Increasing interest rates and discounting provisions

IAS 37 Provisions, Contingent Liabilities and Contingent Assets requires provisions to be measured at the best estimate of the expenditure required to settle the present obligation at the end of the reporting period, discounted to present value where the effect of the time value of money is material.

IAS 37 is not prescriptive on how to determine cash flows or the discount rate to determine present value. Paragraph 47 merely states the following:

The discount rate (or rates) shall be a pre-tax rate (or rates) that reflect(s) current market assessment 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.

IAS 37, paragraph 47

In times of relatively low inflation, most entities use nominal cash flows (which are actual expected cash flows, including the effect of inflation), and nominal (or actual) discount rates. However, given recent increasing inflation rates around the globe, entities may want to measure provisions using estimated real cash flows and real discount rates, which remove inflationary effects, and are therefore lower.

At the end of each reporting period, provisions must be re-estimated. Assuming no changes to the cash flow estimate required to settle the provision in future, the carrying amount of the provision increases in each period to reflect the passage of time, and this increase is recognised as a borrowing cost (IAS 37, paragraph 60).

Given that real interest rates tend to be lower than nominal interest rates, unwinding the discount on a provision using real discount rates to reflect the passage of time would result in a different amount recognised as borrowing costs. That is, borrowing costs would be lower if a real discount rate is used.

Question:

Should borrowing costs resulting from unwinding the discount on a provision to reflect the passage of time be lower if a real discount rate is used compared to if a nominal discount rate is used?

No. As inflation is considered part of the time value of money, the amount of borrowing costs arising from unwinding the discount on a provision to reflect the passage of time should be the same, regardless of whether nominal or real discount rates are used to discount the provision.

Materiality

For many entities, the difference highlighted above may not be material. However, entities should be aware that this issue could have a material impact on whether they meet their loan covenants. For example, if loan covenants depend on keeping borrowing/interest costs within a certain range, material increases in the borrowing cost to unwind provisions could result in the entity breaching ratios.

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