Provisions are being made where there is an uncertainty of an Amount and Timing to discharge these liabilities which are being calculated based on estimations & other procedures adopted by the management prescribed as per applicable accounting standards.
Under the current accounting practice there is no requirement for discounting any provision which could have material impact over the financials and it is being shown at full value.
However, after the applicability of Ind-As/ IFRS there is specific requirement to make such discounting to all provisions where the time value of money is material.
Refer the extract of the standard for the same as mentioned in Ind-AS -37 – “Provisions, Contingent liabilities, & Contingent Assets”-
Para -45– Where the effect of the time value of money is material, the amount of a provision shall be the present value of the expenditures expected to be required to settle the obligation.
Para -46 –Because of the time value of money, provisions relating to cash outflows that arise soon after the reporting period are more onerous than those where cash outflows of the same amount arise later. Provisions are therefore discounted, where the effect is material.
Para -47 –The discount rate (or rates) shall 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) shall not reflect risks for which future cash flow estimates have been adjusted.
Let’s understand the requirement of discounting by using an example-
There is a court case which is currently ongoing and as per the letter received from legal counsel it is estimated that an amount of INR 10,000,000 (ten million Indian rupees) will required to be paid after two years. Discounting will be done using Pre tax-risk-free government bond rate i.e. 5% (assumed). At the initial recognition it will be recognized based on its present value as per the table below-
|Initial recognition||INR 9,070,295||Discounted @ 5%|
|Carrying provision||Borrowing cost|
|End of Year 1||INR 9,523,809||INR 453,514|
|End of Year 2||INR 10,000,000||INR 476,190|
|Total borrowing cost||INR 929,705|
|Balance which will be paid off end of 2nd Yr||INR 10,000,000|
Below are some of the notes and guidance summary for the concept mentioned in the article-
- Provisions are being made based on constructive and legal liability as defined by Ind-As- 37. To understand what is constructive obligation, please refer earlier published article by using the link https://taxguru.in/finance/constructive-obligation-indas-ifrs.html,
- Provisions are those in which amount and timing of cash outflow is not certain and hence it is being calculated based on estimation as prescribed within the standard. Since there is no contractual obligation exists hence this will not be a financial liability because these provisions are being made based on constructive obligations only and that is the reason these provisions are being specifically scoped out from the financial instruments standard,
- Now, relevant Para (as mentioned above) requires to recognize those provisions at its present value where the time value of money is material. It will certainly be a judgmental area where the management can define a threshold limits based on assets size of its recent financial or profits and accordingly the process can be embedded into the system itself to calculate all eligible provisions for discounting,
- Present value will be calculated using a risk- free pre-tax rate of government bond (yield rate and not coupon rate) for that period and recognize the present value in the financial statements. Then each year a borrowing cost will be calculated which will be debited to the profit and loss account and corresponding credit amount will add into the initially recognise liability by which that liability will reach to its face value at the end of year of payment (refer example above),
- In the example, what essentially requires by the standard is to recognize 10M INR at its discounted value i.e INR 9.07M and then each year this amount will keep on increasing and corresponding amount will be part of borrowing cost (debited to PL) and if it will be added together by using all such borrowing costs and initially recognized present value of the provision, then it will end up getting full value of provision i.e. 10 M (initial value),
After the applicability of these new accounting standards, there will be more charge towards PL (as a borrowing costs) each year and there will be reduction in the liabilities side as one has to use discounted values and to accrete over the period.
A reader will appreciate about the main objective of the standard and an approach which one can follow while keeping in mind the basis of origin of such requirements. There could possibly be some specific situations or circumstances where the interpretation of any standard will be different as we should always keep in mind that IND-AS is principle based standards and lot more areas need management judgment in line with the standards relevant interpretation and best practices.
One has to look into all related facts and patterns before concluding this type of assessment based on this concept. Readers are requested not to take this article as any kind of advice (it is not exhaustive in nature) and should evaluate all relevant factors of each individual cases separately.
(Author of this article is an experienced chartered accountant who has specialization on various GAAP conversions assignments covering different industries around different part of the world including acting as an Independent IFRS Advisor & Corporate Trainer. He can be reached via email at firstname.lastname@example.org or Whatsapp +91-9634706933)