Discount rates, or: would you take this at face value?

The IASB has issued a project summary on its research into discount rates

Here’s how it summed things up:

  • Some IFRS Standards require or allow companies to use different discount rates for estimating future cash flows. In some cases, the differences are clearly justified because they reflect different risk factors or circumstances. In other cases, the reasons for the differences are unclear.
  • From 2014 to 2017, the International Accounting Standards Board (Board) conducted a research project on discount rates in IFRS Standards, with the objectives to:
    • investigate reasons for inconsistencies between requirements relating to discount rates in IFRS Standards; and
    • assess whether the Board should consider addressing those inconsistencies.
  • The Board’s investigation found that:
    • inconsistencies between requirements relating to discount rates in IFRS Standards arise in some cases in specifying either:
      • which types of inputs to use in a present value measurement technique; or
      • how to determine the amount of the inputs.
    • some of those inconsistencies arise because different IFRS Standards adopt different measurement bases. Other inconsistencies, mostly relating to entity-specific current value measurements, arise partly because different IFRS Standards were developed at different times and with different areas of focus.

The project generated a summary of research findings, and a bunch of information “that the staff will consider in the future when developing recommendations for the Board on present value measurement requirements.” However, the Board has no current plans to conduct a separate standard-setting project on discount rates.

The project summary contains some useful appendices summarizing how measurement bases and inputs, disclosure requirements and other factors vary between different standards. The greatest uncertainty seems to attach to IAS 37, which devotes just three paragraphs to the issue of present value, including this famously troublesome one (IAS 37.47):

  • The discount rate (or rates) shall 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 future cash flow estimates have been adjusted.

As the project summary notes, many aspects of what this means are unclear and/or subject to mixed practice. For instance, it might seem on some intuitive basis that if (say) a given remediation liability arises from a particularly high-risk project (in the sense that it’s subject to various political and other uncertainties, that the prospects of a successful outcome are hard to quantify, etc.) then the risks specific to the liability might be high. But on the other hand, if a reliable estimate can be made of the amount and timing of the future payment, then the risks attaching to the liability itself may actually not be that high, regardless of how one assesses the rest of the project. That aside though, it’s not clear how to interpret the concept of liability-specific risk. In 2011, IFRIC considered whether an entity’s own credit risk should be excluded from any adjustments made to the discount rate used to measure liabilities. The Committee didn’t take on the issue, but it did note its understanding that “the predominant practice today is to exclude own credit risk, which is generally viewed in practice as a risk of the entity rather than a risk specific to the liability.” Looking at a few random examples just now, I found one where the discount rate was based on “an estimate of the Company’s pricing in the market to obtain debt.” This might sound like an example where the entity’s own credit risk is being included, but it’s hard to draw a firm conclusion.

A different but related issue: the basic premise of IAS 37 is that the amount recognized as a provision is the best estimate of the expenditure required to settle the present obligation at the end of the reporting period. IAS 37.39 says that where a continuous range of possible outcomes exists, and each point in that range is as likely as any other, the mid-point of the range is used. In such a case, the risks attaching to the liability might be assessed as high, given the probability of the ultimate outcome varying in one direction or another. However, the last sentence of IAS 37.47, as quoted above, suggests that future cash flow estimates might be adjusted to reflect risks – perhaps, say, by choosing an estimate above the mid-point of the range, and therefore less likely to be ultimately exceeded. And yet, to move too far in that direction would seemingly contradict what IAS 37.39 says about using the midpoint…

The Board is currently gathering evidence to help it decide whether to undertake a project to amend aspects of IAS 37, and the observations above suggest that might not be the worst idea. In the meantime, the IASB’s summary might be helpful in sensitizing readers to its complexities – not so much, I suppose, in helping anyone resolve them…

The opinions expressed are solely those of the author

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