Discount rates – no imminent solutions, no great sweat?

The UK’s Financial Reporting Council has issued Thematic Review: Discount Rates

Here’s the summary:

  • Discounted cash flows, and discount rates themselves, are commonly used when applying IFRS. Determining an appropriate discount rate is a complex area of financial reporting, which can also be a source of significant estimation uncertainty. The challenge is partly because the reporting requirements relating to discount rates differ across IFRS Accounting Standards, some do not include any explicit requirements, and many require judgement to be applied in determining the construction of the appropriate discount rate.
  • This complexity can present challenges in financial reporting and discount rates can be a source of errors. Although not featuring directly in the Corporate Reporting Review (CRR) team’s Top Ten matters of challenge, they underlie a number of common areas; impairment, for example, and have featured in some of CRR’s most challenging cases and significant findings. We believe that many of these errors could have been avoided if companies had sought specialist third party advice at an appropriate point in their reporting cycle and we encourage companies to make a point of including this in their annual planning process, where no internal expertise exists. We also believe that there is general scope for improvement in the usefulness of the disclosures provided by many companies, particularly in the current interest rate environment of low nominal interest rates and relatively high inflation, which may impact reporting by many companies.

As always with such FRC reports, the document is very appealingly designed and expressed, with some good illustrative material. In this case though, as partly indicated above, the impact and usefulness is somewhat undermined by the second-tier nature of the subject matter. The inherent vagueness of the standards on the area make it harder to pin down any particular approach as being plainly “wrong,” and even where that can be done, for example because risk of variability has been counted twice (both in the cash flows and in the discount rate) it will often be hard to say that the impact on users is materially adverse in a qualitative sense at least. Consequently, the case studies included in the report are all pretty dull and minor, for instance:

  • Background The company received deferred consideration from the sale of a business in the form of long-term loan notes. The loan notes were initially recognized at fair value applying a discount rate of 3%.
  • FRC’s approach We asked the company to explain the basis on which the discount rate was calculated, and whether it reflected a market participant’s view of the counterparty credit risk associated with the loan.
  • The company’s response The company acknowledged that the discount rate applied did not appropriately reflect the factors that a market participant would consider when assessing the risks attached to the notes’ cash flows. As such the discount rate used to value the loan notes on initial recognition was increased to 12%, which was determined to be the appropriate market rate. The initial carrying value of the loan notes was restated.
  • The company also enhanced its disclosure of the assumptions used by management.

Although the revised estimate was no doubt better than the original one, the amount in question (and revised accretion amounts to be recognized in future periods) carry limited relevance whatever it’s valued at, being a one-off with no predictive value beyond the collectability of the amount itself; it seems a bit dubious to me whether such tangential matters are the best use of the FRC’s time.

The report points out the occasional use of negative interest rates in recent financial reporting, including the following real-life instance:

  • The provision represents the discounted values of the estimated cost to decommission and rehabilitate the mines at the expected date of closure of each of the mines. The present value of the provision has been calculated using a real pre-tax annual discount rate, based on a US Treasury bond of an appropriate tenure adjusted for the impact of inflation as at 31 December 2020 and 2019 respectively, and the cash flows have been adjusted to reflect the risk attached to these cash flows. Uncertainties on the timing for use of this provision include changes in the future that could impact the time of   closing the mines, as new resources and reserves are discovered. The discount rate used was -1.58% (2019: 0.00%).

Although the FRC seems content with that disclosure, it seems to me that more explanation of what that negative rate actually means wouldn’t have been misplaced. Anyway, the area of discount rates was highlighted in the request for information relating to the IASB’s recent agenda consultation, but didn’t ultimately rise to the top level of priority – a staff paper noted among other things that the matters noted by respondents in this area “are not necessarily acute, as they primarily relate to the complexity and understandability of the requirements in Accounting Standards rather than the outcomes of applying those requirements.” It also noted that a project on the area would be complex and that “the feasibility of potential solutions is doubtful.” Which sounds like the same kind of stifled yawn I expressed above…

The opinions expressed are solely those of the author

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