Navigating the effects of increasing interest rates on accounting estimates

Mori Fathallah

In the realm of financial reporting, accounting estimates are crucial for providing accurate information to stakeholders. However, the effects of interest rates are often overlooked, resulting in unpleasant surprises during reporting season. Solely focusing on improving financial results can lead to higher impairment charges and other discrepancies that auditors may challenge. 

To maintain transparency and avoid challenging conversations management must proactively address the potential impact of rising interest rates in their management reports. Prioritising accurate financial reporting over short-term appearances builds trust and enables informed decision-making in a dynamic economic environment. 

This article explores the multifaceted effects of rising interest rates on accounting estimates, including impairment models, right-of-use asset valuation, and financial instruments.  

By understanding and diligently addressing the effects of rising interest rates on these estimates, companies can ensure accurate financial reporting, comply with audit requirements, and provide stakeholders with reliable and transparent information. 

Impairment models in a shifting interest rate environment

Impairment models assess the recoverability of assets like long-lived assets or goodwill. Rising interest rates can impact impairment calculations in multiple ways. Higher borrowing costs can reduce future cash flows and profitability, potentially triggering impairment charges. Moreover, increasing interest rates may raise the discount rates used in impairment models, which are often based on risk-free rates, resulting in higher impairment losses.  To mitigate these impacts, companies should carefully review and adjust key assumptions and inputs in their impairment models. 

Valuation of right-of-use assets

The valuation of right-of-use (ROU) assets, governed by IFRS 16, is influenced by increasing interest rates. As interest rates rise, the discount rate used to calculate the present value of lease payments also increases.  

Given the sensitivity of ROU asset valuations to discount rates, businesses must reassess the appropriateness of the discount rate used in their calculations. This reassessment should consider both the impact of rising interest rates and the specific characteristics of the leases, such as lease term, lease type, and the lessee's credit risk. By employing more accurate discount rates, companies can ensure that their ROU asset valuations reflect prevailing market conditions.  

Managing financial instruments

Financial instruments, including derivatives and hedging arrangements, are sensitive to interest rate changes. Companies utilising these instruments must evaluate their fair value calculations and income recognition methods in response to increasing interest rates.  

They should also assess whether the designated hedging instruments and hedged items effectively offset the impact of interest rate changes. If necessary, adjustments should be made to maintain the effectiveness of the hedging strategy and appropriately account for hedging gains or losses in financial statements.  

Enhanced disclosures and transparency

As interest rates fluctuate, comprehensive disclosures in financial statements should address the potential impacts on accounting estimates. Transparent reporting enables stakeholders to understand the underlying assumptions and potential risks associated with interest rate fluctuations and enable informed decision-making. 

Take control of your accounting estimates in the face of rising interest rates. Contact the Crowe Audit team today for expert guidance and ensure accurate financial reporting. Let us help you navigate the complexities and make informed decisions. Reach out to our team now. 

The views and opinions expressed in this article are those of the author/s and do not necessarily reflect the thought or position of Crowe Australasia.