What does:"unwinding the discount" mean, and how to do it??

Question

e.g. "in the year 20X0 there is $500 000 deferred liability to be paid off in 3 yrs time. Interest rates are at 10%pa, appropriate discount factor=0.751.

so: PV = 0.751 x 500= 376

2 yrs later (20X2):

PV of deferred consideration at acquisition: 376

PV of def.cons. at reporting date : 455

the reporting date is 2yrs' liability and there is only 1 yr to go until it will be paid, therefore the liability in the Statement of financial position at this date is

376 x 1.10 x 1.10"

why do we multiply it by 1.1??

Answer 1

The discount is created by the fact that $500,000 three years from now is worth less than $500,000 today. In the example provided, it is worth roughly $376,000 of today's dollars. Hence today's books show a discounted liability of $376,000 instead of $500,000.

To calculate the discount factor (0.751)

(a) convert the percentage into a rate by dividing by 100 and adding 1

10%/100 + 1 = 1.1

(b) since the rate will occur for three years, raise the rate to the third power

1.1 ^ 3 = 1.331

(c) than divide 1 into the result

1 / 1.331 = 0.751

As time passes the discount factor must be multiplied by the rate each year to adjust for the passage of time. This also means that the liability increases each year by the rate, in this case 1.1.

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The reason it is called unwinding the discount is that the $500,000 liability is discounted in the books for the years prior to its due date.

In your example with three years to go the discount was

$500,000 - $376,000 = $124,000

but with one year to go the discount was only

$500,000 - $455,000 = $45,000.

Since the discount decreases it is called unwinding.