represents the median as well as the expected value. The latter may have been what
was intended, but the median could be equally well justified on the basis that it is 50%
probable that at least this amount will be payable, while anything in excess of that
constitutes a possible but not a probable liability, that should be disclosed rather than
accrued. Interestingly, US GAAP has a different approach to this issue in relation to
contingencies. FASB ASC Topic 450 – Contingencies – states that where a contingent
loss could fall within a range of amounts then, if there is a best estimate within the range,
it should be accrued, with the remainder noted as a contingent liability. However, if
there is no best estimate then the lowest figure within the range should be accrued, with
the remainder up to the maximum potential loss noted as a contingent liability.4
Where the obligation being measured relates to a single item, the standard suggests that
the best estimate of the liability may be the individual most likely outcome. However,
even in such a case, it notes that consideration should be given to other possible
outcomes and where these are predominantly higher or mainly lower than the most
likely outcome, the resultant ‘best estimate’ will be a higher or lower amount than the
individual most likely outcome. To illustrate this, the standard gives an example of an
entity that has to rectify a fault in a major plant that it has constructed for a customer.
The most likely outcome is that the repair will succeed at the first attempt. However, a
provision should be made for a larger amount if there is a significant chance that further
attempts will be necessary. [IAS 37.40].
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4.2
Dealing with risk and uncertainty in measuring a provision
It is clear from the definition of a provision as a liability of uncertain timing or amount
that entities will have to deal with risk and uncertainty in estimating an appropriate
measure of the obligation at the end of the reporting period. It is therefore interesting
to consider how the measurement rules detailed in IAS 37 help entities achieve a faithful
representation of the obligation in these circumstances. A faithful representation
requires estimates that are neutral, that is, without bias. [CF(2010) QC12, QC14]. The
Conceptual Framework (2010) warns against the use of conservatism or prudence in
estimates because this is ‘likely to lead to a bias’. It adds that the exercise of prudence
can be counterproductive, in that the overstatement of liabilities in one period
frequently leads to overstated financial performance in later periods, ‘a result that
cannot be described as prudent or neutral’. [CF(2010) BC3.28]. In March 2018, the IASB
issued a revised Conceptual Framework for Financial Reporting. The revised
framework became effective immediately for the IASB and IFRS Interpretations
Committee and is effective from 1 January 2020 for entities that use the Conceptual
Framework to develop accounting policies when no IFRS standard applies to a
particular transaction. The revised Conceptual Framework also notes that a faithful
representation requires estimates that are neutral, i.e. without bias. [CF 2.13, 2.15].
The standard does not refer to neutrality as such; however, it does discuss the concept
of risk and the need for exercising caution and care in making judgements under
conditions of uncertainty. It states that ‘the risks and uncertainties that inevitably
surround many events and circumstances shall be taken into account in reaching the
best estimate of a provision’. [IAS 37.42]. It refers to risk as being variability of outcome
and suggests that a risk adjustment may increase the amount at which a liability is
measured. [IAS 37.43]. Whilst the standard provides an example of a case in which the best
estimate of an obligation might have to be larger than the individual most likely
outcome, [IAS 37.40], it gives no indication of how this increment should be determined.
It warns that caution is needed in making judgements under conditions of uncertainty,
so that expenses or liabilities are not understated. However, it says that uncertainty does
not justify the creation of excessive provisions or a deliberate overstatement of
liabilities. Accordingly, care is needed to avoid duplicating adjustments for risk and
uncertainty, for example by estimating the costs of a particularly adverse outcome and
then overestimating its probability. [IAS 37.43]. Any uncertainties surrounding the amount
of the expenditure are to be disclosed (see 7.1 below). [IAS 37.44].
The overall result of all this is somewhat confusing. Whilst a best estimate based solely
on the expected value approach or the mid-point of a range addresses the uncertainties
relating to there being a variety of possible outcomes, it does not fully reflect risk,
because the actual outcome could still be higher or lower than the estimate. Therefore,
the discussion on risk suggests that an additional adjustment should be made. However,
apart from indicating that the result may be to increase the recognised liability and
pointing out the need to avoid duplicating the effect of risk in estimates of cash flows
and probability, [IAS 37.43], it is not clear quite how this might be achieved. This leaves a
certain amount of scope for variation in the estimation of provisions and is further
complicated when the concept of risk is combined with considerations relating to the
time value of money (see 4.3.2 below).
