Expected cash flow

IFRS 13 Definition of expected cash flow: The probability-weighted average (ie mean of the distribution) of possible future cash flows.


Context

Estimated cash flow and expected cash flow

In the past, accounting pronouncements have used the terms estimated cash flow and expected cash flow interchangeably, after IFRS 13 Fair value measurement the two have distinct definitions/meanings:

  • Estimated cash flow refers to a single amount to be received or paid in the future.
  • Expected cash flow refers to the sum of probability-weighted amounts in a range of possible estimated amounts; the estimated mean or average.

Fair value measurement techniques- Cash flow projections [IFRS 13 B12 – B17]

The traditional approach versus the expected cash flow approach

Traditional cash flow approach (in IFRS 13 ‘Most likely cash flow) Expected cash flow approach
Single set of estimated cash flows Complex set of estimated cash flows
Do not use probabilities Use statistical methods, mainly probabilities, to estimate the future cash flows
Estimated cash flows or interest rates reflect a single most-likely, minimum, or maximum possible amount Estimated cash flows or interest rates should reflect the range of possible outcomes
Is encouraged when comparable assets and liabilities can be observed in the marketplace Is useful when comparable assets and liabilities cannot be observed in the marketplace
Single discount rate
  • Method 1 – Single discount rate as a risk-free rate, with risk-adjusted expected cash flows, or
  • Method 2 – Single discount rate adjusted to include the risk premium (as required by market participants) , with expected cash flows that are not risk adjusted
The expectations regarding cash flows (e.g. amount and timing) and risks can be embedded in the discount rate See single discount rate, above, two methods available

 

Expected cash flows – two methods of cash flows and discounting

The objective of a present value technique is to convert future cash flows into a present amount (i.e., a value as at the measurement date). Therefore, time value of money is a fundamental element of any present value technique. A basic principle in finance theory, time value of money holds that “a dollar today is worth more than a dollar tomorrow”, because the dollar today can be invested and earn interest immediately.

Therefore, the discount rate in a present value technique must capture, at a minimum, the time value of money. For example, a discount rate equal
to the risk-free rate of interest encompasses only the time value element of a present value technique. If the risk-free rate is used as a discount rate, the expected cash flows must be adjusted into certainty-equivalent cash flows to capture any uncertainty associated with the item being measured and the compensation market participants would require for this uncertainty.

Depending on the present value technique used, risk may be incorporated in the cash flows or in the discount rate. However, identical risks should not be captured in both the cash flows and the discount rate in the same valuation analysis. For example, if the probability of default and loss given default for a liability are already cash flows should not be further adjusted for the expected losses.

The present value techniques discussed in IFRS 13’s application guidance differ in how they adjust for risk and in the type of cash flows they use:

  • The discount rate adjustment technique uses a risk-adjusted discount rate and contractual, promised or most likely cash flows.
  • Method 1 of the expected present value technique uses risk-adjusted expected cash flows and a risk-free rate.
  • Method 2 of the expected present value technique uses expected cash flows that are not risk-adjusted and a discount rate adjusted to include the risk premium that market participants require. That rate is different from the rate used in the discount rate adjustment technique.

If the risks are accounted for fully and appropriately, the three present value techniques noted above should all produce an identical fair value measurement, regardless of whether risk is captured in the cash flows or the discount rate.

Expected cash flow

Expected cash flow

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