From the IFRS Institute – June 3, 2022
After a sustained period of low interest rates, interest rates are now rising. This may impact the measurement of assets, liabilities and net interest expense, under IFRS Standards, and trigger impairment losses. Rising interest rates may also lead to alternative financing and capital structuring and result in contract modifications or terminations, which can be complex to account for, as companies seek to adapt their business models and mitigate their risk. Here, we highlight some of the key financial reporting areas that may be affected by rising interest rates, while also looking at some of the business implications.
Interest rate and inflationary environment
The Federal Reserve announced at its May 2022 meeting that it is raising interest rates 0.5% – bumping the federal funds rate to a target of 0.75% to 1%. This move follows an increase of 0.25% in March 2022, as the Federal Reserve continues reducing liquidity to the financial markets to help control rising inflation. Likewise, in May 2022, the European Central Bank firmed up expectations that it will raise its benchmark rate in July 2022 for the first time in more than a decade to fight inflation.
In the US, a combination of rising inflation and expectations regarding future interest rate hikes by the Federal Reserve has also caused an increase in Treasury yields. The 10-year Treasury yield recently surpassed 3%, which is almost double the 10-year yield from the end of December 2021. Treasury yield increases impact the pricing of long-term debt and equity instruments and enterprise value as the yields affect the cost of debt, the cost of equity and the weighted-average cost of capital (WACC).
Having experienced benchmark rates which were consistently close to zero over the last number of years, this evolving interest rate landscape presents new challenges for companies, both from an operational and financial reporting perspective. Below we look at areas of financial reporting under IFRS Standards that may be impacted by increasing interest rates and consider related business implications that companies should be aware of.
Financial reporting considerations
|Nonfinancial assets and leases|
Impairment tests for goodwill, intangible assets, items of property, plant and equipment, and right-of-use assets require companies to determine the recoverable amount of the individual asset, or the cash-generating unit (CGU) to which it belongs. Impairment losses arise 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, which represents the discounted net future cash flows associated with the continued use and ultimate disposal of the asset (or CGU). It also can be key to FVLCD if an income approach (rather than a market approach) is used. Discount rates are typically estimated using the WACC formula as a starting point, and therefore combine different elements such as the risk-free interest rate and equity-risk premium. Rising long-term risk-free rates (i.e. yields of long-term treasury bonds) may result in higher discount rates unless equity-risk premiums go down. Higher discount rates may reduce valuations, absent any offsetting adjustments to cash flow projections, for example due to inflation. This could be an impairment trigger, even if recent impairment tests have shown significant headroom.
Additionally, estimates of future cash flows and the discount rate reflect consistent assumptions about price increases attributable to general inflation. Therefore, if the discount rate includes the effect of price increases attributable to general inflation, future cash flows are estimated in nominal terms. If the discount rate excludes the effect of price increases attributable to general inflation, future cash flows are estimated in real terms1.
|Lease assets and lease liabilities||
Lessees report most of their leases on-balance sheet at amounts that reflect discounted lease payments. Discount rates are often based on a lessee’s incremental borrowing rate (IBR).
The discount rate is typically not revised throughout the lease term. However, some events that trigger a remeasurement of existing lease liabilities require the lessee to revise the discount rate to reflect conditions at the date of the remeasurement – e.g. changes in lease payments due to a change in floating interest rates, changes in the lease term, and certain lease modifications.
Prevailing interest rates since the adoption of IFRS 162 in 2019 have been low. Therefore, for those companies that adopted IFRS 16 using a modified retrospective approach, for remeasurements of existing lease liabilities that require a revised discount rate and new leases, rising interest rates will drive higher discount rates, lower lease liabilities and lower corresponding right-of-use assets. Therefore, in the long run, lease expenses could shift from amortization to interest expense.
|Measurement – amortized cost||After initial recognition, financial assets and financial liabilities are measured at amortized cost or fair value. Amortized cost is based on the instrument’s original effective interest rate; therefore, existing fixed rate instruments are not directly affected by rising interest rates, unless they are modified. On the other hand, floating rate instruments may be affected by rising interest rates as anticipated cash flows may need to be re-estimated to reflect current and expected conditions. Any periodic re-estimation of cash flows, to reflect movements in interest rates, will affect the effective interest rate of a floating rate financial asset or financial liability.|
|Measurement – fair value||Fair value measurement of financial assets and financial liabilities is frequently based on discounted cash flows, and therefore could be directly affected by rising interest rates.|
|Expected Credit Losses (ECLs)||The ECL model covers, among other items, financial assets measured at amortized cost and investments in debt instruments measured at fair value through other comprehensive income (FVOCI). ECLs are based on the present value of expected cash shortfalls – the rate used to discount ECLs is the original effective interest rate, unless the financial asset has a floating rate, in which case the current effective interest rate is used. Therefore, ECL calculations for variable rate instruments will be affected by rising interest rates. Any reduction in ECLs for variable rate financial assets, due to higher discount rates, could however be offset by potential increases in estimates of cash shortfalls because borrowers may be adversely affected by rising interest costs and inflation.|
|Derivatives and hedge accounting||
Rising interest rates may affect the fair value measurement of derivatives, along with the hedge effectiveness assessment of any related hedging relationships. Companies may also seek to close out existing hedge positions.
