In recent times due to action taken by central banks to curb higher inflation, official interest rates have rapidly increased in Australia and in many economies across the world.
In Australia, the RBA official cash rate has increased from 0.1% in April 2022 to 3.6% in April 2023. From a financial reporting perspective, rising interest rates are likely to impact a number of financial statement balances, transactions and disclosures. As we get closer to the June 2023 reporting season it is important to consider how these impacts may present challenges for financial statement preparers. Below we look at some areas which should be considered in the lead up to the June 2023 reporting period.
Impairment of assets
Accounting Standards require annual impairment testing on goodwill and certain intangible assets and otherwise on other assets such as property, plant and equipment, right-of-use assets and investment properties where impairment indicators are identified at the end of a reporting period.
Impairment testing involves determining the recoverable amount of an asset or the cash generating unit (CGU) to which the asset belongs to. The recoverable amount is the higher of an asset’s or CGU’s fair value less costs of disposal and its value in use. Where an asset’s or CGU’s recoverable amount is less than an its carrying amount, an impairment loss equal to this difference is required to be recognised.
A key input in the determination of the value in use of an asset or CGU is the discount rate which is used to discount future cash flows assumed in the value in use model to present value. Practically, many financial statement preparers will reference an entity’s weighted average cost of capital (WACC) as a starting point to estimate a discount rate for this purpose. The WACC comprises of the cost of equity and cost of debt which both rely on or are influenced by movements in risk-free interest rates (as well as other elements). All things being constant, an increase in the discount rate will reduce the present value of future cashflows of an asset or CGU in a value in use model and therefore may increase the possibility of impairment losses being recognised, especially in the case of those assets or CGU’s that had little headroom in prior period impairment tests.
Furthermore, rising interest rates and inflation may also indicate impairment indicators now exist which could trigger the need for more detailed impairment testing across a wider range of assets compared to prior periods.
Many assets and liabilities are required or are otherwise permitted to be measured at fair value under Accounting Standards. Where an asset or liability does not have an observable quoted price in an active market (such as a quoted price on a stock exchange) generally a valuation technique involving the use of observable (market-based) and unobservable inputs will be used to measure fair value.
Key inputs in some valuation techniques (either directly or indirectly) are inputs that reflect or are otherwise impacted by market-based interest rates. Rising interest rates as a result will likely impact asset and liability fair values and in some circumstances force financial statement preparers to perform or revise fair value measurements that were historically only prepared periodically due to the fact that inputs used in valuation techniques had not changed significantly period to period.
Lease liabilities and right-of-use assets
Lease liabilities represent the present value of future lease payments. The present value of future lease payments are estimated using a discount rate which is determined based on either the interest rate implicit in the lease or if that rate cannot be readily determined, the lessee’s incremental borrowing rate. Right-of-use assets are correlated to lease liabilities and represent the value of the lease liability adjusted for various items such as lease incentives received, initial direct costs and other restoration and dismantling costs.
In previous reporting periods, discount rates applied to leases (either implicit in the lease or based on the lessee’s incremental borrowing rate) were likely lower given the lower interest rate environment which existed, which led to higher lease liabilities and right-of-use assets (assuming all things constant) given lower discount rates yielded higher present value estimates of future lease payments.
For new leases, or in certain circumstances where existing lease liabilities are reassessed or lease modifications occur, new discount rates estimated using current market interest rates (including the effect of credit risk) will need to be determined (where an incremental borrowing rate is used).
Discount rates used on similar leases in prior periods are likely to be no longer relevant and the degree of estimation required to determine new discount rates may be greater in a rising interest rate environment.
Higher discount rates will also lead to lower lease liabilities (and right-of-use assets) and over time will change the portions of interest expense and depreciation expense recognised on leases (interest expense will increase and depreciation expense will decrease) compared to prior periods.
Accounting Standards require provisions to be discounted where the effect of the time value of money is material. In addition to the specific risks of the provision in question, discount rates applied to provisions must reflect current market assessments of the time value of money and therefore are substantially based on market interest rates that exist at the end of a reporting period.
In prior periods, the impact of time value of money discounts may have not been material but with recent rising interest rates it is likely that this may no longer be the case especially for long-term provisions. The effect of discounting will reduce the carrying amount of a provision and result in additional interest expense being recognised in profit or loss.
Finance facility covenants and going concern
Higher interest rates have a direct impact on the cost of borrowings for many entities. The effects of higher financing costs alone could impact directly on an organisation’s available cash flows as it services these higher borrowing costs. Higher financing costs may also impact borrowing covenants, especially covenant ratios that are based on interest expense, such as an interest cover ratio.
In some areas of the economy, we are observing significant increases to supply chain input costs which are impacting gross margins if organisations are not able to pass on increased costs to their customers.
We are also observing indications of increased financial distress in some sectors which increases potential counter party risks if a significant customer or supplier was to fail. The impact of these risks, along with the impact of higher borrowing costs need to be considered in forecasts and cash flow modelling, as they may impact on an entity’s ability to continue as a going concern.
While these matters have a commercial impact, they also may lead to additional disclosures and potentially affect the classification of borrowings in financial statements.
Rising interest rates will likely impact a number of financial statement balances, transactions and disclosures for the June 2023 reporting period. Asset values and impairment are also expected to continue to be significant focus areas for Boards, finance teams, auditors and regulators.
Financial statement preparers should closely analyse and understand the impacts higher interest rates will have on their financial statements and year end close processes both for the upcoming June 2023 reporting period and future reporting periods.
Please reach out to us if you would like to discuss how these impacts can be identified and addressed in a timely manner.
This article was first published in Issue 15 of The Bottom Line.