[AnHa]

Hello,

I’m studying F7, and I’m struggling with unwinding of discount as well. This is how I understand it, hope it’s correct.

Let’s say a company knows that it has to make some sort of future payment, so the company will make a PROVISION. For example, the company buys a new machine with a useful life of 5 years. But this machine will cause some damage to the environment, and the company knows that it has to incur some decontamination cost (or environmental clearance cost, anything, just example) at the end of the useful life of this machine, ie 5 years. So the company will have to make a provision for this decontamination cost. And as required by IAS 37, the company has to SHOW this provision from today (you know, not just wait until the end of year 5 and say hey we have to pay this much for decontamination costs). So the question is how to account for this provision.

Let’s say the provision need to make is $5 million at the end of year 5. But the company has to account for that today, and has to consider value of money as well. Then, it needs the discount rate to calculate this amount of money in today’s value. Let’s say the appropriate discount rate is 10%. So today’s value of $5m (in 5 year’s time) is
$5 m x 0.62092 = $ 3,104,607

Now how to account for this figure ($3.1m), of course, no cost is incurred now. So what IAS 37 says is that first of all, this figure has to be added to the plant costs and depreciated over 5 years, and a finance cost of 10% has to be charge to the Income statement. Now it sounds complicated, so please let me throw some numbers and then I’ll point out something interesting

(in ‘000)
Year — Br. forward — Finance cost (10%) — Carried forward (NCL)
1 ——– 3,105 —————– 311 ———————— 3,416
2 ——– 3,416 —————– 342 ———————— 3,758
3 ——– 3,758 —————– 376 ———————— 4,134
4 ——– 4,134 —————– 413 ———————— 4,547
5 ——– 4,547 —————– 454 ———————— 5,001 (rounded difference)

So, hey there you go, by the end of year 5, in the company’s SFP it shows a non-current liability of $5m which is exactly the amount needed for the decontamination cost.

And what’s unwinding of discount, that is when you apply 10% discount rate to the brought forward amount every year to calculate finance cost for that particular year. So over 5 years, the total finance cost is (311+342+376+413+454) $1,896,000. And the total depreciation charge to the Income statement over 5 years is $3,105,000 (each year depn is $621, straight line). So, hey $1,896,000 + $3,105,000 = $5m (rounding creates some difference).

These finance costs and depn are not cash flows, but accounting treatment. So over 5 years, the company has an accounting charge to its income statement of $5m. I think it’ll be a shock if the company suddenly charge $5m in one year (year 5), so it has to spread the charge like this.

This is how I understand the whole thing, I think it’s quite connecting. Hope this helps. And please correct me if I’m wrong.

Cheers!

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