Discounted cash flow approaches are a helpful tool used in US GAAP accounting for valuation and impairment assessments. A discounted cash flow approach involves projecting a stream of cash flows for an item and then applying a discount rate to those cash flows to calculate a single value or a range of values for that item. A discounted cash flow approach is a type of “income approach” or “present value technique,” two terms used frequently in the FASB Accounting Standards Codification®.
Mastering discounted cash flow approaches can assist in the accounting for investments, loans and receivables, debt, credit losses, fair value measurements, pension plans, leases, business combinations, goodwill, intangible assets, asset retirement obligations, and exit or disposal cost obligations, to name a few. Discounted cash flow approaches are also utilized within other functions of an organization, such as treasury, budgeting, financial planning and analysis, and tax planning. A discounted cash flow analysis also may be used to support key business decisions, like whether to make a loan, take on debt, or enter into a merger or acquisition.
In this post, we explore the use of discounted cash flow approaches in accounting, including developing assumptions for expected cash flows and the discount rate, understanding the calculation and the output, and challenges in today’s environment.
Developing Assumptions for Expected Cash Flows and the Discount Rate
To use a discounted cash flow approach, an entity must develop assumptions for:
- The expected cash flows; and
- The discount rate.
Developing reasonable and supportable assumptions is key. The process is highly subjective and requires a large degree of management judgment. Collecting the information necessary to establish proper assumptions can be a lot of work, so management must ensure it puts aside adequate time and resources for this exercise. Management often employs valuation specialists and actuaries to help select and review assumptions.
Expected Cash Flows
To develop an estimate of the expected cash flows, an entity considers both cash inflows and cash outflows. The nature of the expected cash flows depends on the type of item. For instance, the expected cash flows on a bond may involve payments of principal, interest, penalties, or other amounts. The cash flows from an entire business include inflows and outflows from investing, financing, and operating activities (such as sales, collections on receivables, expenditures, and settling accounts payable).
The technique used to develop expected cash flows varies based on the facts and circumstances. However, in general, the estimate may be affected by past history, the current environment, and anticipated future activity. An entity may draw from its own experience as well as that of its peers, industry, geography, market, or other pertinent source. In some cases, a contract or a set of financial statements may be a good starting point to gauge potential cash flows. An entity must be mindful, though, that the actual cash flows may differ from historical or agreed-upon amounts.
Developing an estimate of expected cash flows involves considering both a) the amount and b) the timing of the expected cash flows. Although it can be easy to focus on the amount of the expected cash flows, entities must not overlook the importance of the timing of the expected cash flows. For instance, assume a bank is performing a discounted cash flow analysis for a mortgage. If a bank expects a borrower to make mortgage payments before the contractual due dates, the prepayments would lead to a lower end value in the discounted cash flow calculation than if the payments were made per the contract terms.
The discount rate is a critical assumption when using a discounted cash flow approach. You may have heard of assets being overvalued or liabilities being understated due to improper discount rates being used. Even small changes in discount rates can have a material effect on the end value in the discounted cash flow calculation. As such, applying proper care and expertise to select this assumption is important.
The Codification often provides guidance on how to select a discount rate for a particular area of accounting. The Codification may require the use of a risk-free rate in some places and a risk-adjusted rate in others. In some areas, it also may prescribe different ways of determining discount rates for public and private companies or offer practical expedients. For instance, a public company may be required to use a risk-adjusted rate, whereas a private company may be permitted to use a risk-free rate to reduce complexity.
The adjustment added to the risk-free rate to arrive at the risk-adjusted rate is often referred to as the “risk premium.” The risk premium reflects that market participants require compensation for taking on uncertainty. The risk premium may incorporate factors such as credit risk or market illiquidity. New risks may emerge over time that need to be factored into the risk premium. The risk premium generally includes the uncertainties that market participants expect to be compensated for. Various techniques may be used in estimating a risk premium; examples are matrix pricing, option-adjusted spread models, and fundamental analysis.
At times, developing a reliable estimate of the risk premium may not be possible, the risk premium might be small, or the chance of misstating the risk premium may be great. For these (and other) reasons, the Codification may call for the use of a risk-free rate instead of a risk-adjusted rate in a particular area.
