International GAAP® 2019: Generally Accepted Accounting Practice under International Financial Reporting Standards
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Own credit risk is not taken into account
In considering the risk factors that might give rise to a difference between the actual
cash flows required to settle a liability and their previously estimated amounts, an
entity would not take into account its own credit risk; that is, the risk that the entity
could be unable to settle the amount finally determined to be payable. This is because
IAS 37 requires the discount rate to reflect ‘the risks specific to the liability’. [IAS 37.47].
In March 2011, the Interpretations Committee decided not to take to its agenda a
request for interpretation of the phrase ‘the risks specific to the liability’ and whether
this means that an entity’s own credit risk should be excluded from any adjustments
made to the discount rate used to measure liabilities. In doing so, the Interpretations
Committee acknowledged that IAS 37 is not explicit on the question of own credit
risk; but understood that the predominant practice was to exclude it for the reason
that credit risk is generally viewed as a risk of the entity rather than a risk specific to
the liability.7
4.3.4
Pre-tax discount rate
Since IAS 37 requires provisions to be measured before tax, it follows that cash flows
should be discounted at a pre-tax discount rate. [IAS 37.47]. No further explanation of this
is given in the standard.
This is probably because, in reality, the use of a pre-tax discount rate will be most
common. Supposing, for example, that the risk-free rate of return is being used, then
the discount rate used will be a government bond rate. This rate will be obtained gross.
Thus, the idea of trying to determine a pre-tax rate (for example by obtaining a required
post-tax rate of return and adjusting it for the tax consequences of different cash flows)
will seldom be relevant.
The calculation is illustrated in the following example.
Example 27.8: Use of discounting and tax effect
It is estimated that the settlement of an environmental provision will give rise to a gross cash outflow of
£500,000 in three years’ time. The gross interest rate on a government bond maturing in three years’ time is
6%. The tax rate is 30%.
The net present value of the provision is £419,810 (£500,000 × 1 ÷ (1.06)3). Hence, a provision of £419,810
should be booked in the statement of financial position. A corresponding deferred tax asset of £125,943 (30%
of £419,810) would be set up if it met the criteria for recognition in IAS 12 (See Chapter 29 at 7.4).
Provisions, contingent liabilities and contingent assets 1893
4.3.5
Unwinding of the discount
IAS 37 indicates that where discounting is used, the carrying amount of a provision
increases in each period to reflect the passage of time, and that this increase is
recognised as a borrowing cost. [IAS 37.60]. This is the only guidance that the standard
gives on the unwinding of the discount. IFRIC 1 in relation to provisions for
decommissioning, restoration and similar liabilities requires that the periodic unwinding
of the discount is recognised in profit or loss as a finance cost as it occurs. The
Interpretations Committee concluded that the unwinding of the discount is not a
borrowing cost for the purposes of IAS 23 – Borrowing Costs – and thus cannot be
capitalised under that standard. [IFRIC 1.8]. It noted that IAS 23 addresses funds borrowed
specifically for the purpose of obtaining a particular asset and agreed that a
decommissioning liability does not fall within this description since it does not reflect
funds borrowed. Accordingly, the Interpretations Committee concluded that the
unwinding of the discount is not a borrowing cost as defined in IAS 23. [IFRIC 1.BC26].
However, there is no discussion of the impact that the original selection of discount rate can
have on its unwinding, that is, the selection of real versus nominal rates, and risk-free versus
risk-adjusted rates. The IASB appears to have overlooked the fact that these different
discount rates will unwind differently. This is best illustrated by way of an example.
Example 27.9: Effect on future profits of choosing a real or nominal discount
rate
A provision is required to be set up for an expected cash outflow of €100,000 (estimated at current prices),
payable in three years’ time. The appropriate nominal discount rate is 7.5%, and inflation is estimated at 5%. If
the provision is discounted using the nominal rate, the expected cash outflow has to reflect future prices.
Accordingly, if prices increase at the rate of inflation, the cash outflow will be €115,762 (€100,000 × 1.053).
