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The COVID-19 pandemic has significantly affected the global economy and financial markets in 2020. Stock markets declined sharply earlier in the year and have since rebounded, volatility has increased, and treasury bond yields have reached record lows. The current uncertain economic conditions have posed a real challenge for companies in forming accounting estimates, in particular in estimating appropriate discounts rates to be used in the measurement of certain liabilities and provisions.

The topic has come to the attention of the Financial Reporting Council, with its 2019/20 annual review of Corporate reporting noting that, “It is unclear in some cases why the discount rates applied to measure certain long-term provisions appeared to be higher than risk-free rates”. In the current economic conditions, Companies should expect the regulator to raise questions in this area.

Under IAS 37: Provisions, contingent liabilities and contingent assets, the future cash outflows relating to a provision are required to be discounted where the effect is material. The standard requires the application of a pre-tax discount rate, that reflects the time value of money and risks specific to the liability. While the determination of an appropriate discount rate for known near-term outflows is usually straightforward, estimating discount rates for more uncertain long-term cash flows, such as decommissioning costs and environmental rehabilitation costs, is challenging.  

The starting point is to determine an appropriate risk-free rate, to which adjustments are made to reflect the risks specific to the cash flows being discounted. And it is the determination of that risk-free rate that is the subject of our attention here.

The appropriate risk-free rate is generally estimated based on the yield on government bonds that have a similar timing and currency of cash flows as compared to those being discounted. However, in the current environment Central banks in many countries are cutting interest rates in response to increasing concerns about the economic impact of COVID-19,  which may result in negative real rates, as is the case in Eurozone economies, Denmark, Sweden, Japan and Switzerland. Where observed interest rates are negative, determining an appropriate interest free rate may be particularly judgemental.

Further, government bonds are not risk-free. The yield on government bonds reflects the credit risk of the economy of the government that has issued it. In the current dramatically changing economic environment, companies should assess whether the yield used needs to be adjusted to determine the appropriate risk-free rate.

The appropriate discount rate (and the risk-free rate on which it is based) should reflect the conditions at the balance sheet date. The observable yield, which as noted is typically based on a government bond, may be impacted by temporary fluctuations that are inconsistent with a market-based expectation over the period of the cash flows that are being discounted. These fluctuations in yield may arise because of temporary government actions such as quantitative easing or asset rotation effects. In some cases, adjustment to the yields by way of short-term averaging or specific adjustments to the observable yields may be appropriate. This is a highly judgemental and complex area and companies should consider obtaining specialist valuations support where the impact of these fluctuations to the discount rate is expected to be material.

Where the discount rates used have changed materially, companies need to consider whether disclosure of effects of these changes needs to be made. Additionally, as required by IAS 1: Presentation of Financial Statements and further encouraged by FRC, companies should disclose ranges of possible outcomes and/ or sensitivities to changes in key assumptions, such as discount rates used in the measurement of provisions, if there is a significant risk of a material adjustment to provisions within the next year. In the current environment of elevated risks, clear and transparent disclosures of judgements and assumptions made in estimating the carrying amounts of assets and liabilities, including provisions, is expected by investors and regulators.

If you would like to discuss any of the topics in more detail, then please contact us.