What the six recent interest rate increases mean for your 31 December 2022 financial statements

The measurement of many assets and liabilities involves the use of fair values or other techniques that include determining the present value of future cash flows. Recent increases in interest rates in Australia are likely to have a direct impact on the measurement of many of these items because when interest rates increase, so do the discount rates used in present value calculations.

Present value calculations can be used for determining:

• Impairment of assets (IAS 36 Impairment of Assets)
• Fair value of financial assets and financial liabilities (IFRS 7 Financial Instruments: Disclosures and IFRS 9 Financial Instruments)
• Fair value of investment property (IAS 40 Investment Property)
• Fair value of biological assets (IAS 41 Agriculture)
• Leases (IFRS 16 Leases)
• Long service leave liability and defined benefit superannuation obligations (IAS 19 Employee Benefits)
• Fair value of options issued (IFRS 2 Share-based Payment)
• Appropriate measurement of provisions, including restoration provisions (IAS 16 Property, Plant and Equipment and IAS 137 Provisions, Contingent Liabilities and Contingent Assets).

Impairment of assets

IAS 36 mainly applies to property, plant and equipment, goodwill and other intangible assets. An impairment loss is recognised for the amount by which an asset’s carrying amount exceeds its recoverable amount. The recoverable amount is the higher of an asset’s fair value less costs of disposal and value in use.

Value in use is the present value of the future cash flows expected to be derived from an asset or a group of assets (cash-generating unit). The discount rate used is a pre-tax rate that reflects current market assessments of the time value of money (risk-free interest rate), and the risks specific to the asset for which the future cash flow estimates have not been adjusted. Due to the recent six consecutive interest rate increases, discount rates are expected to increase due to increases in the risk-free rate used as a starting point when determining discount rates. In addition, adverse business impacts as a result of COVID-19 may also result in some entities having poorer credit ratings. Therefore, for some entities, discount rates may increase not just because the risk-free rate is increasing, but also because of poorer credit ratings.

While the impact of the first two interest rate increases in May and June may not have had a material impact on the recoverable amount of assets and cash-generating units (CGUs) at 30 June 2022, we expect the situation at 31 December 2022 to be more dire for some entities. This is because higher discount rates cause a reduction in the recoverable amount of assets, which could lead to more frequent and larger impairment losses being recognised.

Entities will have to recalculate their impairment models for items that must be tested annually for impairment (goodwill, intangibles with indefinite useful lives and intangibles that are not ready for use) using higher discount rates than what they used in June 2022 half-years, or in the 2021 annual period. Further, the rise in interest rates and business impacts of COVID-19 could well trigger the need for impairment testing of assets not previously tested for impairment, such as property, plant and equipment, or even investment properties measured using the cost model.

Financial instruments

Many types of financial instruments are required to be recognised in the balance sheet at their fair value. If not, they are recorded at amortised cost and their fair values will be disclosed under IFRS 7. Increases in interest rates will cause a change in the fair value of many financial assets and liabilities, particularly those with fixed interest rates and interest-free intercompany loans.

For those assets and liabilities measured at fair value, this will directly reduce their carrying values. For those measured at amortised cost, this will reduce the disclosed fair value and may affect the assessment of whether such financial assets are impaired.

The fair value of a financial asset or a financial liability for which there are no quoted prices in an active market for an identical asset or liability is commonly measured using a valuation technique (i.e. where no Level 1 inputs are available). Inputs to valuation techniques that will affect the fair value include interest rates (the basic or risk-free rate and the premium over the basic rate for credit risk). The reassessment of these valuation models may initiate some further significant write-offs, particularly in large sophisticated financial institutions.

Fair value of investment property

Investment property is accounted for using either the cost model or the fair value model. Under the fair value model, if relevant current prices in an active market for similar properties are not available, discounted cash flow projections are normally used. Increases in interest rates will generally decrease the fair value of investment property using this method unless rents are determined to increase as a result of rises in interest rates. Where the cost model is used, the fair value of investment property still needs to be disclosed.

Biological assets

Biological assets (living animals and plants) are measured at fair value less costs to sell. Where an active market does not exist for the biological asset, an entity may use the present value of expected net cash flows from the asset. An increase in interest rates will decrease the fair value of biological assets determined using this method.

