IASC’s project on discounting

The International Accounting Standards Committee (IASC) added to its work plan a project on discounting (or present value) in 1998. IASC was the predecessor of the International Accounting Standards Board (the IASB). When the IASB came into being in 2001 and took over from IASC, the IASB decided not to continue with the project.

In this post, I summarise:

• the reason for the project
• the topics an IASC Steering Committee planned to cover in an Issues Paper it was developing in 2001
• why the IASB didn’t continue the project in 2001
• input from the IASB’s Agenda Consultations in 2011 and 2015
• whether the project is needed now

Reason for the project

IASC added a project on discounting (or present value) to its work plan in 1998. Issues related to present value had arisen in several recent IASC projects, including Income Taxes, Employee Benefits, Impairment of Assets, Provisions, Financial Instruments, Investment Property and Agriculture.

IASC had been dealing with discounting on a piecemeal basis in individual Standards, and only in fairly general terms. There were inconsistencies between requirements in different IASC Standards, partly because different IASC Standards were developed at different times by different people and with different areas of focus.

IASC intended to use this project to develop more detailed requirements that would be conceptually valid, capable of practical implementation and consistent from Standard to Standard. IASC planned to consider:

• when assets and liabilities should be measured at present value (discounted);
• how present value should be determined in those IASC Standards that require or permit discounting; and
• how the effect of using discounting should be presented and disclosed in financial statements.

Topics covered in the draft Issues Paper

Steering Committee and Issues paper

Using its normal process, IASC appointed to carry out the initial work on the project a Steering Committee chaired by a ‘Board Representative’. Board representatives were individuals representing organisations on the Board of IASC. A list of the Present Value Steering Committee’s members appears at the end of this post.

Reports on the Steering Committee’s discussions appeared in the IASC’s quarterly magazine IASC Insight in September 2000 (Building a Framework for Discounting) and December 2000 (Real Options: the next Revolution in Accounting?)  

By April 2001, the Present Value Steering Committee had almost completed an Issues Paper, which it planned to publish for public comment.

At that stage, the IASB came into being and took over from IASC. The IASB decided not to continue with the project. So, the Steering Committee did not finalise and publish the Issues Paper.

Contents of draft Issues Paper

I summarise below the unpublished draft of the Issues Paper, prepared in April 2001, and containing 12 chapters.

Chapters of the draft Issues Paper
1. Introduction    
2. Fundamentals of present value techniques
3. Objectives and Scope   
4. Estimating the amount and timing of cash flows    
5. Adjustments for risk and uncertainty        
6. Discount rate  
7. Foreign currency cash flows
8. Income taxes
9. Real options   
10. Changes in fair value and entity-specific value
11. Amortised cost issues 
12. Presentation and disclosure

The draft Issues Paper identified important accounting issues related to present value. To provide a focus for commentators, it also set out the Steering Committee’s tentative views on the issues discussed. The Steering Committee did not necessarily reach unanimous agreement on all those tentative views.

Status of the draft Issues Paper
The Steering Committee developed the Issues Paper without input from the Board of IASC. By April 2001, the Issues Paper was substantially complete.

If the project had continued, I believe the Steering Committee would have been ready to publish the paper in 2 to 3 months, though some work was still need on the chapters on income taxes and on real options. In all other respects, although the Steering Committee had not yet signed off on the Issues Paper, I believe the April 2001 draft of the Issues Paper was complete and required no further discussion by the Steering Committee.

Introduction   

Apart from some general introduction, chapter 1 explained the Steering Committee’s view that the project would probably:

• insert general concepts into IASC’s Conceptual Framework, to guide the Board in future projects that could involve discounting;
• lead to a separate Standard describing how present value techniques should be applied in Standards that require present value measurements; and
• amend some existing standards to eliminate inconsistencies, expand application guidance, and remove explicit or implicit choices.

The draft Issues Paper does not deal specifically with the measurement of financial assets and liabilities. That is because an international Joint Working Group of Standard Setters (JWG) published proposals at the end of 2000 for a comprehensive approach to fair value accounting for financial instruments and similar items. 

Fundamentals of present value techniques

The Steering Committee noted that present value techniques play an important role not only in financial reporting. They are also important in many initiatives to develop useful measures of shareholder value from information reported in financial statements. 