Understanding the Calculation and the Output
The amount of expected cash flows, the timing of those cash flows, and the discount rate are all important levers in the discounted cash flow calculation. It’s helpful to know how each assumption affects the end value. Overall:
- Amount of expected cash flows: The higher the amount of expected cash flows, the higher the end value (and vice versa).
- Timing of expected cash flows: The longer the time period over which the cash flows are expected, the lower the end value (and vice versa).
- Discount rate: The higher the discount rate, the lower the end value (and vice versa).
Although selecting assumptions is a critical aspect of a discounted cash flow analysis, the work doesn’t stop there. A common pitfall is for an entity to throw assumptions into a model without understanding how the calculation works. An entity can’t have a “black box” where no one knows what’s inside; an entity must understand the formulas used in its discounted cash flow calculation and have professionals with appropriate expertise involved in their implementation and testing. An entity also must review the calculation’s output for reasonableness, each time the calculation is run. For instance, an unexpected output could reveal a previously-unidentified mistake in the mechanics of the calculation.
Having proper checks and balances around a discounted cash flow analysis is extremely important. An entity generally must establish processes and controls around the inputs (assumptions), the calculation itself, and the output. Individuals with proper knowledge and experience must be involved in each stage of the process. Management also must prepare and maintain documentation supporting its approach and ongoing analysis, including judgments made and conclusions reached. If the Codification provides specific guidance on how to select assumptions, management’s documentation should show how its assumptions comply. If management has relied on third parties (such as external actuaries or valuation specialists), it must be comfortable with the third party’s qualifications, work, and conclusions.
Challenges in the Current Environment
Over the past year, making estimates has been a particularly difficult aspect of financial reporting given the uncertainty surrounding the COVID-19 pandemic and the related economic fallout and recovery. Many entities have navigated disruptions to their own businesses as well as to their customers, suppliers, lenders, borrowers, and other business partners.
These disruptions pose challenges for a discounted cash flow analysis, in particular for developing assumptions. In many cases, the timing and amount of expected cash flows has been affected. Over the past year, businesses frequently amended contracts to provide leniency or financial relief to one or both parties. For instance, amendments to debt, lease, and customer contracts often reduced or delayed expected cash flows. Even without a formal amendment, contracts may have been suspended or canceled due to resource constraints, such as insufficient labor, materials, and funding. Local, state, and national restrictions (such as temporary business shutdowns and travel bans) decimated cash inflows for businesses like restaurants, airlines, and cruise ships. On the other end of the spectrum, shifts in customer behavior led to cash windfalls for certain entities in the technology, online, and delivery spaces. Cash outflows have also been in flux as businesses have curbed existing costs to make room for new expenditures around customer and employee safety. Just like cash flows in 2019 were not indicative of cash flows in 2020, the same is true for this year and beyond. Historical cash flows may not be telling of what is to come. In light of the pandemic, however, entities should continue to be on the lookout for contract amendments, new or amended regulations, shifts in industry norms, changes in the behavior or creditworthiness of key stakeholders, or other disruptors that may affect the timing or amount of expected cash flows.
Recent events have also impacted the components of the discount rate. Risk-free rates plunged in 2020 as the US attempted to thwart a recession. Since that time, risk-free rates have risen slightly, but remain low as market influencers like the Federal Reserve hope to spur an economic recovery. Risk premiums have been hard to estimate since the outset of the pandemic due to heightened and pervasive uncertainty. Generally, risk premiums have increased due to deteriorations in creditworthiness, market illiquidity, and other uncertainties.
Overall, the current environment amplifies the time and care necessary to perform a discounted cash flow analysis. Facts and circumstances continue to change rapidly. An entity must base projections on the most recent and reliable information available. Documenting the basis for assumptions and conclusions is of paramount importance in the current environment. Management may need to rely on valuation specialists and actuaries even more so than usual. Even so, management is ultimately responsibility for the estimates and assumptions used in financial reporting.
Interested in learning more about the use of discounted cash flow approaches? Measuring, Managing and Creating Value: A Framework for Accountants Serving Privately Held Companies, can help, with its numerous computational examples and practice aids. Visit our estore today.