The net present value of €115,762, discounted at 7.5%, is €93,184 (€115,762 × 1 ÷ (1.075)3). If all assumptions
remain valid throughout the three-year period, the movement in the provision would be as follows:
Undiscounted
cash flows Provision
€ €
Year 0
115,762 93,184
Unwinding of discount (€93,184 × 0.075)
6,989
Revision to estimate
–
Year 1
115,762 100,173
Unwinding of discount (€100,173 × 0.075)
7,513
Revision to estimate
–
Year 2
115,762 107,686
Unwinding of discount (€107,686 × 0.075)
8,076
Revision to estimate
–
Year 3
115,762 115,762
If the provision is calculated based on the expected cash outflow of €100,000 (estimated at current prices), then
it needs to be discounted using a real discount rate. This may be thought to be 2.5%, being the difference between
the nominal rate of 7.5% and the inflation rate of 5%. However, it is more accurately calculated as 2.381%, being
(1.075 ÷ 1.05) – 1. Accordingly, the net present value of €100,000, discounted at 2.381%, is €93,184
(€100,000 × 1 ÷ (1.02381)3), the same as the calculation using future prices discounted at the nominal rate.
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If all assumptions remain valid throughout the three-year period, the movement in the provision comprises
both the unwinding of the discount and the increase in the level of current prices used to determine the
estimate of cost, as follows:
Undiscounted
cash flows Provision
€ €
Year 0
100,000 93,184
Unwinding of discount (€93,184 × 0.02381)
2,219
Revision to estimate (€100,000 × 0.05)
5,000 4,770
Year 1
105,000 100,173
Unwinding of discount (€100,173 × 0.02381)
2,385
Revision to estimate (€105,000 × 0.05)
5,250 5,128
Year 2
110,250 107,686
Unwinding of discount (€107,686 × 0.02381)
2,564
Revision to estimate (€110,250 × 0.05)
5,512 5,512
Year 3
115,762 115,762
Although the total expense in each year is the same under either method, what will be
different is the allocation of the change in provision between operating costs (assuming
the original provision was treated as an operating expense) and finance charges. It can
be seen from the second table in the
above example that using the real discount rate
will give rise to a much lower finance charge each year. However, this does not lead to
a lower provision in the statement of financial position at the end of each year.
Provisions have to be revised annually to reflect the current best estimate of the
obligation. [IAS 37.59]. Thus, the provision in the above example at the end of each year
needs to be adjusted to reflect current prices at that time (and any other adjustments
that arise from changes in the estimate of the provision), as well as being adjusted for
the unwinding of the discount. For example, the revised provision at the end of Year 1
is €100,173, being €105,000 discounted for two years at 2.381%. After allowing for the
unwinding of the discount, this required an additional provision of €4,770.
A more significant difference will arise where the recognition of the original provision
is included as part of the cost of property, plant or equipment, rather than as an expense,
such as when a decommissioning provision is recognised. In that case, using a real
discount rate will result initially in a lower charge to the income statement, since under
IFRIC 1 any revision to the estimate of the provision is not taken to the income
statement but is treated as an adjustment to the carrying value of the related asset, which
is then depreciated prospectively over the remaining life of the asset (see 6.3.1 below).
A similar issue arises with the option of using the risk-free or the risk-adjusted discount
rate. However, this is a more complex problem, because it is not clear what to do with
the risk-adjustment built into the provision. This is illustrated in the following example.
Example 27.10: Effect on future profits of choosing a risk-free or risk-adjusted rate
A company is required to make a provision for which the estimated value of the cash outflow in three years’
time is £150, when the risk-free rate (i.e. the 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 reporting
entity is risk averse and would settle instead for a certain payment of, say, £160 in three years’ time rather
than be exposed to the risk of the actual outcome being as high as £200. The measurement options to account
for risk can be expressed as either:
Provisions, contingent liabilities and contingent assets 1895
(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%.
Assuming that there are no changes in estimate required to be made to the provision during the three-year
period, alternative (a) will unwind to give an overall finance charge of £22 and a final provision of £160.
Alternative (b) will unwind to give an overall finance charge of £12 and a final provision of £150.
In this example, the unwinding of different discount rates gives rise to different
provisions. The difference of £10 (£22 – £12) relates to the risk adjustment that has been
made to the provision. As the actual date of settlement comes closer, the estimates of
the range of possible outcomes (and accordingly the expected value of the outflow) and
the premium the entity would accept for certainty will converge. As such, the effect of
any initial difference related to the decision to apply a risk-free or risk-adjusted rate
will be lost in the other estimation adjustments that would be made over time.