Leases

Lease liabilities are measured on commencement date of the lease as the present value of future lease payments that are unpaid on that date. Lease payments are discounted using the interest rate implicit in the lease, or if that cannot be readily determined, the lessee’s incremental borrowing rate. In practice, the lessee’s incremental borrowing rate is more commonly used, and takes into account the type of security (the leased asset), as well as the lessee’s credit risk. The discount rate is only adjusted if the assessment of the lease term changes, or the lease is modified. In such cases, recent interest rate increases, as well as changes in the lessee’s credit risk must be considered when determining revised discount rates for lease liabilities.

Long service leave liability and defined benefit superannuation obligations

Long service leave liabilities are measured as the present value of expected future payments. The main component of a liability or asset for defined benefit superannuation obligations is also measured as the present value of expected future payments. In Australia, expected future payments are generally discounted using corporate bonds rates. However, government bond rates are used by not-for-profit public sector entities. An increase in anticipated future interest rates will decrease the amount of these liabilities. However, an increase in anticipated future salary costs as a result of increased interest rates will increase these liabilities.

Share-based payments – options

Equity-settled share-based payment transactions with employees are measured based on the fair value of the equity instruments granted at grant date. If market prices are not available, the fair value of the equity instruments granted is estimated using a valuation technique. Share options are normally valued using an option pricing model. All option pricing models take into account the risk-free interest rate for the life of the option. Accordingly, increases in interest rates will decrease the fair value of options issued at the grant date. As the fair value of an equity-settled share-based payment transaction is not remeasured after the grant date, increases in interest rates will not change subsequent measurement of these options.

Measurement of provisions

The amount recognised as a provision for decommissioning or restoration (‘make-good’) is required to be the best estimate of the expenditure required to settle the present obligation at the reporting date. This is measured at present value using a current pre-tax market-based discount rate (where the effect of the time value of money is material). The measurement of provisions must be reviewed at each reporting date and adjusted to reflect the current best estimate of the liability. Where discounting is used, the carrying amount of the provision increases in each period to reflect the passage of time. This increase is recognised as a finance expense in profit or loss.

Property, plant, and equipment

Under IAS 16, the cost of an asset includes the estimated cost of dismantling and removing the asset and restoring the site. Accordingly, many provisions relating to costs of decommissioning of assets, site restoration and lease make-good obligations are also included in the cost of related assets at the initial amount of the provision. The total cost of the asset, including the cost of decommissioning or site restoration, is depreciated over the asset's useful life.

Changes in existing decommissioning, restoration and similar liabilities included in the cost of property, plant and equipment

The effect of changes in provisions is further dealt with in Interpretation 1 Changes in Existing Decommissioning, Restoration and Similar Liabilities. The Interpretation addresses the accounting for changes in the measurement of decommissioning, restoration and similar liabilities that are recognised as part of the cost of an item of property, plant and equipment. There are two main kinds of changes dealt with in the Interpretation, i.e. those that arise from:

• Revisions of estimated outflows, for example, the estimated costs of decommissioning an asset may vary significantly both in timing and amount
• Revisions to the current market-based discount rate.

Where there is a change in estimated cash outflows or a change in the market-based discount rate, entities that account for their property, plant and equipment using the cost model in IAS 16 are required to add or deduct the change to the provision to/from the cost of the item. Depreciation must then be adjusted prospectively over the asset’s remaining useful life. This is consistent with the treatment under IAS 16 of other changes in estimates relating to property, plant and equipment. The adjustments to the asset are restricted such that the asset cannot decrease below zero and cannot increase above its recoverable amount.

Where an entity accounts for property, plant and equipment using the revaluation model, a change in the liability does not affect the valuation of the item for accounting purposes. Instead, it changes the revaluation gain or loss on the item, which is the difference between its valuation and what would be its carrying amount under the cost model. The effect of the change is treated consistently with other revaluation increases or decreases. Any cumulative decrease is taken to profit or loss, but any cumulative increase is credited to the revaluation reserve.

Overall effect of increase in interest rates

Where an increase in interest rates causes an increase in the discount rate applied to a provision and there is a related asset, the provision and asset will decrease initially by the same amount. Subsequently, finance expenses will be higher, and depreciation will be lower.

In Summary

Because interest rates have fluctuated significantly during the past six months, their impact must be considered by preparers of financial statements for 31 December 2022 financial statements. IAS 36 refers to increases in market interest rates as an external indicator of impairment and, as such, it is expected that auditors will require an automatic assessment of impairment for assets that do not usually require an annual impairment test, such as investment properties and property, plant and equipment.

Changing interest rates will further complicate the application of IFRS 9 when measuring financial instruments. They will also affect disclosures about fair values of financial instruments required by IFRS 7, as well as the detailed fair value disclosures required by IFRS 13 Fair Value Measurement.