I have selected discounted cash flows (DCF) as the most confusing cash flow because there are four of them. Two use the same initials, DCF, one has no initials, and one is not even a cash flow, with or without the initials.
DCF number 1
DCF is a division of the Securities and Exchange Commission in the USA, the Division of Corporation Finance which manages the disclosure and compliance of oversees corporations. I didn’t know that before making a search for DCF on the SEC website, hoping to find what the SEC thinks of discounted cash flow.
DCF number 2
The most well-known is the DCF – discounted cash flow – which measures the cash that the company’s management expects to flow in the future. I’d rather call it ‘imaginary’ because this cash flow doesn’t exist, at least not yet; it is only in the minds of management. DCF is based entirely on management assumptions and projections of their future financial performance; all values in its calculation are variables. When management changes then, by definition, so does DCF.
Accountants admit that it is highly sensitive and speculative. Accountants that prepare DCFs believe in the process so much that they record it officially. But then they argue that if they expect to receive say €100 in five years’ time, by the time it arrives, it may not be exactly €100 so they reduce it by an arbitrary amount called ‘discount’, to something like €90. They then argue that this imaginary but hopeful €90 is equivalent to €100 in the bank today, whereas any normal person would take the €100 in the bank today.
In addition, accountants use the imaginary DCF to, among other things, justify another imaginary asset class – ‘intangible’ assets – in the balance sheet. Imaginary cash to justify imaginary assets. Even better, intangible cash to justify intangible assets.
DCF Number 3
The relatively unknown DCF is the discretionary cash flow. This can be calculated from the official financial statements if you ever want to know what the amount is. They call it ‘discretionary’ because, once it’s calculated, management can decide what to spend it on. They are even judged on how they use it, with the choices being almost unlimited: capital expenditure, repaying outstanding debt, increasing working capital, buying back shares, issuing dividends, or acquiring companies.
And it is often used with its close cousin, DCF or discounted cash flow. I know this because the ICAEW got together with CISI, the Chartered Institute for Securities and Investment to make a syllabus for their Diploma in Corporate Finance, where in Paper 1, candidates must ‘use and appraise methods of equity analysis for’ FCF free cash flow and be able to apply ‘discounted cash flow (DCF) techniques to FCF.’
You can also use discretionary cash flow to calculate discounted cash flow. Use DCF to calculate DCF, how useful is that?
DCF Number 4
And then there is unDCF: undiscounted cash flow. I am the only accountant to use these initials for this new term invented by the FASB. It comes up in FASB ASC Topic 360, in paragraph 360-10-35-17. It is used to calculate an impairment loss. The FASB slips in this term and by doing so officialises it as the ‘sum of undiscounted cash flows’, as though it were the most common term in the accounting world. It isn’t. What, I wonder, is the difference between the sum of cash flows and the sum of undiscounted cash flows?
I searched the glossary of the FASB in the hope I would find its definition. But the FASB have decided not to define it. I guess this term shows the popularity of DCF for accountants. Nobody calls a cash flow statement an undiscounted cash flow statement. But now that the FASB considers it important, we may be required to do so in the near future.
