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Should all Short term Receivables be Discounted?

The purpose of this circular was to bring to the attention of preparers, auditors and users certain issues where the International Financial Reporting Interpretations Committee (IFRIC) had agreed not to issue interpretations because it was believed that the appropriate accounting was clear but, where South African practice may be inconsistent with international practice, it seems that some questions have arisen about the application of the circular.

One of the issues it deals with is the accounting for extended payment terms, such as six months" interest-free credit. IFRIC stated that its 'members were of the opinion that the accounting treatment was clear, and declined to add the issue to the agenda. IFRIC members agreed that IAS 39 Financial Instruments: Recognition and Measurement applies to the receivable in such circumstances, and that the effect of the time value of money should be reflected when this is material (paragraphs AG69-AG82 of Application Guidance to IAS 39). IFRIC members noted that the wording of paragraph 11 of IAS 18 Revenue lacked clarity and needed to be improved.'

Should this guidance apply to all amounts receivable?

It seems some believe this interpretation should be applied to all amounts receivable, even though its stated purpose is that it was only dealing with the issue that IFRIC had considered, that of extended payment terms.

How is 'extended payment terms' defined?

While no definition of extended payment terms is given in International Financial Reporting Standards (IFRSs), from the wording used by IFRIC, 'such as the granting of six months' interest free credit' it appears that IFRIC was dealing with that example only and not the issue of a much shorter period of credit (e.g. 30 days).
In this regard, the following guidance given in IFRSs should be considered:

• IAS 2 - Inventories, paragraph 18 'An entity may purchase inventories on deferred settlement terms. When the arrangement effectively contains a financing element, that element, for example a difference between the purchase price for normal credit terms and the amount paid, is recognised as interest expense over the period of financing.'
  
  
• IAS 16 - Property, Plant and Equipment, paragraph 23 'The cost of an item of property, plant and equipment is the cash price equivalent at the recognition date. If payment is deferred beyond normal credit terms, the difference between the cash price equivalent and the total payment is recognised as interest over the period of credit unless such interest is recognised in the carrying amount of the item in accordance with the allowed alternative treatment in IAS 23.'
  
  
• IAS 38 - Intangible Assets, paragraph 32 'If payment for an intangible asset is deferred beyond normal credit terms, its cost is the cash price equivalent. The difference between this amount and the total payments is recognised as interest expense over the period of credit unless it is capitalised in accordance with the capitalisation treatment permitted in IAS 23 Borrowing Costs.'

These references state that interest is generally expected to be recorded if payment is deferred beyond normal credit terms; implying that no interest is expected to be recorded when these assets are paid in accordance with normal credit terms. While the meaning of ‘normal credit terms' is not explained, from the IFRIC comment on extended payment terms it seems that six months' interest free credit would not be regarded as normal credit terms. Accordingly even if six months' interest free credit was regarded as a normal credit term in a particular industry it seems that the IFRIC would regard that as extended payment terms for accounting purposes, as there is no exception from six month's interest free credit being regarded as an extended payment term.

The use of the phrase 'credit terms' implies that customers have been given credit; in other words, payment is not required when an asset is acquired. The IFRS wording also distinguishes between normal and extended credit terms.

What about the guidance given in IAS 39?

It seems that those that believe that all short term receivables should be discounted base their argument on paragraphs AG 79 and 84 of IAS 39 – Financial Instruments: Recognition and Measurement. In this regard, the context of these paragraphs needs to be understood.

Paragraph AG 79 states that 'Short-term receivables and payables with no stated interest rate may be measured at the original invoice amount if the effect of discounting is immaterial.'  This guidance applies when fair value measures are being considered when applying valuation techniques, because there is no active market and a discounted cash flow analysis is applied. This guidance applies when fair values are being considered either on initial recognition or subsequent measurement.

These comments are based on paragraph AG 64, which states 'The fair value of a financial instrument on initial recognition is normally the transaction price (i.e. the fair value of the consideration given or received, see also paragraph AG 76). However, if part of the consideration given or received is for something other than the financial instrument, the fair value of the financial instrument is estimated, using a valuation technique (see paragraphs AG 74–AG 79). For example, the fair value of a long-term loan or receivable that carries no interest can be estimated as the present value of all future cash receipts discounted using the prevailing market rate(s) of interest for a similar instrument (similar as to currency, term, type of interest rate and other factors) with a similar credit rating. Any additional amount lent is an expense or a reduction of income unless it qualifies for recognition as some other type of asset'.

The guidance given in paragraph AG 64 assumes that (1) transaction price is fair value and (2) requires an entity to consider whether part of the consideration given or received is for something other than the financial instrument, and if so then to use a valuation technique. In other words, the guidance given in paragraph AG 79 is only to be applied when it is believed that the consideration includes something other than the financial instrument, even though the standard gives no guidance as to what this 'something other' includes or excludes.

