In July 2022, the European Central Bank’s (ECB) Governing Council increased interest rates for the first time in 11 years, followed by a subsequent increase in September 2022. This follows a series of interest rate increases by the Federal Reserve and the Bank of England. In this regard, the Federal Reserve has increased interest rates by 3.00% between March and September 2022, moving the federal funds rate to a target of 3.00% to 3.25%. Similarly, the Bank of England increased the official bank rate from 0.5% to 2.25% between March and September 2022. The rising interest rate environment may have various financial reporting implications under International Financial Reporting Standards (IFRS).
The increase in interest rates may affect the measurement of assets and liabilities as presented and disclosed in the balance sheet. In addition, the increase in interest rates may impact interest income/ expense or could trigger impairment losses.
The implications of the increasing interest rates may result in the adaption of business models and rethinking business decisions such as the financing and capital structure. Additionally, businesses and customers could renegotiate or terminate contractual agreements. The accounting treatment of these implications, amongst others, may be complex.
Naazneen Moosa and Úna Hegarty of our Accounting Advisory team highlight some of the key financial reporting considerations as a result of the rising interest rate environment in this article.
EU interest rate environment
The ECB announced a 0.5% increase in July 2022 and a further 0.75% in September 2022 in the main borrowing rate, marginal lending rate and deposit rate (interest rates). This series of interest rate hikes is the first of its kind since 2011 and resulted in the main borrowing rate increasing to 1.25%, the interest rate on marginal lending increasing to 1.5% and the deposit rate moving from a negative position to 0.75% for the first time since 2014.
The increases in interest rates come amidst significant pressure to tackle high inflation rates in order to stabilise prices in the economy. The combination of rising inflation and expectations regarding future interest rate hikes are likely to impact the euro area yield curves thus impacting the pricing of long-term debt, equity instruments and enterprise values as the cost of debt, the cost of equity and the weighted-average cost of capital (WACC) are likely to be impacted.
Over the last decade, many companies have experienced benchmark rates which were consistently close to zero. Thus, the evolving interest rate environment presents new challenges for companies, both from an operational and financial reporting perspective.
Some of the key financial reporting considerations
The rising interest rates may impact measurement, presentation and disclosure in the financial statements. We summarise below some of the key financial reporting considerations arising from the recent and ongoing increases in interest rates.
Non-financial assets and leases
Impairment IAS 36: Impairment of Assets
- Impairment tests require companies to determine the recoverable amount of the individual asset or cash-generating unit (CGU).
- Impairment losses are recognised when the carrying amount of the asset (or CGU) exceeds its recoverable amount.
- The recoverable amount is the higher of fair value less costs of disposal (FVLCD) and value in use (VIU).
- The discount rate is a key input in the calculation of VIU and FVLCD (if an income approach rather than a market or cost approach) is used.
- Discount rates typically comprise of different elements such as the risk-free interest rate and equity-risk premium.
- The increasing interest rate environment impacts the long-term risk-free rates which may result in higher discount rates unless this is offset by decreasing equity-risk premiums.
- Provided that there are no other offsetting changes in the cash flow projections (e.g. inflation), the increase in discount rates would reduce VIU and FVLCD calculations, increasing the risk that individual assets (or CGU) are impaired.
- Rising interest rates aim to reduce the inflation rate which could result in less spending power. This has the potential to change VIU inputs such as forecast sales and growth rates.
- Impairment could be triggered despite previous impairment tests showing significant headroom.
Lease assets and liabilities: IFRS 16 Leases
- All leases (with the possible exception of short-term leases and/or low value leases) are included in the balance sheet of lessees.
- Leases are measured in a way that reflects the present value of the lease payments.
- Lease payments are discounted using either the interest rate implicit in the lease or more often, the lessee’s incremental borrowing.
- The discount rate is not usually revised throughout the lease term.
- Changes in lease payments due to floating interest rates may trigger a remeasurement of the existing lease liability using a revised discount rate and a corresponding adjustment in the measurement of the right-of-use asset.
- Where a remeasurement of the lease liability using a revised discount rate is required, the lessee reflects conditions at the date of the remeasurement.
