Discount rate it4/20/2023 ![]() 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. ![]() The appropriate discount rate (and the risk-free rate on which it is based) should reflect the conditions at the balance sheet date. ![]() 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 yield on government bonds reflects the credit risk of the economy of the government that has issued it. Where observed interest rates are negative, determining an appropriate interest free rate may be particularly judgemental.įurther, government bonds are not risk-free. 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. 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. And it is the determination of that risk-free rate that is the subject of our attention here. 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. 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 standard requires the application of a pre-tax discount rate, that reflects the time value of money and risks specific to the liability. 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. In the current economic conditions, Companies should expect the regulator to raise questions in this area. 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”. 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. Stock markets declined sharply earlier in the year and have since rebounded, volatility has increased, and treasury bond yields have reached record lows. The COVID-19 pandemic has significantly affected the global economy and financial markets in 2020.
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