Some concepts discussed in the Issues Paper might have been unfamiliar to some readers. So, Chapter 2 gives an overview of the fundamental principles of present value techniques. (Some of those concepts may still be unfamiliar to some readers.)

The draft also contains a glossary, a brief bibliography and several other appendices:

• summarising existing applications of discounting in International Accounting Standards
• summarising more detailed guidance on discounting existing at that time in International Accounting Standards
• illustrating fair value, entity-specific value and cost accumulation
• on finance lease income
• showing an example disclosure for nuclear decommissioning liabilities

Objectives and Scope 

Measurement Objectives

The Steering Committee noted that International Accounting Standards were using present value principles in meeting 3 main measurement objectives:

• estimating fair value (FV) when it cannot be observed directly in the market.
• determining the entity-specific value (ESV) of an asset or liability. Entity-specific value represents the value of an asset or liability to the entity that holds it, and may reflect factors that are not relevant to other market participants. One form of entity-specific value is value in use, as in IAS 36 Impairment of Assets. For liabilities, entity-specific value later came to be called fulfilment value.
• determining the amortised cost (AC) of some financial assets and financial liabilities, by using the effective interest rate.

The Steering Committee developed tentative conclusions on how to implement each of these three objectives. But the Steering Committee did not expect to recommend when to use each objective. The Steering Committee believed that the Board of IASC should make continue to make this decision in individual projects. 

Unless stated below, the following summary of some of the Steering Committee’s tentative conclusions applies to both FV and ESV. A separate summary for AC follows in the summary of chapter 11.

Scope of present value principles

The Steering Committee concluded tentatively that all measurements based on future cash flows should use present value principles (unless the time value of money and uncertainty have no material effect).  Among other things, present value principles would apply to:

• deferred tax. Under IAS 12 Income Taxes, deferred tax represents the incremental income taxes that an entity will pay or receive when it recovers / settles the carrying amount of its assets / liabilities.
• determining recoverable amount, for impairment testing, of assets not covered by IAS 36 (inventories, construction contracts and deferred tax assets), as well as loan losses.
• prepayments and revenue received in advance (in the rare cases when the effect is material)

The Steering Committee also concluded tentatively that:

• present value principles should not be applied in determining depreciation and amortisation, because the cost of applying present value concepts would exceed the benefits.
• the project would probably not require fundamental changes to IAS 29 Financial Reporting in Hyperinflationary Economies.
• capitalising borrowing costs in accordance with IAS 23 Borrowing Costs, is more compatible with present value principles than not capitalising them. But the approach should be modified. Instead of deferring borrowing costs actually incurred, the approach should restate costs incurred during the construction period into present values as at the date when the asset is ready for its intended use or sale.
• discount rates and the amount and timing of future cash flows can generally be estimated in practice in a sufficiently reliable and objective way at a reasonable cost, so that present value techniques will be suitable for use in financial reporting.

Estimating the amount and timing of cash flows        

Chapter 4 expresses a tentative conclusion that cash flows should reflect all future events that would affect the cash flows arising for:

• a typical market participant that holds the asset or liability (FV).
• the entity that holds the asset or liability (ESV).

Cash flows should reflect:

• information that is available without undue cost or effort about the market’s assessment of the future cash flows (FV).
• the entity’s assessment of the cash flows (ESV).

Other points:

• administrative costs should be included in cash flows (not in the discount rate). 
• cash flows and discount rates should be determined using consistent principles, to avoid double counting and omissions. For example, cash flows and the discount rate should be expressed consistently, either both in real terms (excluding general inflation) or both in nominal terms.
• market-based assumptions should be based on current market experience and trends, except where reliable and well-documented evidence indicates that current experience and trends will not continue.  Such evidence is likely to exist only if a single, objectively identifiable, event causes severe and short-lived disruption to market prices.
• traditional approaches to discounting are deterministic—they use a single point estimate of future cash flows.  It is conceptually preferable to use an expected present value approach. That approach considers the full range of possible outcomes and weights each outcome by its probability. That approach deals better than traditional approaches with uncertainties about timing, with uncertainties about future decisions by outside parties (such as employees or suppliers) and with cash flows that are sensitive to interest rates.  For symmetrical distributions centred on the most likely cash flows (such as the normal distribution), a single point estimate may provide a reasonable approximation. 

