Using expected cash flow under FAS 5

How can liability costs be estimated under FAS 5, Accounting for Contingencies, despite cost uncertainty?

The application of expected cash flow, an expected value approach, should be considered. It incorporates cost uncertainty (as probability) into cost estimation. An example can show how the expected cash flow approach is implemented.

This is from Appendix C of FAS 143, Asset Retirement Obligations. It demonstrates use of the expected cash flow approach in estimating labor costs to retire (i.e., dismantle and remove) an offshore oil platform.

Three possible labor cost cash flows are identified: $100,000, $125,000, and $175,000. (They could represent three ways of performing the work.) The probability for each being the outcome amount is assessed, respectively: 25%, 50%, and 25%.

The product of the probabilities and the cash flow amounts gives expected cash flows, respectively: $25,000, 62,500, and $43,750. Summing the probability-weighted, individual cash flows gives the project’s expected value for labor costs, $131,250.

So, the expected value (in this example, $131,250) incorporates consideration of cost uncertainty as probability, and is the probability-weighted average of expected cash flows.

For situations in which there is no market for obtaining a quoted price, e.g., the normal circumstance for environmental cleanup liabilities, ASTM E2137-06, Standard Guide for Estimating Monetary Costs and Liabilities for Environmental Matters, ranks the expected value approach higher (in robustness and comprehensiveness) than other familiar measurement options (i.e., most likely value, cost range, and known minimum value).

This example pertains, as well, for estimating environmental liability costs under FAS 141R, Business Combinations (Revised), and FAS 157, Fair Value Measurements. That is, calculating expected cash flow is part of measuring cost (at fair value under those standards) for liabilities that have no active market for otherwise establishing value.

[See the March 4, 2009, post in Knowing Disclosure for using expected present value under FAS 141R.]