Such a keen interest has been caused by mass-scale switch of large Ukrainian companies to International Financial Reporting Standards (IFRS) and the need to report according to IFRS for 2019, and by adoption of amended Ukrainian Accounting Standards (UAS). More relevance has been added to the topic by the fact that tax authorities now often charge additional income tax due to discounting.
Despite amendments in the Ukrainian Accounting Standards introduced since October 2019, the issue of discounting procedure in compliance with UAS still remains somewhat disputable, while IFRS offers more clear rules and requirements.
This article covers the main rules and debating points of accounting and taxation of debt financial instruments hold to maturity, namely: credits, loans, financial aid, other financial assets and liabilities.
In financial management theory discounting is the process of determining the present value of a stream of payments which will be received in the future. This being said, two main factors that affect the discounted amount are future cash flows and discount factor. But when this issue is viewed in the accounting theory, it is a classical accounting estimate for which assumption should be applied.
According to IFRS, financial instruments shall be initially recognized at fair value, plus (in case of a financial asset not measured at fair value through profit or loss) or minus (in case of a financial liability not measured at fair value through profit or loss) transaction costs, that can be directly attributed to acquisition or issuance of a financial asset or financial liability.
Fair value will normally equal to the transaction price, i. e. fair value of compensation that has been given or received. For example, fair value of interest-free financial instruments can be measured at the current value of future cash flows using a certain financial instrument, discounted at an overriding market rate (similar in terms of currency, term, interest rate type and other factors) with a similar credit score.
Thereat, the difference between fair value and transaction price is shown as income or loss, but only if such operations do not lead to establishment of a separate asset or liability, or additional capital (according to the availability of other transactions between the parties that make up for discrepancy between fair value and the cost of transaction or transactions between the companies belonging to one group).
Trade receivables are initially recognized at the transaction price, except cases when the transaction price includes significant financing component (considerable deferment of payment or receiving advance payment); in this case the present value has to be calculated. However, IFRS allows not allocating a significant financing component if the business expects that the period between the moment when promised goods or service is transferred to a client and the time when the client pays for such goods or service will not exceed one year.
The formula as follows is used to determine the present value:
PV = FV/ (1+r)n, where
PV – present value
FV – future cash flow value
R – effective interest rate for the period n
n – number of periods.
It is worth noting that such formula can be applied only when cash flows provide for full payment at maturity, and the number of periods will depend on calculation frequency: for monthly reporting the number of periods should be shown in months, for quarterly reporting — in quarters and for annual reporting only — in years.
Respectively, the interest rate shall be shown on a monthly, quarterly or annual basis.
However, if a financial instrument provides for payment by instalments or payment of interest, for determining the present value it will be necessary to calculate all cash flows (repayment of principal and interest) by periods of such payments, and to discount each payment separately. In this case the formula for calculating present value will look as follows:
PV =ΣFV/ (1+r)n
According to IFRS, all financial assets and liabilities held to maturity will further be accounted at amortized net cost which is determined as the amount at which the financial asset or liability is initially recognized, minus principal repayment, plus or minus amortization of any difference between the initial and terminal value, determined through the effective interest method.
Requirements of Ukrainian Accounting Standards
According to UAS, the need to apply discounting at initial recognition of financial assets or liabilities is indirectly governed by a number of standards, namely: UAS 10, UAS 11, UAS 13, UAS 19, UAS 12, UAS 28.
Formalistically approaching the previous edition of UAS, one could draw the conclusion that only an interest-bearing liability should be discounted. Besides, discounting provisions with regard to long-term financial liabilities were defined quite clearly. However the question is still open, how one should recognize the difference between the actual net cost at initial recognition and the present value as of the date of the balance. At the same time not enough attention has been paid to the issue of discounting financial assets. According to UAS 13 “Financial Investment”, financial assets shall be accounted at amortized net cost which is determined as a net cost of financial investment considering its partial write off due to diminishing its utility, increased (decreased) by the amount of accumulated amortization of discount (premium). Thus, if the discount (premium) has not been determined at initial recognition, financial assets held to maturity shall be accounted at their net cost, taking into consideration only diminishing utility.
Basically, updates as regards application of provisions on discounting for any long-term accounts payable or receivable should be noted among important changes to UAS.
At the same time there are disputes with regard to the period from which updated standards should be applied, that is, whether such updates should be viewed as changes in the accounting policy that are applicable retrospectively, or as changes in accounting estimates applicable prospectively. According to the position of the Ministry of Finance, which, in our opinion, should be detailed in the transitional provisions, amendments to UAS should still be viewed as changes in accounting estimates, although the questions with regard to obligations existing as of the date of amendments still remain open.
In practice disputes often arise around the choice of discounting rate.