Members of the Steering Committee were divided on whether the cash flows should include non-cash opportunity costs, such as overheads, depreciation, and profit margins for use of internal resources.

The Steering Committee did not conclude on whether the measurement of financial liabilities should reflect the issuer’s own credit standing.

This chapter also contains some discussion of: transaction costs; cash flows that will affect internally generated goodwill, if it is practicable to exclude them; cash flows that will be capitalised; and goods or services to be transferred to or from related parties at a price that differs from fair value.

Adjustments for risk and uncertainty

Chapter 5 expresses the view that FV and ESV should reflect risk and uncertainty to the extent that these would be reflected in the price of an arm’s length transaction between knowledgeable, willing parties.

• For FV, the adjustment for risk reflects the market’s assessment of the amount of risk and the risk is priced using the market’s risk and time preferences.
• For ESV, the risk adjustment reflects the entity’s own assessment of the amount of risk, priced using the market’s risk and time preferences.

Other points:

• Risk may be reflected by adjusting either the cash flows or the discount rate.  In principle, both approaches often give the same answer. If risk-adjusted discount rates are observable in the market, it may be best to use these rates directly. Conversely, if risk does not decline evenly over time, it may be best to reflect risk in the cash flows.
• Both FV and ESV should reflect only undiversifiable risk, unless there is persuasive empirical evidence that market prices would also reflect diversifiable risk. 
• The FV or ESV of an uncertain liability is always more than FV or ESV of a fixed liability with the same expected cash flows. 
• In principle, both FV and ESV should reflect risk of imperfect information, illiquidity and market imperfections, although it may often be impracticable to quantify these without observable market data.
• The FV or ESV of a portfolio of assets or liabilities (or of a large block of divisible assets, such as a large shareholding) is not necessarily the same as the sum of the individual FVs or ESVs, but it may often be impracticable to quantify the difference.
• Expected value concepts are equally applicable to small populations, even populations consisting of one item.

In relation to asset liability management:

• The presence (or absence) of asset-liability mismatch risk does not affect FV or ESV. A mismatch will affect the risk of an unfavourable outcome, but an entity should deal with that risk by holding an appropriate level of capital and, perhaps, also by disclosing sensitivity information that will reveal the level of mismatch risk. Entities should report the amount of assets, liabilities and equity they actually have, not the amount of assets and equity that they need to hold in order to cope with shocks.
• It is possible, at least for some liabilities, to identify a replicating portfolio of assets that responds to undiversifiable risk in exactly the same way as the liability. If present values reflect only undiversifiable risk, the risk adjustment for the liability should be the same as the risk adjustment for the portfolio of assets. However, if present values reflect both diversifiable and undiversifiable risk, the measurement of assets is unlikely to give much insight into the effect of diversifiable risk on the measurement of liabilities.
• Mismatch risk may be relevant to the measurement of assets and liabilities if the terms of a liability specify that: the entity must hold specific assets to match all or part of a liability; or the amount of payments required by a liability is directly linked to the returns from specified assets. In both cases, the link is one of the characteristics of the liability. A liability without this requirement would probably have a different FV and ESV.

Discount rate  

According to chapter 6, the discount rate should reflect:

• current market interest rates;
• the characteristics of the asset or liability being measured, rather than the entity’s incremental borrowing rate or cost of capital. Similarly, the FV or ESV of a liability should not reflect returns on assets (unless the terms of the liability require specific investments); and
• the term (maturity) of the asset or liability. Conceptually, a different discount rate should be used for each future period to reflect yield curve effects, but a single rate may be a reasonable approximation.

Other points:

• Government securities are the benchmark for determining the risk-free component of discount rates. If there is no active market in government securities, the benchmark should be yields on other high-quality securities (net of deductions for estimated defaults). If practicable, the yield should also exclude risk premiums for bearing the risk of variability in defaults or other variations in returns. The yield should also eliminate the effect of any special tax treatment that may distort market returns on the instruments used as a benchmark.
• regulatory capital requirements may affect the FV or ESV of an asset or liability, but not significantly. 
• in principle, interest should be compounded quarterly, if the frequency of compounding has a material effect.