Provisions, contingent liabilities and contingent assets 1889
4.3
Discounting the estimated cash flows to a present value
The standard requires that where the effect of the time value of money is material, the
amount of a provision should be the present value of the expenditures expected to be
required to settle the obligation. [IAS 37.45]. The discount rate (or rates) to be used in
arriving at the present value should be ‘a pre-tax rate (or rates) that reflect(s) current
market assessments of the time value of money and the risks specific to the liability. The
discount rate(s) shall not reflect risks for which the future cash flow estimates have been
adjusted.’ [IAS 37.47]. However, it is worth noting that no discounting is required for
provisions where the cash flows will not be sufficiently far into the future for
discounting to have a material impact. [IAS 37.46].
The main types of provision where the impact of discounting will be significant are
those relating to decommissioning and other environmental restoration liabilities.
IFRIC 1 addresses some of the issues relating to the use of discounting (in the context of
provisions for obligations to dismantle, remove or restore items of property, plant and
equipment, referred to as ‘decommissioning, restoration and similar liabilities’) which
are discussed at 6.3.1 below.
4.3.1
Real versus nominal rate
IAS 37 does not indicate whether the discount rate should be a real discount rate or a
nominal discount rate (although a real discount rate is referred to in Example 2 in
Appendix D which illustrates the narrative disclosure for decommissioning costs). The
discount rate to be used depends on whether:
(a) the future cash flows are expressed i
n current prices, in which case a real discount
rate (which excludes the effects of general inflation) should be used; or
(b) the future cash flows are expressed in expected future prices, in which case a
nominal discount rate (which includes a return to cover expected inflation) should
be used.
Either alternative is acceptable, and these methods may produce the same figure for the
initial present value of the provision. However, the effect of the unwinding of the
discount will be different in each case (see 4.3.5 below).
4.3.2
Adjusting for risk and using a government bond rate
IAS 37 also requires that risk is taken into account in the calculation of a provision, but
gives little guidance as to how this should be done. Where discounting is concerned, it
merely says that the discount rate should not reflect risks for which the future cash flow
estimates have been adjusted. [IAS 37.47]. One may use a discount rate that reflects the
risk associated with the liability (a risk-adjusted rate). The following example, taken
from the UK Accounting Standards Board’s (ASB) Working Paper – Discounting in
Financial Reporting,5 shows how an entity might calculate such a risk adjusted rate.
Example 27.7: Calculation of a risk-adjusted rate6
A company has a provision for which the expected value of the cash outflow in three years’ time is £150, and
the risk-free rate (i.e. the nominal rate unadjusted for risk) is 5%. However, the possible outcomes from which
the expected value has been determined lie within a range between £100 and £200. The company is risk
averse and would settle instead for a certain payment of, say, £160 in three years’ time rather than be exposed
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to the risk of the actual outcome being as high as £200. The effect of risk in calculating the present value can
be expressed as either:
(a) discounting the risk-adjusted cash flow of £160 at the risk-free (unadjusted) rate of 5%, giving a present
value of £138; or
(b) discounting the expected cash flow (which is unadjusted for risk) of £150 at a risk-adjusted rate that will
give the present value of £138, i.e. a rate of 2.8%.
As can be seen from this example, the risk-adjusted discount rate is a lower rate than the
unadjusted (risk-free) discount rate. This may seem counter-intuitive initially, because the
experience of most borrowers is that banks and other lenders will charge a higher rate of
interest on loans that are assessed to be higher risk to the lender. However, in the case of
a provision a risk premium is being suffered to eliminate the possibility of the actual cost
being higher (thereby capping a liability), whereas in the case of a loan receivable a
premium is required to compensate the lender for taking on the risk of not recovering its
full value (setting a floor for the value of the lender’s financial asset). In both cases the
actual cash flows incurred by the paying entity are higher to reflect a premium for risk. In
other words, the discount rate for an asset is increased to reflect the risk of recovering less
and the discount rate for a liability is reduced to reflect the risk of paying more.
A problem with changing the discount rate to account for risk is that this adjusted rate is a
theoretical rate, as it is unlikely that there would be a market assessment of the risks specific
to the liability alone. [IAS 37.47]. However the lower discount rate in the above example is
consistent with the premise that a risk-adjusted liability should be higher than a liability
without accounting for the risk that the actual settlement amount is different to the estimate.
[IAS 37.43]. It is also difficult to see how a risk-adjusted rate could be obtained in practice. In
the above example, it was obtained only by reverse-engineering; it was already known that
the net present value of a risk-adjusted liability was £138, so the risk-adjusted rate was just
the discount rate applied to unadjusted cash flow of £150 to give that result.