Experts often tend to think that to financial assets the company’s deposit rate can be applied, while the rate on credit shall be applicable to financial liabilities.
In our opinion, such approach has no sufficient economic grounding, since a rate should reflect market conditions in which the company is functioning, as well as its credit risk. If deposit rates are used for financial assets, credit risk of a financial institution (bank) is applied instead of that of a company that has issued such tool, thus it cannot be used for discounting.
As we have noted before, discounting rate is one of the key factors in the discounting theory, thus more attention should be paid to determining such rate. This rate can vary in different cases. The minimum factors influencing the rate should be as follows: currency of the instrument, maturity term, economic circumstances in which the issuer is functioning, as well as the issuer’s credit risk.
Sometimes consultants advise benchmarking for determining the market rate, similarly to the transfer pricing, even for transactions between residents.
Of course benchmarking that uses commercial databases can be viewed as a more reliable estimate, the possibility to choose the best-matching conditions considered. But we realize that the market rate determined on the basis of such approach can lead to significant financial and administrative burden for business, and sometimes process-related expenses can even exceed economic impact of such estimate.
In our opinion, overriding market rate can be determined using official statistical data provided by the National Bank of Ukraine, arranged by term, region, currency and company size. The above mentioned statistical information shows weighted mean market rates for secured loans granted by Ukrainian financial institutions, and can be used as base rate for financial instruments that includes the country risk. At the same time it is necessary to additionally explore the issue of determining the amount of adjustment by the company’s or contractor’s credit risk. Of course in this case calculation will be less reliable in determining market conditions as compared to benchmarking. But such duly documented calculation can become a solid proof-point in arguments with tax authorities, since the latter during inspections usually take annual average refinancing rate or even NBU base rate as a market rate.
Tax disputes on discounting
Even before amendments to UAS were introduced, tax authorities had been quite unanimous in their interpretations with regard to mandatory character of discounting any long-term liability, which fact is confirmed by numerous tax disputes and judicial practice.
Consultants have a joke that amendments to national standards are their harmonization with the position of tax authorities.
As of today judicial practice with regard to discounting in most cases favours taxpayers, but, firstly, such tax disputes arose before the amendments to UAS were introduced, and secondly, courts view the issues of discounting quite formally, without due investigation of the economic nature of determining the time-based value of money. Court rulings were usually based on the lack of methods to determine fair and amortized value, lack of any clarifications on the part of controlling authorities as well as lack of discounting practice. We suppose that the amendments to UAS that have been introduced will give additional proof-points to tax authorities in future disputes as regards mandatory nature of discounting, while strengthening the tax payers’ standing with regard to challenging the previous decisions of controllers.
In practice, to avoid the risk of disputes with auditors and tax authorities, businesses increasingly try to recognize a liability as short-term, which is formalized by provisions for payment on demand or by annual prolongation of agreements.
Example 1. A company has granted 1 mln UAH interest-free financial aid for 5 years, with market interest rate being 18%.
To determine the present value of such financial instrument one should apply a formula as follows (in case of discounting with the accounting period equal to one year):
PV = 1 000/(1+0.18)5 = 437.11 thousand UAH
For calculating financial income to be displayed in each year, a table as follows should be made:
|Year||Present value at the beginning of period||Financial income for the period||Present value at the end of period|
Thus, the difference between the present (discounted) value of financial aid and its face value will be shown during 5 years as a part of the company’s financial incomes.
Example 2. The company has received a 1 mln UAH loan for 14 months at 5% annual interest, with interest to be paid monthly. The face value of the loan shall be repaid at maturity. Overriding market interest rate amounts to 18%.
As loan interest rate is not the market one, present value should be reassessed. For this it is necessary to calculate the amount of cash payments for each month and discount each payment:
|Month||Cash flows (interest rate according to contract and principal repayment)||Discounted value|
Respectively, the present value of a 1 mln UAH loan under these conditions will amount to 864.11 thousands UAH. For distributing financial expenditures by periods it is necessary to create a table:
|Month||Present value at the beginning of period||Financial expenditures for the period||Payment||Present value at the end of period|
Thus, the loan will be fully repaid at the end of the 14th month.
As shown by the examples, if one understands basic principles and existing methods of discounting, calculation will not be a hard task; it will need minimum time and MS Excel skills. But it is worth remembering that to successfully undergo audit and tax inspections, one should duly ground the accounting approaches that have been adopted with regard to the respective calculations.
Taking into consideration the need for companies to use discounting rules regardless of whether their accounting system complies with IFRS or UAS, our suggestion is to thoroughly analyse all current and potential transactions for the need of discounting, and develop documentary background for any applicable accounting estimates.
Yulia Rybalko, Senior consultant on IFRS, EBS
Iegor Sinitsyn, Partner, Tax and Transfer Pricing, EBS