Foreign Currency Cash Flows

Chapter 7 suggests that foreign currency cash flows should be discounted using discount rate(s) appropriate for that currency. The discounted amounts should then be converted into the reporting currency at the period-end spot rate. No adjustment should be made to reflect foreign exchange risk (although repatriation risk should be reflected).

Income Taxes

Chapter 8 deals with income taxes and still needed some work when work on the Issues Paper stopped. The draft chapter discusses the interaction between pre-tax and post-tax cash flows and discount rate. It also suggests that: 

• future tax effects should continue to be recognised separately as ‘deferred’ tax, but present value principles should be introduced into deferred tax. That is because the objective of measuring deferred tax assets and liabilities is to reflect the present value of incremental tax cash flows that would arise from differences between the carrying amount of existing assets and liabilities and their tax base.
• it may be difficult to apply consistent discounting principles to deferred tax liabilities and deferred tax assets arising from underlying assets and liabilities that are measured on an undiscounted basis. 
• part of the risk and uncertainty about future tax cash flows relates to risk and uncertainty arising from the underlying asset or liability. This component is already reflected in the carrying amount of the underlying asset or liability, so no adjustment for this component is needed in measuring deferred tax.
• if other factors cause risk or uncertainty about the extent of the tax consequences that will flow from recovering (or settling) the carrying amount of an asset (or liability), those factors should affect the measurement of deferred tax, if their effect is significant and if the effect can be measured reliably.

Real options    

The other chapter still requiring more work was chapter 8, on real options. Many people are familiar with financial options: explicit contractual options that are either financial instruments in their own right or embedded in another financial instrument.  Examples of financial options are call options to buy shares, conversion options embedded in convertible bonds and prepayment options embedded in loans.

When the Steering Committee was working on the Issues Paper, there was a rapidly growing number of books and articles on ‘real options’ (as opposed to financial options). And many leading textbooks on corporate finance now contain a section on real options.

Real options are implicit managerial and operating flexibilities that are embedded in many non-financial assets and liabilities.  They permit entities to delay an irreversible decision until after some uncertainty has been resolved.

Examples of real options
The owner of a factory has various options: to continue operating the factory; to change how it uses the factory; to stop using the factory and leave it idle or empty; or to sell the factory.

The holder of a patent has options: to use the patent; to sell the patent; to cease or suspend the use of the patent; or to conduct further research and development using the knowledge embedded in the assets.

The owner of a gold mine has options to increase, decrease, suspend, delay or cease production in the light of changes in gold prices and production costs.

An owner of several factories has the option to switch production between the factories. It may also have an option to change production methods or the level of output.

The owner of an investment property has options: to lease part or all of the property out; to sell the property; to occupy it for the owner’s own operating activities; to demolish the property and either sell or redevelop the land; or to leave the property vacant temporarily in the hope that market conditions may change.

A manufacturer issuing an explicit or implicit product warranty may have an option to subcontract the remedial work or to carry out the corrective work itself.

Real options give entities flexibility that has a value. Traditional discounted cash flow methods do not typically capture this value.

The Steering Committee was leaning towards the following preliminary views:

• when real options would be available to other parties that hold an asset or liability, the real option should be considered in measuring the fair value or entity-specific value of that asset or liability. They should not be recognised as separate options.
• when real options are associated with an asset or liability and are only available to the current owner, they are not part of the asset or liability’s fair value, but are part of its entity-specific value. IAS 38 Intangible Assets would determine whether to recognise any such real options excluded from fair value.

Standard discounted cash flow computations are not very successful at valuing financial options. That is because those computations focus on expected value rather than considering all paths that lead to possible outcomes. Also, the effect of an option varies in a non-linear way with changes in the cash flows from the underlying item.  Established option-pricing models (eg the Black-Scholes model) may give some insight into the valuation of real options.

Some real options are very similar to the financial options that are valued routinely in the financial markets. For example, the owner of a gold mine holds real options that enable it to suspend or cease production, to accelerate or decelerate production and to restart suspended production. If these decisions are driven largely by the price of gold, it may be possible to treat the real options as a bundle of derivatives whose underlying is the gold price. The techniques used to value financial options might be directly applicable in valuing these real options.

In other cases, real options will respond mainly to factors that are not traded in active markets. Option pricing models may provide useful conceptual tools for analysing real options of this kind. That may be the case even if the techniques used for financial options do not apply directly.

