For instance, the expected cash flows on a bond may involve payments of principal, interest, penalties, or other amounts. The nature of the expected cash flows depends on the type of item. To develop an estimate of the expected cash flows, an entity considers both cash inflows and cash outflows. Management often employs valuation specialists and actuaries to help select and review assumptions. 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. The process is highly subjective and requires a large degree of management judgment. To use a discounted cash flow approach, an entity must develop assumptions for:ĭeveloping reasonable and supportable assumptions is key. 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.ĭeveloping Assumptions for Expected Cash Flows and the Discount Rate 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. Discounted cash flow approaches are also utilized within other functions of an organization, such as treasury, budgeting, financial planning and analysis, and tax planning. 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. 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®. 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. Discounted cash flow approaches are a helpful tool used in US GAAP accounting for valuation and impairment assessments.
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