Present value techniques (Appendix A)

Learning objectives

• Distinguish the traditional approach (single most likely cash flow, risk-adjusted discount rate) from the expected cash flow approach (probability-weighted cash flows).L2, L3
• Calculate a probability-weighted expected cash flow and its present value.L3, L4

Normative references

• IAS 36 §A1Lists the elements that together capture the economic differences between assets in a present value measurement: an estimate of future cash flows, expectations about possible variations in their amount or timing, the time value of money (current risk-free rate), the price for bearing the uncertainty inherent in the asset and other factors (for example, illiquidity) that market participants would reflect.
• IAS 36 §A2Contrasts the traditional approach with the expected cash flow approach and states that, whichever approach is used, the result should reflect the expected present value, that is, the weighted average of all possible outcomes.
• IAS 36 §A3Sets out the general principles: discount rates consistent with the cash flows (without double counting of risks), cash flows and discount rates free from bias, and consideration of the range of possible outcomes.
• IAS 36 §A4Describes the traditional approach: a single set of cash flows (the most likely) discounted at a single rate intended to capture all the risk, the emphasis being on the selection of the rate.
• IAS 36 §A5States that the traditional approach is relatively easy to apply when comparable assets can be observed in the marketplace, and that for assets with contractual cash flows it is consistent with the manner in which marketplace participants describe them.
• IAS 36 §A6Emphasises that the traditional approach may not appropriately address complex measurement problems, such as non-financial assets for which no market exists for the item or a comparable item: searching for a rate commensurate with the risk requires analysing at least one item observed in the marketplace and deriving the applicable rate from it, which requires cash flows with similar characteristics.
• IAS 36 §A7Presents the expected cash flow approach, which uses all expectations about possible cash flows weighted by their probabilities instead of the single most likely cash flow.
• IAS 36 §A8Shows that the expected cash flow approach also allows a cash flow whose timing is uncertain to be discounted: each possible date is discounted at its own rate, then the resulting present values are weighted by their probability to give an expected present value.
• IAS 36Compares the expected present value in the uncertain-timing example with the traditional best estimate (most likely scenario): the traditional approach requires a single timing to be chosen and ignores the probability of the others, which the discount rate cannot reflect.
• IAS 36 §A10Responds to the objection that assigning probabilities to highly subjective estimates suggests greater precision than in fact exists: the traditional approach, properly applied, requires the same estimates and judgement, without providing the computational transparency of the expected cash flow approach.
• IAS 36 §A11Notes that many estimates developed in current practice already incorporate the elements of expected cash flows informally, and that an asset must often be measured using limited information about the probabilities; illustrates the calculation of an expected cash flow with cases (a range with no amount more likely than another, a range with a most likely amount, probabilities by amount).
• IAS 36 §A12Subjects the expected cash flow approach to a cost-benefit constraint: depending on the data available, the entity may develop many scenarios or only general statements about the variability of cash flows, and balances the cost of obtaining additional information against the additional reliability that information will bring to the measurement.
• IAS 36 §A13Some argue that expected cash flow techniques are unsuitable for measuring a single item or an item with only a few possible outcomes; they give the example of an asset with two very different outcomes whose expected cash flow matches none of the amounts that could ultimately be paid, and consider that result open to criticism. The standard's answer is in para. A14.
• IAS 36 §A14Responds to the objection that expected cash flows are inappropriate for a single item or for few possible outcomes (an example with two outcomes whose average corresponds to neither): this criticism addresses a different measurement objective, whereas the Standard seeks the recoverable amount of the asset, which the most likely amount alone does not represent.

Original summaries of the paragraphs (reference register), never a quotation of the standard.

6 questions

• In the traditional present value approach described in Appendix A of IAS 36, how is the risk specific to the asset built into the measurement?L2
• The financial controller of Brivane is preparing a present value estimate for an impairment test. Which of the following practices comply with the general principles of Appendix A of IAS 36? (several answers)L3
• For a specialised press, Ortalis expects a single net cash flow next year: 20,000 with a probability of 40% or 70,000 with a probability of 60%. An analyst argues that the expected cash flow is meaningless, since neither outcome equals that average, and proposes using 70,000. Which answer complies with Appendix A of IAS 36?L3
• To compute the value in use of a bottling line, Valtera uses three scenarios for the net cash flow it will receive in one year: {low_cash_flow} (probability {low_probability}), {mid_cash_flow} (probability {mid_probability}) and {high_cash_flow} (probability {high_probability}). The discount rate provided, {discount_rate}, contains no adjustment for the risks already reflected in the weighting of the scenarios. Compute the expected cash flow, then its present value.L3
• Nordalis licenses out a process patent. Next year's net royalties, received at year-end, will depend on demand: {low_cash_flow} if it weakens ({low_probability} chance), {mid_cash_flow} if it holds steady ({mid_probability}) and {high_cash_flow} if it grows ({high_probability}). The rate of {discount_rate} provided by group treasury is consistent with cash flows already weighted by their probabilities. Determine the expected cash flow and its present value.L3
• Grimaldo expects a single cash receipt of {cash_flow} from using a piece of equipment, of which only the date is uncertain: in one year (probability {probability_year_1}) or in two years (probability {probability_year_2}). The applicable discount rates are {rate_year_1} per year for a one-year maturity and {rate_year_2} per year for a two-year maturity. Compute the expected present value of this receipt under the expected cash flow approach.L4