FINANCIAL REPORTING & IR

After a series of interest rate hikes and an anticipated recession on the horizon, many companies are bracing for various economic factors that are expected to disrupt short-term achievements and upend long-term growth plans. Having experienced benchmark rates that were consistently close to zero over the last several years, the evolving interest rate landscape presents new challenges for companies, not only from an operational perspective but also in financial reporting. Below are some common financial reporting implications under IFRS resulting from rising interest rates.

Impairment of non-financial assets

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. The recoverable amount is the higher of ‘fair value less costs of disposal’ (FVLCD) and ‘value in use’ (VIU).

One of the key assumptions in the calculation of the ‘value in use’ is the discount rate, which represents the discounted net future cash flows associated with the continuing operation and ultimate disposal of the asset. In some instances, a discount rate is also relevant in the calculation of the ‘fair value less costs of disposal’, depending on the methodology applied. Discount rates are typically estimated using the weighted average cost of capital (WACC) formula as a starting point, and therefore require reference to market data such as risk-free interest rates and equity risk premiums. The rising long-term risk-free rates (for example, yields on long-term treasury bonds) may result in higher discount rates unless equity-risk premiums decrease. Higher discount rates will reduce valuations in the absence of other factors. This could give rise to an impairment trigger – even if previous impairment tests may have shown headroom. This needs to be a significant focus in financial reporting, especially when considering the compounding effect of a recession, which may negatively impact cash flow forecasts and future growth rates.

Derivatives and hedge accounting

Rising interest rates may affect the fair value measurement of derivatives, and therefore also the hedge effectiveness assessment of any related hedging relationships. Companies may be compelled to revisit their existing hedge strategies – whether to reconsider existing hedge positions or to begin to think of new hedges as a way of managing exposure to interest rate risks, especially if interest rate risks have been largely disregarded when they were historically low.  

Employee benefits – defined benefit plans

Employee benefits, particularly any post-employment defined benefit plans offered to employees, often represent a significant balance on the financial statements. Rising interest rates could be particularly impactful for companies with defined benefit plans because higher discount rates can affect numerous areas of measurement, including:

• present value of the defined benefit obligation;
• fair value of plan assets;
• asset ceilings on plan surpluses;
• net interest on the net defined liability (asset), recognized in the income statement; and
• remeasurement gains or losses recognized in other comprehensive income or loss.

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.

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 contractual terms with customers. Companies that extend financing to their customers may realize a reduction in revenue and a corresponding increase in interest income – which may impact key performance indicators and metrics monitored by management.

Conversely, companies that receive financing from their suppliers may see higher revenue and interest expense.

Provisions

Under IFRS, provisions are discounted when the effect of discounting is considered material. While a higher discount rate results in a lower discounted amount, other pertinent factors such as rising costs and risk adjustments may have an offsetting impact on the present value of the provision. Finance expenses would increase because the unwinding of the discount is presented as interest cost over time.

As noted, rising interest rates can have significant and broad financial reporting and operational consequences. While rising interest rates may generate immediate losses from areas such as impairment accounting, they can also have an offsetting impact caused by other factors such as inflation, and thereby disguise the full implication of such factors in the absence of rising interest rates. Investor relations professionals would benefit from understanding the implications of rising interest rates from an accounting perspective because there could be many different layers of risks to decipher, some of which may have longer-term implications for the company’s growth trajectory.

Keith Leung, CPA, CA is a Senior Manager, Accounting Advisory Services, and Rob Brouwer, FCPA, CPA is Canadian Managing Partner, Clients and Markets, for KPMG LLP in Canada.