- The increasing interest rate environment may impact the remeasurement of existing lease liabilities (if applicable) and new leases as it will drive higher discount rates, lower lease liabilities and lower corresponding right-of-use assets.
- Lease associated expenses generally comprise of the depreciation on the right-of-use asset and the interest expense on the lease liability.
- Increase in incremental borrowing rates could result in lease expenses shifting from consisting of higher depreciation amounts to comprising of larger interest expense amounts due to the changes in the discount rates.
- Existing lease agreements may be renegotiated where lease payments are linked to floating or variable rates or a consumer price index (inflation).
Measurement of amortised cost instruments: IFRS 9 Financial Instruments
- Subsequent to initial recognition, financial assets and financial liabilities will either be measured at amortised cost or fair value depending on the nature of the financial instrument and in the case of financial assets, depending on the business model of the company.
- The amortised cost of the instrument applies the original effective interest rate of the instrument to determine the related interest expense or income.
- Existing fixed rate instruments are not directly affected by the rising interest rates, unless these instruments are modified.
- The amortised cost of floating or variable rate instruments may be affected by the increase in interest rates as anticipated cash flows are re-estimated to reflect current and expected conditions including movements in interest rates. Thus, the effective interest rate of these instruments is impacted and results in an increase in interest expense.
- Companies that were previously charged for holding deposits with financial institutions may no longer have to pay interest, resulting in a decrease in interest expense.
Measurement of fair value instruments: IFRS 9 Financial Instruments
- Fair value is an exit price that represents the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date.
- The fair value of an instrument may be calculated using the market (e.g. quoted prices) or income (e.g. discounted cash flows) approach.
- The fair value of instruments using the market approach will take into account the changes in interest rates when pricing the debt or equity instrument.
- Where the discounted cash flows technique has been applied to measure the fair value of the instrument, there could be direct implications arising from the increasing interest rate environment attributable to the higher discount rate applied.
- All other things being equal, the increase in interest rates would result in a reduction in the fair value of the asset or liability leading to reduced finance income or increased finance expense respectively.
Expected credit losses (ECLs): IFRS 9 Financial Instruments
- A loss allowance should be recognised for the ECLs on financial assets measured at amortised cost and investments in debt instruments measured at fair value through other comprehensive income (FVOCI) as well as loan commitments, financial guarantee contracts, lease receivables in the scope of IFRS 16 and contract assets in the scope of IFRS 15.
- ECLs represents the probability-weighted estimate of the present value of all cash shortfalls over the expected life of the financial instrument.
- Most ECLs are discounted using the effective interest rate determined on initial recognition of the instrument.
- One of the exceptions relates to floating or variable rate instruments as the ECLs are discounted using the current effective interest rate and are therefore, impacted by the increasing interest rates.
- Contrarily, fixed rate instruments continue to be discounted at the original effective interest rate as they are not impacted by the change in interest rates.
- Borrowers may be adversely impacted by the increasing interest rates and inflation1 , potentially increasing the estimates of cash shortfalls.
- The impact of an increase in estimates of the cash shortfalls may counteract a reduction in ECLs attributable to increases in the discount rates.
- If the credit risk of the borrower is reflected in the cash flows, it should not be built into the credit spread of the discount rate in order to avoid double counting.
Derivatives and hedge accounting: IFRS 9 Financial Instruments
- The fair value measurement of derivatives as well as the hedge effectiveness assessment of any related hedging relationships may be impacted by the rising interest rates.
- Increases in interest rates expose companies to greater interest rate risk.
- The risk management strategy may be reconsidered resulting in the close out of existing hedge positions or opting into new hedging strategies in order to manage this exposure.
- Companies considering entering into hedge accounting arrangements for the first time may need to gather extensive information to enable hedge accounting to be applied and to produce the extensive hedge accounting disclosures.
Other financial instrument considerations: IFRS 9 Financial Instruments & IAS 32 Financial Instruments: Presentation
- The increasing interest rate environment may result in companies considering whether it is beneficial to renegotiate the terms of its existing debt agreements. IFRS 9 requirements with regard to loan modifications are complex and the accounting differs depending on whether or not the assessment leads to derecognition of the existing liability.
