The theory and practice of discounting in financial reporting
ICAS and the European Financial Reporting Advisory Group (EFRAG) have jointly funded and published a study to better understand the practical application of discount rates in financial accounts.
Although discounting is a requirement under several International Financial Reporting Standards (IFRS), the way that discount rates are applied varies between these different standards.
In spite of this inconsistency and complexity, discount rates have received insufficient attention in accounting research relative to their importance. This is a subject that merits greater attention from standards setters, as well as the preparers and users of financial statements.
In response to this significant research gap, this interview-based project by Iain Clacher, Alan Duboisée de Ricquebourg, Mark C. Freeman and Con Keating, set out to critically evaluate and examine:
- the underlying rationale for the different approaches in each standard;
- the economic consequences of the different approaches used, and;
- where appropriate, illustrate alternative methods that may be applicable.
The study also contrasts existing practices under IFRS against public sector guidance, to provide a deeper understanding of the relative strengths and weaknesses of discount rate estimation in financial reporting.
To inform recommendations, the authors spoke to key market actors across a range of industries and policy bodies, as well as accounting firms and standard setters, to discuss the key issues arising from the different approaches to discounting that are applied currently.
Some of the key findings from the project were:
- The use of different approaches to the choice of discount rates across different standards has no consistent or rational basis
In examining several standards, and their associated basis for conclusions, the rationale for selecting a particular discount rate in most instances lacks any fundamental analysis, and often seems arbitrary.
The consequences of this are most clearly illustrated in IAS19 and IFRS17. If a pension fund undertakes a buyout transaction with an insurance company, the discount rate for the pension liability under IAS19 is a AA corporate bond yield, but for insurance companies under IFRS17 it is the return on assets. Through this transaction, the pension liability is automatically smaller under IFRS17, and the surplus assets of the scheme will be increased significantly. This is despite the fact that there is no difference in the long-term obligations of the scheme as it moves from the balance sheet of the sponsor company to the balance sheet of the insurer.
- Accounting researchers ignore discount rates and their importance in financial reporting, and so the intellectual and evidential base for standard setters is weak
In disciplines such as economics, finance, and actuarial science, there are long and well-established literatures that debate and research discount rates extensively, and so there is a substantial body of evidence for industry, regulators, and government, to draw upon when making decisions about what discount rate to choose in a particular setting.
Surprisingly this was not found to be the case in accounting research, and so accounting researchers, and by extension standard setters, are passive recipients of approaches to discounting developed elsewhere that may not be appropriate for the context in which they are being applied.
- The choice of discount rate has real-world economic consequences
Accounting standards construct a picture of the economic reality of the firm and as such influence the behaviour of a range of actors, including management. A recent example of just how significant this can be is the Liability Driven Investment (LDI) induced crisis in the UK gilt market, and the significant losses in pension schemes in both the UK and Holland resulting from LDI.
As a result of an approach to pensions accounting anchored to a market-based discount rate, pension schemes and corporate sponsors focused on the management of transitory volatility between scheme assets and liabilities that resulted from this measurement approach. This volatility was independent of the solvency of pension schemes, and the result of trying to manage this with complex financial products has led to significant and real losses to pension funds that run into the hundreds of billions of euros.
- There have been some improvements in the development of newer accounting standards
More recently we have seen developments in discount rates resulting in significant improvements in newer standards relative to the previous standards they replace. In the application of discount rates to accounting for insurance contracts under IFRS 17 for example, the approach taken to discounting for the Contractual Service Margin (CSM), reflects the underlying economic substance of the insurance contract.
Given that standards can be improved in this way, it is an open question as to why discount rates in financial reporting are not being revisited more broadly, especially when we have moved to a period of rapidly increasing interest across many parts of the world as central banks try to grapple with high inflation.
Preparers need a principles-led best practice guide to support them in the appropriate application of discount rates across standards
Current standards are seen as inconsistent with approaches to setting discount rates varying widely across standards. Many respondents to the analysis of IAS19 in the report highlight these discrepancies and variations. If current standards faithfully represent the underlying activities of a company, then it is incumbent on the IASB to support preparers in achieving this.