Nevertheless, it seems that some assume that paragraph AG 79 should always be applied when initially recording a financial instrument, which is not believed to be the requirement of IAS 39. If it was the intention of the standard setters to expect preparers to apply paragraph AG 79 when initially recognising all financial instruments it is believed the wording in paragraph AG 64 would have made reference to a short-term receivable and not a long-term loan.

Paragraph AG 84 is the other paragraph that some use to argue that all short-term receivables should be discounted, even though it is not included in the paragraphs referred to in the IFRIC rejection note. This paragraph states that ‘Cash flows relating to short-term receivables are not discounted if the effect of discounting is immaterial'.  This guidance applies when financial assets carried at amortised cost are considered for impairment and uncollectability, and does not deal with initial recognition.

Could the 'something other' include cash and settlement discounts or rebates?

It seems that various discounts or rebates should be dealt with separately and not be included in the consideration of whether they are 'something other'. This is based on the standards dealing with these issues separately as noted in Circular 9/2006.

Paragraph 11 of IAS 2 states "Trade discounts, rebates and other similar items are deducted in determining the costs of purchase" while paragraph 10 of IAS 18 states the amount of revenue "is measured at the fair value of the consideration received or receivable taking into account the amount of any trade discounts and volume rebates allowed by the entity".

Does the reference to IAS 18 in the rejection note have any significance?

The paragraph referred to states the following: "In most cases, the consideration is in the form of cash or cash equivalents and the amount of revenue is the amount of cash or cash equivalents received or receivable. However, when the inflow of cash or cash equivalents is deferred, the fair value of the consideration may be less than the nominal amount of cash received or receivable.

For example, an entity may provide interest free credit to the buyer or accept a note receivable bearing a below-market interest rate from the buyer as consideration for the sale of goods. When the arrangement effectively constitutes a financing transaction, the fair value of the consideration is determined by discounting all future receipts using an imputed rate of interest. The imputed rate of interest is the more clearly determinable of either:

1. the prevailing rate for a similar instrument of an issuer with a similar credit rating; or
2. a rate of interest that discounts the nominal amount of the instrument to the current cash sales price of the goods
   or services.

The difference between the fair value and the nominal amount of the consideration is recognised as interest revenue in accordance with paragraphs 29 and 30 and in accordance with IAS 39 Financial Instruments: Recognition and Measurement".

IFRIC believes this wording lacked clarity. It appears that this could be due to it not being clear what is a financing transaction, nor what is regarded as deferred payment or whether deferred payment is regarded as normal or extended credit terms. With IFRIC not providing any explanation as to how it believes this paragraph should be interpreted, it does not help in interpreting these issues.

How does materiality impact any recording of discount?

Even when it is considered that the transaction price includes 'something other' it is only necessary to adjust for the effect of discounting if it is material. What is material is an issue that preparers and their auditors need to consider. While materiality is something that auditors have always considered while carrying out audits, it is only in recent years that preparers have started to consider what they regard as being material.

How materiality should be determined and considered is a subjective matter. While materiality can be considered in relation to the underlying asset, liability or revenue that could be affected, some might question whether it should be determined based on a specific monetary amount or should alternatively be considered in relation to specific elements of the financial statements. Thus some might consider whether the effect on profits is less than a specified amount, while others might consider whether individual elements of the financial statements are affected considerably.

For example, one party might regard the effect on profits as R100 000 and accept that this is not material based on reported profits of R10 million, whereas another might state that this R100 000 affect will have a 50% impact on reported interest income of R200 000 and regard the potential impact as material, even though the impact on reported turnover of R100 million is only 0,1%. As there is little guidance as to how materiality should be considered, it is for entities and their auditors to apply their professional judgment.

How does one conclude on this issue?

It appears that in many other countries that have adopted IFRS, it is not normal practice for short-term receivables to be discounted. While it is not clear what rationale has been followed in arriving at this approach, it appears that it might have been accepted that normal credit terms do not include 'something other' and, therefore, it is not necessary to impute a financing element.

Based on the above it is reasonable to conclude that IFRS does not automatically require all short-term receivables to be discounted on initial recognition, but rather for preparers and their auditors to apply judgment first to whether the consideration to be received includes 'something other' and, if it does, only then to consider whether the effect of discounting is material. If entities wanted to discount all short-term receivables on initial recognition, then there are grounds for this, particularly IAS 18.11, but this is not sufficient to require all entities to follow this approach.

Garth Coppin BCom(Hons), CA(SA), is a registered auditor and National Director of Accounting at Ernst & Young.

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