www.pwc.com Accounting treatment of discount rates Issue paper presented at the EPSAS Working Group meeting Luxembourg, Status report and preliminary matters for discussion
Contents Introduction 3 Available accounting and reporting guidance 6 Current projects 13 Government practices in the EU 15 Matters for discussion 16 2
Introduction Objectives of the issue paper Prepare the future discussion on applying discount rates with the EPSAS stakeholders. This presentation addresses preliminary matters for discussion. Topics currently addressed in the paper: - The accounting areas where application of discount rates may have a significant impact. - Accounting and reporting guidance available or under development. - Country analysis. - Main difficulties in practice. - Matters for discussion to achieve sound, efficient and harmonised application of discount rates by Member States. 3
Introduction Background of the issue (1/2) Discount rate is a key financial assumption in the evaluation of the various types of non-financial assets and liabilities. Key areas of application include: - Employee benefits (especially pension liabilities). - Long-term provisions (e.g. decommissioning obligations). - Impairment of long-term cash-generating assets. Changes in the discount rates to be applied in the measurement of long-term assets and liabilities may lead to materially different amounts recorded. The impact of deviations in the discount rate is significant. As a rule of thumb, a reduction of the discount rate by 1 percentage point increases the DBO by 15% and vice-versa (EPSAS issue paper on pensions). 4
Introduction Background of the issue (2/2) The topic was discussed at the EPSAS Working Group meeting in Rome (22-23 November 2016) in relation to pension liabilities but the problem may be broader. Matters to be further investigated and discussed in priority include: - Comparability of the measurement (significant diversity exists in practice). - The conceptual approach underpinning the choice of the discount rate. 5
Available accounting and reporting guidance IPSAS (1/3) IPSAS 39 Employee Benefits. - The discount rate should reflect the time value of money, not the actuarial risk nor the investment risk. It does also not reflect the entity-specific credit risk borne by the entity s creditors. - This is best approximated by market yields at the end of the reporting period on government bonds, high-quality corporate bonds, or another financial instrument (entity s judgement). - The currency and the term of the underlying financial instrument shall be consistent with the currency and the estimated term of the postemployment benefit obligations. - Nominal rates should be used, unless real rates provide more reliable information (e.g. hyperinflationary economy). - Actuarial assumptions should be unbiased and mutually compatible. 6
Available accounting and reporting guidance IPSAS (2/3) Discount rate topic proposed in IPSASB draft work plan for the period 2019-2023. 7
Available accounting and reporting guidance IPSAS (3/3) IPSAS 19 Provisions, contingent liabilities and contingent assets. - The discount rate (or rates) should 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) should not reflect risks for which future cash flow estimates have been adjusted. IPSAS 26 Impairment of cash-generating assets. - The discount rate should be a pre-tax rate (rates) that reflect(s) current market assessments of the time value of money, represented by the current risk-free rate of interest and the risks specific to the asset. - If not directly available from the market, an entity uses surrogates to estimate the discount rate applying market assessments: entity s WACC, entity s incremental borrowing rate or other market borrowing rates. 8
Available accounting and reporting guidance IFRS (1/2) IAS 19 Employee benefits : - The discount rate should be determined by reference to market yields on high-quality corporate bonds. If no deep market in high-quality corporate bonds in this currency, then yields on government bonds should be used. o Common practice is to consider AA rating as high-quality. IASB/IFRIC deliberately provide no precise guidance as to which rating should be considered high quality. o High quality is an absolute, not a relative measure, which means that current market conditions should not affect on the initially chosen concept of high quality. - Other major considerations (currency and terms of the underlying instruments, nominal rates) are similar to IPSAS 39, which is primarily drawn from IAS 19. 9
Available accounting and reporting guidance IFRS (2/2) IAS 37 Provisions, contingent liabilities and contingent assets : - The guidance is similar to IPSAS 19 which is primarily drawn from IAS 37. o In practice, government bond yields for the currency in which the obligation arises and for the duration of the obligation are a good proxy for a risk-free pretax rates that matches the maturity of the liability. - Both including and excluding entity s own credit risk are considered possible approaches. IAS 36 Impairment of assets. - The text is similar to IPSAS 26 which is primarily drawn from IAS 36. 10