Changes in fair value and entity-specific value

Chapter 10 suggests that:

• if FV or ESV are used for subsequent measurement, an entity should recognise immediately experience adjustments and the effect of changes in; (a) assumptions; (b) the discount rate; and (c) risk adjustments.
• the increase in FV or ESV that arises from the passage of time (‘unwinding of the discount’) should be presented as finance income or expense.

The Steering Committee did not assess whether any of these changes should recognised in other comprehensive income, rather than in profit or loss.

Amortised cost issues 

Amortised cost uses updated estimates of cash flows but keeps the original discount rate.

Points about amortised cost in chapter 11:

• the effect of risk and uncertainty should be included in the discount rate rather than the cash flows, consistently with current practice.  As a result, an entity recognises on a time proportion basis the expected reduction in the variability that arises just because of the passage of time.
• for consistency with the historical cost basis underlying the effective interest method, an entity would not recognise the effect of an unexpected change in the variability of the cash flows or a change in the market price for variability.
• interest should be recognised in a pattern reflecting the initial yield curve, not a single ‘effective interest rate’.
• in principle, interest should be compounded quarterly, if the differences in the frequency of compounding have a material effect.
• the draft Issues Paper discusses some aspects of estimated loan losses.
• further issues may arise if amortised cost is used for non-monetary assets and non-monetary liabilities (assets and liabilities that are not to be received or paid in fixed or determinable amounts of money).

Presentation and disclosure

Chapter 12 suggests that the unwinding of the discount (including both the time component and the risk component):

• should be presented as finance income or expense for an interest-bearing asset or liability, zero-coupon bond or forward contract.
• should not be presented as finance income or expense for a non-interest-bearing asset or liability.

Other points on presentation:

• when an entity measures assets and liabilities on a discounted basis, it should report subsequent cash flows from those assets and liabilities as income or expense, even though it has already accrued the present value of those cash flows. 
• interest income and interest expense for financial assets and financial liabilities should be based on: current present value and the current interest rate (if the objective is to determine FV or ESV); but the original carrying amount and the original effective interest rate (if the objective is to determine AC). 

Disclosures should:

• explain the discounted amounts included in the financial statements.
• give users of financial statements information that will help them estimate the amount, timing and uncertainty of future cash flows. Such information would focus on cash flows and risks from individual assets and liabilities, not on entity-wide cash flows and risks, and would probably be developed in other projects.

Other points about disclosure:

• disclosing information about the sensitivity of cash flows to changes in assumptions is critical.
• discount rates should be disclosed as weighted averages or in relatively narrow ranges, and perhaps separately for each main currency.
• disclosing the discount rate conveys information about the size of risk adjustments incorporated in the discount rate.  So, if risk adjustments appear in cash flows (instead of in the discount rate), there may be a need for summarised disclosure of the size of the risk adjustments.
• components of changes in carrying amount to be disclosed separately are: unwinding of the discount; experience adjustments and (separately, if feasible) the aggregate effect of changes in assumptions; changes in the risk-free discount rate; and changes in risk adjustments.

The Steering Committee felt there was no need for specific disclosure:

• about the timing and amount of cash flows, beyond some disclosure about the average maturity of different classes of assets and liabilities;
• about future tax cash flows;
• to highlight consistently over-optimistic (or consistently over-pessimistic) assumptions.    

Why didn’t the IASB continue the project in 2001?

IASB Board members did not state any reasons for not continuing with the project that IASC’s Steering Committee had started. I suspect the IASB would not have wanted the Steering Committee to publish the Issues Paper without a great deal of input from the IASB. Indeed, the IASB might well have decided to take over full ownership of the document itself. Doing that would certainly have led to the IASB devoting a lot of time and effort to the project and would have diverted the IASB from other topics of higher priority.

Also, some Board members would not have wanted the IASB to publish a document (even one produced by a separate committee) that could have appeared to advocate entity-specific value or amortised cost. They would probably have preferred a document focussing only on fair value. The US Financial Accounting Standards Board (FASB) had recently done that in Statement of Financial Accounting Concepts No. 7 Using Cash Flow Information and Present Value in Accounting Measurements. Concepts Statement 7 concluded that present value measurements used on initial recognition and in fresh-start measurements should attempt to capture the elements that taken together would comprise fair value.  Concepts Statement 7 also deals with amortised cost, but rejects ESV as a measurement objective.