In circumstances where a provision has been discounted using a negative discount rate
(see 4.3.2 above), entities will need to give some consideration to how the unwinding of the
discount should be presented in the statement of comprehensive income. The presentation
of income and expense resulting from negative interest has been discussed by the
Interpretations Committee in the context of financial instruments. Whilst that topic was not
taken on to the Interpretations Committee’s agenda, the Committee noted in their agenda
decision that the expense arising on a financial asset because of a negative interest rate
should not be presented as interest revenue, but in an appropriate expense classification.8
Whilst negative interest rates on financial liabilities were not explicitly addressed in the
agenda decision, the Interpretations Committee noted during discussions that an inflow of
economic benefits arising from a liability cannot be characterised as revenue.9 In our view,
similar considerations are appropriate to the presentation of the unwinding of the discount
on a provision that has been discounted using a negative nominal discount rate.
4.3.6
The effect of changes in interest rates on the discount rate applied
The standard requires the discount rate to reflect current market assessments of the time
value of money. [IAS 37.47]. This means that where interest rates change, the provision
should be recalculated on the basis of revised interest rates (see Example 27.11 below).
Any revision in the interest rate will give rise to an adjustment to the carrying value of the
provision in addition to the unwinding of the previously estimated discount. The standard
requires these movements to be disclosed in the notes to the financial statements (see 7.1
below). [IAS 37.84(e)]. However, the standard does not explicitly say how the effect of
changes in interest rates should be classified in the income statement. We believe that this
element should be treated separately from the effect of the passage of time, with only the
charge for unwinding of the discount being classified as a finance cost. Any adjustment to
the provision as a result of revising the discount rate is a change in accounting estimate,
as defined in IAS 8 – Accounting Policies, Changes in Accounting Estimates and Errors
(see Chapter 3 at 4.5). Accordingly, it should be reflected in the line item of the income
statement to which the expense establishing the provision was originally taken and not as
a component of the finance cost. Indeed, this is the approach required by IFRIC 1 in
relation to provisions for decommissioning, restoration and similar liabilities in relation to
assets measured using the cost model (see 6.3.1 below). However, in that case the original
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provision gives rise to an asset rather than an expense, so any subsequent adjustment is
not included in profit or loss, [IAS 8.36], but added to or deducted from the cost of the asset
to which it relates. [IFRIC 1.5]. The adjusted depreciable amount of the asset is then
depreciated prospectively over its remaining useful life. [IFRIC 1.7]. Nevertheless, the effect
is distinguished from the unwinding of the discount.
In addition, the standard gives no specific guidance on how or when this adjustment should
be made. For example, it is unclear whether the new discount rate should be applied during
the year or just at the year-end, and whether the rate should be applied to the new estimate
of the provision or the old estimate. IFRIC 1 implies that the finance cost is adjusted
prospectively from the date on which the liability is remeasured. Example 1 to IFRIC 1 states
that if the change in the liability had
resulted from a change in discount rate, instead of a
change in the estimated cash flows, the change would still have been reflected in the carrying
value of the related asset, but next year’s finance cost would have reflected the new discount
rate. [IFRIC 1.IE5]. This conclusion is consistent with the requirement in IAS 37 for the value of
a provision to reflect the best estimate of the expenditure required to settle the obligation as
at the end of the reporting period, [IAS 37.36], as illustrated in the following example.
Example 27.11: Accounting for the effect of changes in the discount rate
A provision is required to be set up for an expected cash outflow of €100,000 (estimated at current prices),
payable in three years’ time. The appropriate nominal discount rate is 7.5%, and inflation is estimated at 5%.
At future prices the cash outflow will be €115,762 (€100,000 × 1.053). The net present value of €115,762,
discounted at 7.5%, is €93,184 (€115,762 × 1 ÷ 1.0753).
At the end of Year 2, all assumptions remain valid, except it is determined that a current market assessment
of the time value of money and the risks specific to the liability would require a decrease in the discount rate
to 6.5%. Accordingly, at the end of Year 2, the revised net present value of €115,762, discounted at 6.5%, is
€108,697 (€115,762 ÷ 1.065).
The movement in the provision would be reflected as follows:
Undiscounted
cash flows Provision
€ €
Year 0
115,762 93,184
Unwinding of discount (€93,184 × 0.075)
6,989
Revision to estimate
–
Year 1
115,762 100,173
Unwinding of discount (€100,173 × 0.075)
7,513
115,762 107,686
Revision to estimate (€108,697 – €107,686)
1,011
Year 2
115,762 108,697
Unwinding of discount (€108,697 × 0.065)