Future cash flow measurements.

FASB Concepts Statement no. 7 provides new guidance.

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 fresh-start measurements (see box) 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.

Fresh-Start Measurements

Fresh-start measurements are those a company
uses following initial recognition of an asset or
liability to determine a new carrying amount
that is unrelated to previous amounts. For
example, FASB Statement no. 115, Accounting
for Certain Investments in Debt or Equity Securities,
requires companies in each reporting period to
make fresh-start measurements for securities
classified as "available-for-sale and trading," as
the company's portfolio is "marked-to-market."
FASB Statement no. 121, Accounting
for the Impairment of Long-Lived Assets to be
Disposed Of, uses fresh-start measurements
when an exception or "trigger" requires a
company to recognize an impairment.

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 (see exhibit 1).

[ILLUSTRATION OMITTED]

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 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 risk-free rate of interest. It uses the other factors listed above to adjust expected cash flows in computing risk-adjusted expected cash flows, which are then discounted at the risk-free 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's-length 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--$2,450--takes 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 risk-free 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 risk-free rate--assumed to be 6% in this example. Assets B, D and E where receipt is not certain, should use the rate commensurate with the risk--assumed 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 risk-free 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 risk-free 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 sub-schedule of exhibit 3.

Exhibit 2: Cash Flows for Assets

                                         Discounted
                         Traditional      expected
          Undiscounted   discounted    cash flows at
           cash flows    cash flows    risk-free 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     Asset C

Contractual (promised)
  cash flow              $60,000   $60,000   $ 60,000
Expected cash flow       $60,000   $50,000   $ 60,000
Adjustments to reflect
  risk premium                     $   200
Adjusted cash flows      $60,000   $49,800   $ 60,000
Present value at 6%
  (risk-free rate)       $60,000   $49,800   $42,300([dagger])

                          Assect D        Asset E        Asset F

Contractual (promised)
  cash flow              $60,000       $60,000          $60,000
Expected cash flow       $46,000       $60,000          $55,445(*)
Adjustments to reflect
  risk premium           $ 1,500                        $ 1,400
Adjusted cash flows      $44,500       $60,000          $54,045(*)
Present value at 6%
  (risk-free rate)       $31,372       $49,170          $44,314(*)
                           ([dagger]     ([sections])
                           [dagger])

(*) See exhibit 4, page 64.

([dagger]) $60,000 x .705

([dagger] [dagger]) $44,500 x .705

([sections]) $10,000 x 4.917
Exhibit 4: Present Value Adjusted for Uncertainty for Asset F

                                   Probability-
                                     adjusted     Discount    Present
         Cash flow   Probability    cash flow     factor 6%    value

Year 1    $ 8,000       0.10         $   800
          $10,000       0.90           9,000
                                     $ 9,800
Adjustment to reflect risk premium.   (1,400)
                                     $ 8,400        0.943     $ 7,921

Year 2    $ 7,000       0.15         $ 1,050
          $10,000       0.85           8,500
                                     $ 9,550        0.890     $ 8,500

Year 3    $ 7,000       0.20         $ 1,400
          $10,000       0.80           8,000
                                     $ 9,400        0.840     $ 7,896

Year 4    $ 6,500       0.23         $ 1,495
          $10,000       0.77           7,700
                                     $ 9,195        0.792     $ 7,282

Year 5    $ 6,000       0.25         $ 1,500
          $10,000       0.75           7,500
                                     $ 9,000        0.747     $ 6,723

Year 6    $ 5,000       0.30         $ 1,500
          $10,000       0.70           7,000
                                     $ 8,500        0.705     $ 5,992

Total                                $54,045                  $44,314

The traditional method of measuring present value for assets B, D and F--which have uncertain cash flows--only 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 risk-free rate. A CPA uses the risk-free 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 received--its 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 allocation--FASB will continue to decide this question on a project-by-project 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 period-to-period 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 catch-up 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 catch-up 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%, five-year bonds (semi-annual 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%, five-year bonds (semi-annual 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
Date               payment        expense

January 1, '01       --             --
July 1, '01      $18,000.00    $19,227.76
January 1, '02   $18,000.00    $19,289.14
July 1, '02      $18,000.00    $19,353.60
January 1, '03   $18,000.00    $19,421.28
July 1, '03      $18,000.00    $19,492.35
January 1, '04   $18,000.00    $19,566.96
July 1, '04      $18,000.00    $19,645.31
January 1, '05   $18,000.00    $19,727.58
July 1, '05      $18,000.00    $19,813.96
January 1, '06   $18,000.00    $19,906.92(*)

                   Discount     Carrying value
Date             amortization      of bonds

January 1, '01        --         $384,555.14
July 1, '01       $1,227.76      $385,782.90
January 1, '02    $1,289.14      $387,072.04

July 1, '02       $1,353.60      $388,425.64
January 1, '03    $1,421.28      $389,846.93
July 1, '03       $1,492.35      $391,339.27
January 1, '04    $1,566.96      $392,906.24
July 1, '04       $1,645.31      $394,551.55
January 1, '05    $1,727.58      $396,279.13
July 1, '05       $1,813.96      $398,093.08
January 1, '06    $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 Long-Lived Assets and for Obligations Associated with Disposal Activities, which would supersede FASB Statement no. 121, Accounting for the Impairment of Long-Lived Assets to be Disposed Of, reflects cash flow treatment consistent with the statement. Future pronouncements also will be based on Concepts Statement no. 7.

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.

* Post-retirement benefits.

EXECUTIVE SUMMARY

* FASB ISSUED CONCEPTS STATEMENT NO. 7 TO HELP CPAs who use present value and cash flow information as the basis for accounting measurements. Using Cash Flow Information and Present Value in Accounting Measurements includes general principles governing accountants' use of present value, particularly when the amount of future cash flows, their timing or both, are uncertain.

* THE STATEMENT INTRODUCES AN EXPECTED CASH flow approach that focuses on the explicit assumptions about the range of possible cash flows and their respective probabilities. It also describes techniques CPAs can use to estimate the fair value of liabilities, taking into account the entity's credit standing.

* CONCEPTS STATEMENT NO. 7 APPLIES ONLY TO measurements at initial recognition, to fresh start measurements and to amortization techniques based on future cash flows. It does not apply to measurements based on the amount of cash or other assets an entity pays or receives or on fair value observations in the marketplace.

* FASB SAYS THE EXPECTED CASH FLOW APPROACH is a better measurement tool than the traditional approach in many circumstances. CPAs should use it to develop asset and liability values when there is no contractual cash flow--taking into account all expectations about possible cash flows rather than just the most likely one.

* THE GUIDANCE IN THE FASB CONCEPTS STATEMENT applies to both liabilities and assets. Measuring liabilities involves problems that are different from measuring assets. When using present value to estimate the fair value of a liability, the objective is to estimate the value of the assets required to settle the liability with the holder or to transfer it to another entity.

DAVID T. MEETING, CPA, DBA, is professor of accounting at Cleveland State University, Cleveland, Ohio. His e-mail address is [e-mail]. RANDALL W. LUECKE, CPA, CMA, CFM, is vice-president, finance, at CSA Group in Toronto, Ontario, Canada. His e-mail address is [e-mail]. LINDA GARCEAU, CPA, DBA, is dean, College of Business, East Tennessee State University, Johnson City. Her e-mail address is [e-mail].