implement it
at a reasonable cost. This approach records the amount of an asset or liability
(when there is no change in estimated cash flows) as the present value of the
estimated future cash flows discounted at the original effective interest rate.
When there is a change in estimate, the measurement basis will be the same as
before the change (estimated cash flows discounted at the original effective
interest rate).
The
amortization of bond premiums and bond discounts uses the interest method of
allocation. Exhibit 5, above, calculates the proceeds for $ 400,000 of 9%, fiveyear
bonds (semiannual interest payments on July 1 and January 1) at $ 384,555.14
when the market rate of interest is 10%.
Exhibit 5: Amortization of Bond Discount
Using the Interest Method
[] $ 400,000 of 9%, fiveyear bonds (semiannual
interest payments) sold to yield 10% at January 1, 2001.
[] Selling price is calculated as follows:
Present value of $ 400,000
in 5 years 
$ 400,000 
0.61391 
$ 245,564.00 

Present value of
interest payments 
$ 18,000 
7.72173 
$ 138,991.14 




$ 384,555.14 


Cash 
Interest 
Discount 
Carrying value 


Date 
payment 
expense 
amortization 
of bonds 


January 1, '01 
 
 
 
$ 384,555.14 


July 1, '01 
$ 18,000.00 
$ 19,227.76 
$ 1,227.76 
$ 385,782.90 


January 1, '02 
$ 18,000.00 
$ 19,289.14 
$ 1,289.14 
$ 387,072.04 


July 1, '02 
$ 18,000.00 
$ 19,353.60 
$ 1,353.60 
$ 388,425.64 


January 1, '03 
$ 18,000.00 
$ 19,421.28 
$ 1,421.28 
$ 389,846.93 


July 1, '03 
$ 18,000.00 
$ 19,492.35 
$ 1,492.35 
$ 391,339.27 


January 1, '04 
$ 18,000.00 
$ 19,566.96 
$ 1,566.96 
$ 392,906.24 


July 1, '04 
$ 18,000.00 
$ 19,645.31 
$ 1,645.31 
$ 394,551.55 


January 1, '05 
$ 18,000.00 
$ 19,727.58 
$ 1,727.58 
$ 396,279.13 


July 1, '05 
$ 18,000.00 
$ 19,813.96 
$ 1,813.96 
$ 398,093.08 


January 1, '06 
$ 18,000.00 
* $ 19,906.92 
$ 1,906.92 
$ 400,000.00 


* $ 2.27 rounding error
A GLIMPSE OF THE FUTURE
Concepts Statement no. 7 provides CPAs
with guidance on measuring and disclosing cash flow information. Although it
does not require accountants to modify any current cash flow treatments, the
statement expresses FASB's mindset on certain cash flows, which will be further
revealed in future pronouncements. For example, the exposure draft, Accounting
for the Impairment or Disposal of LongLived Assets and for Obligations
Associated with Disposal Activities, which would supersede FASB Statement no. 121,
Accounting for the Impairment of LongLived Assets to be Disposed
Of, reflects cash flow treatment consistent with the statement. Future
pronouncements also will be based on Concepts Statement no. 7.
GRAPHIC:
FIGURE,
When Accountants Use Cash Flow Information [] Discounts and premiums on bonds
payable.
[] Notes payable or receivable. [] Acquiring assets by
incurring liabilities. [] Receivables acquired. [] Liabilities assumed in business combinations. [] Capital leases. [] Pensions. [] Postretirement benefits. GARRY GAY/THE IMAGE BANK