Available accounting and reporting guidance EAR EAR 12 Employee benefits. - Similar to IPSAS. Requirement to determine discount rates by reference to market yields on government bonds at the reporting date. EAR 10 Provisions, contingent liabilities and contingent assets. - Similar to IPSAS. As an example, the zero coupon Euro bond yield curve can often be used as discount rate suitable for EU bodies. EAR 18 Impairment of assets. - Similar to IPSAS. Discount rate should reflect consistent assumptions about price increases attributable to general inflation. 11
Available accounting and reporting guidance ESA 2010 ESA 2010 addresses discounting of social insurances including pensions, and refers to the discount rate as one of the single most important assumptions to be made in the modelling of pension schemes. Some guidelines are given. - The discount rate to be applied is a risk-free rate, e.g. the discount rate on high-quality government and corporate bonds. Recommendation to use a stable rate of 3 per cent in real terms and 5 per cent in nominal terms. - A AAA -rated bond is provided as an example of a high quality bonds. - It is advisable to use a basket of instruments (e.g. European central government debt securities), not debt securities of a single country. 12
Current projects IASB and EFRAG Projects on discount rates are currently being undertaken by: - The IASB. The findings of a research project on discount rates are expected to be published later in 2017 or in H1 2018. o Items being discussed include: opportunity to continue to use pre-tax rates in IAS 36, discount rates for pension scheme benefits that depend on return of assets, components to be included in the measurement of provisions. - The EFRAG (European Financial Reporting Advisory Group) which addresses both the measurement issue and the presentation issue. o First, EFRAG investigates whether discounting with a negative rate always results in relevant information (the present value of an asset or liability then exceeds its ultimate recoverable or settlement amount). Secondly EFRAG considers the presentation of changes in liabilities due to the reassessment of discount rates (Are large re-measurements in profit or loss helpful in depicting the entity's performance? How to treat the inconsistency between IAS 19 and IAS 37?). 13
Current projects National standard setter - The FRAB (Financial reporting Advisory Board) in the UK as the impact of using negative interest rates may seem counter-intuitive. o Strong justification needed if change of methodology envisaged. o Any future methodology should include a reasonableness test to ascertain if the long term rate remains appropriate and continues to reflect the time value of money at the extreme end of provision durations. 14
Government practices in the EU Country analysis (in progress) Finland France Scope Pension liabilities only. Pension commitments, provisions for staff costs, provisions for transfers, intangible assets. Basic methodology Main source of methodology -Central Government: stable discount rate (2,7% since 2006). -Buffer pension fund: stable discount rate (3%) with adjustment factors, including to reflect return on investments. -Local authorities: no discounting. -Assets: less relevant, no discounting. National regulations. -Provisions: reference to the yield on long term government bonds with maturity dates matching the duration of the related commitments. -Assets: none specifically mentioned. International accounting standards. Specific concerns -Complexity and subjectivity of the calculation. -Lack of understanding by users. -Source of undesired variability. -Comparability. None specifically mentioned. 15
Matters for discussion Key questions and potential consequences Key questions Comparability Limitations in fluctuations Use of a common conceptual approach for determining the discount rate? (e.g. refinancing rate? Or rate of return on investments? Or risk-free rate? Or rate following IPSAS 39 rules?) Simplicity IPSAS compliant? ( ) N? Use of nominal rates or real rates? N? Use of government bonds vs high quality corporate bonds? How to determine high-quality? E.g. AA rating or above? For LT provisions inclusion of own credit risk? How to deal with negative interest rates? Y Y Y Y 16
Matters for discussion Key questions and potential consequences Centrally set discount rate? At what level? Comparability Limitation in fluctuations Simplicity IPSAS compliant? Y Application of baskets of instruments? Y Application of average rates over a certain period? N Use of a stable rate? ( ) N Use of rate of return of plan assets for pension liabilities that depend on return on plan assets? Presentation of impacts of changes in discount rates (in equity vs in surplus or deficit vs in other comprehensive income?) N ( ) ( ) N? 17
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