Accounting framework: discounting of provisions or reserves
Discounting is the practice of taking account of the time value of money and has potential relevance to the making of provisions. A liability to pay £1,000 in five years’ time is less onerous than a liability to pay £1,000 today, because the £1,000 can earn interest in the meantime, and this can be recognised by discounting the future liability back to its present value, using an appropriate discount rate.
Paragraph 53(7) of Schedule 3 to the accounting Regulations (SI2008/410) prohibits implicit discounting; that is, placing a current value on a claim which is expected be settled at a higher value in the future, for example by not taking account of anticipated inflation.
Paragraph 54 does allow explicit discounting of outstanding claims in certain narrowly prescribed circumstances. The expected average interval between the date for the settlement of claims being discounted and the accounting date must be at least four years. The discounting must also
- be on a recognised prudential basis
- take account of all possible increases in costs
- be based on a reliable model of claims settlement, and
- be based on a prudential rate of interest.
Discounting of claims provisions is consequently uncommon in the UK, though developing regulatory (Solvency II) and reporting (IFRS Phase II) standards are moving towards compulsory discounting plus an explicit risk margin.
FA00/S107 contained rules designed to compensate mechanically for the setting of provisions that failed to reflect all the relevant circumstances including discounting. These rules were found to be onerous to operate and were repealed by FA07/SCH11 and replaced by a rule which limits provisions to an ‘appropriate amount’. See GIM6000+.