The FASB Explores Accounting for Future Cash Flows

Healthcare Financial Management, March, 2001 by Randall W. Luecke, David T. Meeting

Consider, for example, that an asset has a potential for different future cash flows, each having different probabilities. In this instance, the probabilities are 20, 50, and 30 percent that the cash flows will be $1,000, $3,000, and $5,000, respectively The traditional approach focuses on the most likely amount, and thus, the estimated cash flow is $3,000. The traditional approach, however, ignores the upside probability that the cash flow will exceed the most likely amount (ie, the 30 percent probability that the cash flow will be $2,000 more than the most likely amount versus the 20 percent probability that it will be $2,000 less than the most likely amount). Accounting for all three probabilities reveals that the expected cash flow would be $3,200 ([0.20 x $1,000] [0.50 x $3,000] [0.30 x $5,000] = $200 $1,500 $1,500 = $3,200).

Interest Methods of Allocation

While the previous discussion pertains to measurement of assets and liabilities at initial recognition and at "fresh start," present values also are frequently used in allocating amounts such as bond premiums or discounts over related cash-flow periods. Statement No. 7 provides a framework for amortizing these amounts using this process, commonly referred to as the "interest method of allocation."

Statement No. 7 suggests that the FASB generally considers the interest method of allocation to be more relevant than other methods when applied to assets and liabilities that exhibit one or more of the following characteristics:

* The transaction that gave rise to the asset or liability generally is considered to be a borrowing-and-lending transaction;

* The interest method of allocation typically is used for period-to-period allocation of similar assets or liabilities;

* A particular set of estimated future cash flows is closely associated with the asset or liability; and/or

* The measurement at initial recognition was based upon present value.

Statement No. 7 goes on to state that the use of the interest method should include a detailed description of:

* The cash flows to be used (promised cash flows, expected cash flows, or some other estimate);

* The convention that governs the choice of interest rate (effective rate or some other rate);

* The method by which the rate is applied (constant effective rate or a series of annual rates); and

* The method by which changes in the amount or timing of estimated cash flows will be reported.

Existing accounting pronouncements vary in the way they provide guidance concerning allocations, amortizations, and interest-rate methods. In most situations, however, the interest method is based upon contractual cash flows and assumes an effective interest rate over the life of those cash flows. Accordingly the method uses contractual cash flows (rather than expected cash flows) and bases the interest rate on the single rate that equates the present value of the contractual cash flows with the initial price of the asset or liability.

Often, actual cash flows vary from expected cash flows in terms of amount or timing. If changes in cash flows occur, the interest amortization scheme should be altered to reflect the new estimate of cash flows. Each of the following techniques have been used to address such changes: