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When you apply discounting to a future cash payment to arrive at a present value, it then becomes necessary to unwind that discount for each successive year until you arrive eventually at the date of payment.
The double entry to unwind (in its simplest form) is Dr Expense – finance costs and Cr the Obligation Account
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May you please you use an example to explain the meaning of unwinding of the discount.
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 = $ 3,104,607Now 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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This is interesting. It helped a lot.
Cheers!- Topics: 0
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Nice and very clear explanation. I was getting confused. Thanks you
So the Income Statement is having double hit
1) Depreciation on the NCA and 2) Interest @ effective rate on the obligation.
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Thank you so much, AnHa! It helped me a lot!
Thanks a lot this really help me a lot , i struggled to understand unwinding discount for ages 🙂
im doing F7 and I really wanted to understand what this unwinding of discount is and now I can put it into proper context now. Many thanks to AnHa and to Openttuition.com for having this site for us students to communicate
Thanks very much writing tomorrow F7 you have helped me figure this all out this is an excellent illustration of what unwinding of the discount means..
Hi, totally get the provision unwind and income statement impact (thanks!) but confused by the treatment of depreciation on the £5m NCA…why would this not be depreciated on a straight line basis (£1m per year for 5 years) rather than at a discounted rate? I am assuming the Plant was not leased and was owned by the company on day 1. Any help would be much appreciated!
From my understanding …..Unwinding a discount is the difference from the liability payable now as compare to the liability payable in the future after reporting date usually 12 months. This is accounting for the time value of money re present value of the obligation. The unwinding of the difference is the difference of the present value of the obligation at the end of the period and the present value of the obligation at the start of the period or the present value at the start of the period * mutiply by the discount rate.
A provision should be created i.e accounted by debiting finance cost and crediting liability of the obligation. Kindly inform me whether my understanding is correctmay I ask.. how come you are charging the depreciation on the basis of the provision made by the company and not on the value of the asset?
Sir, one doubt regarding Cost of Capital or interest taken to unwound the discount, will it be fixed at a single % or we can change it according to changing circumstances ? as Cost of Capital changes variably.
vis12213, welcome to the Opentuition forums. If you want a direct response from the tutor, I would ask you to post the above on the ask the tutor forum. This forum is primarily designed for students to help one another-
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