IAS 37 offers an alternative approach – instead of using a risk-adjusted discount rate,
the estimated future cash flows themselves can be adjusted for risk. [IAS 37.47]. This does
of course present the problem of how to adjust the cash flows for risk (see 4.2 above).
However, this may be easier than attempting to risk-adjust the discount rate.
For the purposes of discounting post-employment benefit obligations, IAS 19 requires the
discount rate to be determined by reference to market yields at the end of the reporting
period on high quality corporate bonds (although in countries where there is no deep
market in such bonds, the market yields on government bonds should be used). [IAS 19.83].
Although IAS 19 indicates that this discount rate reflects the time value of money (but not
the actuarial or investment risk), [IAS 19.84], we do not believe it is appropriate to use the
yield on a high quality corporate bond for determining a risk-free rate to be used in
discounting provisions under IAS 37. Accordingly, in our view, where an entity is using a
risk-free discount rate for the purposes of calculating a provision under IAS 37, that rate
should be based on a government bond rate with a similar currency and remaining term
as the provision. It follows that because a risk-adjusted rate is always lower than the risk-
free rate, an entity cannot justify the discounting of a provision at a rate that is higher than
a government bond rate with a similar currency and term to the provision.
Provisions, contingent liabilities and contingent assets 1891
Whichever method of reflecting risk is adopted, IAS 37 emphasises that care must be
taken that the effect of risk is not double-counted by inclusion in both the cash flows
and the discount rate. [IAS 37.47].
In recent years, government bond rates have been more volatile as markets have
changed rates to reflect (among other factors) heightened perceptions of sovereign
debt risk. In some cases, government bond yields may be negative. The question has
therefore arisen whether government bond rates, at least in certain jurisdictions,
should continue to be regarded as the default measure of a risk-free discount rate.
Whilst the current volatility in rates has highlighted the fact that no debt (even
government debt) is totally risk free, the challenge is to find a more reliable measure
as an alternative. Any adjustment to the government bond rate to ‘remove’ the
estimate of sovereign debt risk is conceptually flawed, as it not possible to isolate one
component of risk from all the other variables that influence the setting of an interest
rate. Another approach might be to apply some form of average bond rate over a
period of 3, 6 or 12 months to mitigate the volatility inherent in applying the spot rate
at the period end. However, this is clearly inappropriate given the requirements in
IAS 37 to determine the best estimate of an obligation by reference to the expenditure
required to settle it ‘at the end of the reporting period’, [IAS 37.36], and to determine the
discount rate on the basis of ‘current market assessments’ of the time value of money.
[IAS 37.47].
With ‘risk’ being a measure of potential variability in returns, it remains the case that
in most countries a government bond will be subject to the lowest level of var
iability
in that jurisdiction. As such, in most countries it remains the most suitable of all the
observable measures of the time value of money in a particular country. Where
government bond rates are negative or, more likely, result in a negative discount rate
once adjusted for risk, we believe that it is not appropriate to apply a floor of zero to
the discount rate as this would result in an understatement of the liability. As
discussed above, and at 4.3.1 above, IAS 37 offers various approaches to determining
an appropriate discount rate. It may sometimes be the case that one or more of the
allowed approaches result in a negative discount rate whereas the application of an
alternative permitted approach would not. In order to avoid some of the
presentational difficulties associated with a negative discount rate, entities faced with
a negative real discount rate before risk adjustment may wish to consider the
alternative approach of discounting expected future cash flows expressed in future
prices, at a nominal discount rate (see 4.3.1 above), if the nominal rate is not negative.
Similarly, entities that are faced with a negative risk-adjusted discount rate only
because of risk adjustment (i.e. where risk free rates themselves are not negative)
may wish to adopt the alternative approach of adjusting the estimated future cash
flows to reflect the risks associated with the liability, rather than risk-adjusting the
discount rate.
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A difficulty that can arise in certain countries is finding a government bond with a
similar term to the provision, for example when measuring a decommissioning
provision expected to be settled in 30 years in a country where there are no
government bonds with a term exceeding 10 years. In such cases, the government
bond rate might be adjusted and the techniques adopted by actuaries for measuring
retirement obligations with long maturities, that involve extrapolating current market
rates along a yield curve, [IAS 19.86], might be considered. The difficulties of finding an
appropriate discount rate in the context of retirement benefit obligations are
discussed in Chapter 31 at 7.6.
4.3.3
International GAAP® 2019: Generally Accepted Accounting Practice under International Financial Reporting Standards Page 372