Further, rising interest rates expose companies to greater interest rate risk. Companies that elected not to enter into any derivative or hedging arrangements when interest rates were low may now opt for hedging strategies as a way of managing this exposure. See further discussion below in business implications.
|Employee benefits and provisions|
|Defined benefit plans||
Rising interest rates could be particularly impactful for companies with defined benefit plans because higher discount rates may affect numerous areas of measurement, including:
While rising interest rates reduce defined benefit obligations, inflation and rising costs may have an offsetting impact on the underlying valuations. Companies may also need to think through whether any changes to future funding levels may be required.
Provisions are discounted under IFRS Standards, when the effect of discounting is material. Rising interest rates could mean that more long-term provisions need to be discounted. While a higher discount rate results in a lower discounted amount, rising costs and risk adjustments may have an offsetting impact on the amount of the provision. Finance expenses would increase because the unwinding of the discount is presented as interest cost.
Separately, rising inflation may trigger inflation adjustments. In our view, if the cash flows are expressed in current prices, the effects of inflation should not be included in the discount date – i.e. a real discount rate should be used. If the cash flows include inflation, the discount rate should include the effects of inflation – i.e. a nominal discount rate should be used.
|Revenue recognition||For new revenue contracts, rising interest rates may affect a company’s assessment of whether a contract contains a significant financing component if the company does not change its standard trading terms accordingly. Companies that provide financing to their customers may see a reduction in revenue and an increase in interest income. Conversely, companies that receive financing from their suppliers may see an increase in revenue and interest expense.|
|Borrowing costs||Borrowing costs are capitalized under IFRS Standards, if they are directly attributable to the acquisition, construction or production of qualifying assets. Qualifying assets are generally assets that are subject to major development or construction projects. Borrowing costs eligible for capitalization will likely increase with rising interest rates because interest expense would be expected to increase.|
|Financial statement disclosures||
Financial statements should disclose the nature and extent of the risks arising from financial instruments and related mitigation efforts. These disclosures generally include qualitative and quantitative data.
Further, companies should be mindful of disclosure requirements around sources of estimation uncertainty and any changes in accounting estimates.
In addition to the direct financial reporting impacts described above, rising interest rates might prompt companies to reconsider existing contractual arrangements or strategies. For example, companies that have lease agreements in which lease payments are indexed to floating interest rates or a consumer price index (given recent inflation trends) may look to modify those agreements so that payments do not track interest rate or inflation changes. Companies may also consider whether it might be beneficial to renegotiate existing debt agreements. Lease and debt modification arrangements can be complex and require carefully analysis of the accounting implications of any contemplated modification. See KPMG IFRS Perspectives article, Debt modifications: IFRS® Standards vs US GAAP.
In this environment, preference shares or similar instruments might provide a more attractive financing option than debt to some companies. However, when considering preference shares or similar instruments as a form of financing, the terms and conditions need to be carefully assessed relative to equity classification considerations under IAS 323 so that liability classification isn’t unintentionally triggered.
Lastly, more companies may now look to hedging strategies (e.g. interest rate swaps) as a means of managing increased interest rate risk. The related accounting and disclosure requirements under IFRS Standards are extensive and complex. Companies considering such arrangements for the first time should ensure they have the necessary accounting knowledge and experience to handle these requirements and plan accordingly.
Rising interest rates are likely to have a pervasive impact on financial reporting under IFRS Standards. Companies should think through how the measurement of assets and liabilities may be affected for existing, modified and new arrangements, and how to disclose their exposure to rising interest rates. Accounting judgments may need revisiting (e.g. lease reassessments, conclusions around whether the effect of discounting is material for long-term provisions). Implementing mitigating strategies and structuring future contracts will also require attention to avoid adverse accounting consequences associated with rising interest rates.
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- IAS 36, Impairment of Assets
- IFRS 16, Leases
- IAS 32, Financial Instruments: Presentation