In April 2001, the IASB decided tentatively not to proceed at that stage with the present value project inherited from the old IASC. It identified a broader review of measurement as one of 16 potential agenda topics that it might add to its work programme in due course.

At subsequent meetings, in June and July 2001, the Board discussed the relationship between fair value, entity-specific value, replacement cost and net realisable value.  Much of the discussion focused on examples concerning impairment. A report on that discussion appeared in the IASB’s quarterly magazine IASB Insight in September 2001 under the title Narrowing the Range for Measurement.

Real Options

In the discussion in April 2001, 2 IASB members said they were glad the present value project was looking at real options. As far as I remember, the IASB has never discussed real options since then. It is a pity that topic has dropped off the IASB’s radar for over 20 years.

Agenda Consultations

Many respondents to the IASB’s first 2 Agenda Consultations (in 2011 and 2015) asked the IASB to carry out a project on discounting, because of inconsistencies between standards. In response, the IASB carried out a research project between 2014 and 2017.

I think there were 3 main drivers of the requests for a project on discounting:

• differences arising because different standards have different measurement objectives. But, in my view, a project on present value techniques cannot consider which measurement objective should be set; it can only consider which present value techniques meet a measurement objective once that measurement objective has been set.
• inconsistencies between standards that arose because different IFRS Standards were developed at different times, by different people and with different areas of focus. The IASB’s research project in 2014-17 created an inventory of inconsistencies that IASB could address in due course if that seems appropriate, although that project identified no areas requiring urgent action. That project also produced a summary of matters for the staff to consider in the future when developing recommendations for the IASB on present value measurement requirements. https://www.ifrs.org/content/dam/ifrs/project/discount-rates/project-summary.pdf
• a wish for help on estimating appropriate discount rates for very long maturities. I have written separately about this topic at  https://accountingmiscellany.com/discount-rates-for-very-long-maturities

Is such a project still needed now?

Up to the late 1990s, IASC had developed its requirements on present value in a piecemeal way. The best way to avoid unintended inconsistencies between requirements would have been:

• to look at all present value measurements in a single project; and
• to put all requirements and guidance on present value and discounting in a single standard.

There is no real need for such a project now. That is because the IASB has been looking at present value and discounting in a more co-ordinated way. It has also been putting more detailed (and more consistent) requirements in some of the standards where discounting plays a major role. The IASB has made important improvements including:

• issuing IFRS 13 Fair Value Measurements.
• inserting in IAS 36 Impairment of Assets an appendix on discounting in estimating value in use.
• including in IFRS 9 Financial Instruments: Recognition and Measurement improved guidance on amortised cost.
• including in the upgraded Conceptual Framework for Financial Reporting (2018) greatly expanded and improved material on measurement, including discussion of amortised cost, fair value, value in use and fulfilment value and cash-flow-based measurement techniques.
• carrying out a research project on discount rates in IFRS Standards. As discussed above, this research project produced an inventory of inconsistencies for possible future action (not urgent) and a summary of matters for the staff to consider in future work (akin to a checklist for future projects on individual topics).

Although there is no longer a need for a comprehensive project on present value techniques and discounting, the draft Issues Paper does contain some material that the IASB staff might find useful in future work on present value techniques.

One topic that may deserve some work is real options. I will write a separate post about real options.

Members of the Present Value Steering Committee
Voting Members
Patricia Doran Walters (Chair), International Council of Investment Associations
Jörg Baetge, Germany
Nelson Carvalho, International Association of Financial Executives Institutes
Malcolm Cheetham, Switzerland
Sam Gutterman, International Actuarial Association
Eric Phipps, United Kingdom
Shinichi Tanimoto, Japan
Dominique Thouvenin, France

Observers
International Organisation of Securities Organizations (IOSCO), represented by Richard Thorpe
European Commission, represented by Ulf Linder
Basel Committee on Banking Supervision, represented by Bengt-Allan Mettinger
International Association of Insurance Supervisors (IAIS), represented by Nico Van Dam (until 2000) then by Paul Sharma (from 2000)
[Staff of the US] Financial Accounting Standards Board, represented by Wayne Upton

Project Manager
Peter Clark, IASC staff