- Preference shares or similar instruments might appear to be a more attractive financing option rather than debt in such an environment.
- The terms and conditions of preference shares or similar instruments may impact the classification of such instruments as either equity or liability. Companies should, therefore, consider the guidance contained in IAS 32 in order to ensure the correct classification of the preference shares or similar instruments issued.
Employee benefits and provisions
Defined benefit plans: IAS 19 Employee Benefits
- Defined benefit plans comprise of complex actuarial assumptions and discounting in order to measure the obligation for the company and related pension assets.
- Rising interest rates may affect numerous areas in measuring the defined benefit plan, including:
- Present value of the defined benefit obligation;
- Fair value of pension assets;
- Asset ceilings on plan surpluses (present value of refunds or reductions in future contributions);
- Net interest on the net defined liability (asset); and
- Remeasurement gains or losses.
- While the increase in interest rates reduce the defined benefit obligation, this may be offset in the net defined benefit liability/asset by reductions in the valuation of pension assets as a result of inflation and increasing costs.
- Companies may contemplate and adjust the future funding levels required.
Provisions: IAS 37 Provisions, Contingent Liabilities and Contingent Assets
- Where the effect of discounting is material, the amount of a provision represents the present value of the expenditures expected to be required to settle the obligation.
- Discounting may become material for longer-term provisions.
- The increase in discount rates will result in a lower present value for the provision, but this may be offset against increases attributed to rising costs1 and risk adjustments.
Revenue recognition: IFRS 15 Revenue from Contracts with Customers
- Provided that there are no additional changes in the standard trading terms, existing calculations for revenue contracts that contain a significant financing component are not impacted by the changes in interest rates as it is based on the original effective interest rate.
- For new revenue contracts that contain a significant financing component, the increased interest rates will drive increased discount rates resulting in a higher element of finance cost and reduced revenue.
- Financing received from suppliers may result in an increase in revenue and interest expense.
Borrowing costs: IAS 23 Borrowing Costs
- Borrowing costs that are directly attributable to the acquisition, construction or production of a qualifying asset are capitalised as part of the cost of that asset.
- Qualifying assets are assets that take a substantial period of time to get ready for its intended use or sale.
- The increase in interest rates may increase the borrowing costs eligible for capitalisation due to an increase in interest expense associated with variable rate borrowings.
Disclosures: IAS 1 Presentation of Financial Statements & IFRS 7 Financial Instruments: Disclosures
- Companies are required to disclose information about the assumptions related to estimates including the major sources of estimation uncertainty and any changes in estimates.
- The sensitivity of calculations such as impairment headroom to changes in discount rates may be more material and result in them becoming disclosable sources of estimation uncertainty.
- Companies are required to disclose the nature and extent of risks arising from financial instruments to which it is exposed to at the end of the reporting period as well as how these risks have been managed. Disclosures regarding interest rate risk in particular may become more significant to the financial statements.
- These disclosures comprise of both qualitative and quantitative information.
Other areas for consideration
Interest rates or discount rates may impact other areas of which some are listed below and therefore, should be considered by companies:
- Share based payment charges can be impacted by the risk-free interest rates (through the valuation models).
- Business combination accounting and the fair value of assets and liabilities as well as the fair value of contingent and deferred consideration.
- Implications of potential breaches of covenants where the company is exposed to variable interest rates (e.g. potential impact on current/non-current presentation).
The rising inflation rate may trigger inflation-related adjustments to cash flows. This means that where the cash flows include the impact of inflation, the discount rate should follow a consistent approach and include the effects of inflation (i.e. nominal rate). On the other hand, if the cash flows are reflective of current prices, the effects of inflation should be excluded from the discount rate (i.e. real rate).
Management may need to pay far more attention, than perhaps they have in previous years, to movements in interest rates, given their potential to have material impacts on measurement, presentation and disclosure in the company’s financial statements.
Should you have any questions on the financial reporting implications of the increases in interest rates, please contact Naazneen Moosa or Úna Hegarty of our Accounting Advisory team. We'd be delighted to hear from you.