In May 2022, the FRC published its Thematic Review of discount rates for companies applying IFRS.

The report sets out key findings as well as identifying a number of complexities associated with discount rate determination, and potential improvements in disclosures.

1. Incorporating risk into discounting

The value of future cash flows is affected by the variability, or risk, associated with those cash flows in addition to the time value of money.

A risk associated with cash flows can be reflected by:

• adjusting the expected value of the cash flow for the risk and the adjusted figure is discounted at a risk free rate; or
• the expected value of the cash flows can be discounted at a risk-adjusted rate.
  The FRC report highlighted that, whilst both practices will provide the same result, in the majority of cases it is easier to adjust the expected value of the cash flows.

Companies should ensure that the risk adjustment is not double counted i.e., either reflected in adjusted cash flows or reflected in a risk-adjusted discount rate.

2. IAS 36 – pre-tax and post-tax discount rates

Under IAS 36, the discount rate for a value-in-use (VIU) measurement should be a pre-tax rate reflecting the time value of money and the risks specific to the asset that are not reflected in the cash flows. In theory, both approaches should provide the same result.

Many companies use a weighted average cost of capital (WACC) as a starting point which usually results in a post-tax rate. In terms of converting this into a pre-tax rate, the grossing-up of a post-tax rate will not reflect differing tax rates or that the cash flows may fluctuate over time.

Key FRC expectations:

• companies should consider whether applying a post-tax discount rate to post-tax cash flows will provide a materially consistent discount rate to a pre-tax basis;
• companies should provide clear explanations on how discount rates have been determined; and
• if a post-tax discount rate is applied to post-tax cash flows, companies should explain why this approach was used and disclose the equivalent pre-tax discount rates.

3. IAS 37- risk, liquidity premium and own-credit

Variability in cash flows for liabilities is reflected either by:

• adjusting the expected value of cash flows for risk, discounting these at a risk-free rate; or
• discounting the expected value of cash flows at a risk-adjusted rate.

The FRC has identified errors in incorporating risk into discounting of a liability.

Provisions and liabilities calculated under IAS 37 do not typically include own-credit risk or liquidity premium.

Key FRC expectations:

• better disclosures on factors considered in determining the discount rate for provisions; and
• clear explanation of any adjustments to discount rates for own-credit risk or liquidity premium.

4. Inflation – real and nominal discount rates

Inflation will become increasingly relevant in financial reporting with the impact of the 9% rise in May 2022 and the economic outlook

The inputs for present value measurement should be consistent i.e. nominal cash flows which include the impact of inflation, should be discounted at a nominal rate and real cash flows, which exclude the rate of inflation should be discounted at a real rate.

Whilst IFRS 13 is explicit that assumptions about cash flows and discount rates should be consistent, this applies across all areas of financial reporting.

Key FRC expectations:

• explanation of whether inflation has been taken into account thought cash flows or discount rate;
• consideration of whether inflation is a key sources of estimation uncertainty in the financial statements; and
• explanation of how inflation adjustments have been calculated, particle where they could have a material impact on the financial statements.

5. Fair value

The FRC does not normally identify errors in recurring fair value measurement where specialist valuation input is obtained. The FRC has identified errors in ad-hoc fair value measurement such as deferred consideration, royalty and earn-out agreements.

Key FRC expectations:

• management should understand the output of valuations where a third-party specialists is engaged;
• companies are likely to be challenged on their valuation if it is unclear how it has been performed; and
• disclosures should include the key inputs, including discount rate and key assumptions used to derive the inputs.

6. Disclosures

The disclosure requirements for present value measurements differ between IFRS standards. However, the FRC expects companies to apply judgement to determine the information to be disclosed and consider the general disclosure requirements in IAS 1 on sources of estimation uncertainty and significant accounting policies, as well as disclosure of changes in accounting estimates in IAS 8.

Key FRC expectations:

• clear explanation of any changes in methodology in the year and impact on amounts recognised in the financial statements;
• explanation of how discount rates have been determined and what inputs were used;
• explanation of how discount rates used in VIU calculations differ between CGUs, including separate risk adjustments; and
• disclosures in the strategic report to be clear and consistent with the financial statements.

Next steps

The FRC expects entities to consider the guidance with immediate effect. Therefore, companies should review and ensure that they are applying these in their discount rate calculations and disclosures.

For further information or to discuss any of the guidance raised, please contact Lou Ward, Paul Merris or your usual RSM contact.