The RBA has increased interest rates in Australia by 4% in just over a year. The rapid rises and the possibility of additional rises are contributing to the current inflationary cycle, which is damaging consumers balance sheets and businesses investment confidence. The damage is as a result of:

• the speed and frequency of interest rate increases;

• a decade of record low interest rates leading to asset price appreciation, easy credit availability and historic high levels of household borrowing and spending;

• consequent Inflation leading to decreases in employees’ real wages.

So, where are we on the journey to taming inflation? Have we reached the end of the interest rate tightening cycle? Are we there yet? Or, should we strap in for more pain? Given the RBA has a mandate to control inflation, we need to hope for the best, but prepare for possible increases.

This article explores the economic and business impacts of interest rate increases, the implications for businesses and risk management and considerations for the 2023 financial reporting season.

Economics of Increasing Interest Rates - The Interest Rate Brake Pedal

The RBA has had its foot firmly on the brakes for a year, increasing interest rates as a response to increases in inflation which has been propelled by:

• Historic interest rates being held too low for too long

• Covid-19 government stimulus, infrastructure spending and government budget deficits

• Pent up consumer demand

• Population growth

• Low labour productivity and

• Global supply chain issues.

The RBA measures the economy’s speed using the Consumer Price Index (CPI). The policy is to maintain CPI at a low and stable level of 2% - 3% pa.

When CPI is above the target range, the RBA increases the interest rate that it charges on loans and advances to banks and financial institutions. Not surprisingly, banks are quick in passing these on to borrowers, which filters through to financial products including business loans, term deposits and mortgage interest rates.

These interest rate increases work as a national economic brake. This is not a precise tool, stepping on the brakes has a lagged, uneven effect and both intended and unintended consequences, including:

• Reallocation of household income to paying off debt or higher rents

• Lower consumer spending on staples and discretionary items

• Discouraging borrowing money and encouraging higher savings

• Lower investment expenditure by businesses due to tougher lending conditions

• Downward pressure on values of listed equity securities, bonds, financial assets, homes and commercial property

• Increasing the value of the Australian dollar, decreasing the value of our exports and increasing the cost of imports

The Need for Risk Management

The business impacts of these economy wide effects can be rapid, severe and require effective management. The impact of rapid increasing interest rates is illustrated by the recent failure of Silicon Valley Bank (SVB) in the USA. A decade of ultra-low interest rates led to easy money driven investment in speculative technology companies. Many of these companies were customers of SVB. Over time, they built up significant bank deposits with SVB.

To increase income earned on customer deposits, SVB purchased US Treasury Securities and bonds backed by long term loans. As interest rates rapidly increased, the value of these securities decreased.

If these bonds and securities were able to be held to maturity, their full purchase price would have been recovered. However, SVB’s customers were rapidly withdrawing cash as inflows into their businesses dried up. SVB had committed the mistake of borrowing short-term to fund investment in long-term assets, a maturity and pricing mismatch.

To fund these withdrawals, SVB was required to sell securities, crystallising losses, and to seek new capital. News of SVB’s situation and the need to raise capital resulted in a “run on the bank” and an overnight 60% decrease in its share price, which precipitated its failure. Although an extreme case, SVB demonstrates the risks of interest rate movements and poor risk management.

Businesses have to assess the reliability of their cash flow forecasting and review their facilities. Consider:

• Maturity dates and repricing profiles to better match debt to cash flow forecasts and asset profiles

• Fixing borrowing rates or entering into hedging derivatives, such as interest rate swaps and

• Testing prospective compliance with debt covenants, particularly those relating to interest expense coverage and the value of net assets.

Financial Accounting and Reporting Implications

As we work through the 30 June 2023 financial reporting season, the effects of inflation and interest rate increases should be factored into key estimates. Businesses should consider:

Estimates and Judgements Disclosures

International Accounting Standards, as adopted in Australia, increasingly require assets and liabilities to be measured at fair value. Discounted cash flow (DCF) models, which drive many of these measurements, are highly sensitive to interest and discount rate assumptions. Key judgments and assumptions applied, as well as sources of estimation uncertainty, must be disclosed where material to the users of the financial statements. The reasonableness and support for assumptions applied is an area of increasing ASIC scrutiny. ASIC recently released their key focus areas for the June 2023 Reporting Season, you can read more here.

Impairment

The rapid rise in interest rates is an impairment indicator, necessitating detailed impairment testing and DCF analysis. Impairment write downs should be expected in many 30 June 2023 financial reports due to the combined effect of:

• Higher discount rates

• More conservative long term revenue growth assumptions, due to tighter economic conditions and

• Inflationary effects on costs of capital expenditure, wages and operating expenses.

Accounting Standards require that the discount rate used in determining the value in use of an asset (being the present value of expected future cash flows from the asset or business unit) must reflect the time value of money and the risks specific to the estimated future cash flows from the asset or business unit.

In practice, the discount rate is built up using the long-term risk free rate (such as the long term Government Bond rate) and adding premiums for equity risk and the specific risk factors of the asset or business. Given that the Australian Government Bond rate and equity risks are increasing, the discount rate will likely be higher than in previous financial years, pushing asset values downwards.

Fair Value Estimates

Increasing interest rates generally result in lower fair value assessments for financial assets. Fair value estimates for ‘level 3’ assets such as unlisted shares, are often based on DCF analysis which is highly sensitive to discount rates. Key inputs and discount rates are required to be disclosed for level 3 assets.

Additionally, the fair value of certain classes of investment property can be expected to decrease, as the minimum yield required by investors increases, impacting capitalisation rates used by valuers.

Leases

Leased assets and liabilities must be measured at the present value of the minimum lease payments. Increases in interest rates will result in lower lease asset and liability values, with a corresponding increase in interest expense recognised annually in the income statement.

Provisions and Employees Entitlements

Provisions are obligations to make payments where the amount or timing of the payment is uncertain (e.g. a future legal settlement or warranty costs). Accounting standards require that provisions and liabilities for employee entitlements be measured at the present value of expected future cash flows.

If all other inputs are consistent, increasing interest rates result in liabilities being measured at a lower amount whilst the unwinding of the discount, presented as interest expense, will be higher.

Going Concern and Solvency

When directors approve a company’s financial report, they make a declaration that the company can meet its debts as and when they fall due. Auditors must assess this conclusion and look out at least twelve months into the future as part of the overall going concern assessment. Higher borrowing rates, combined with a tightening economy, make these assessments challenging.

Businesses should prepare detailed reliable cash flow forecasts going out at least 12 months from the financial statements signing date to demonstrate that the business can meet its obligations. Where the forecast relies on key assumptions, such as improving profits, compliance with debt covenants, bank debt being refinanced or a capital raising, credible supporting evidence is required.

Conclusion

We can expect the RBA to continue to steer a straight course to control inflation. Although this creates pain, reducing inflation and the consequent slowing of the economy is the RBA’s mandate. The ultimate high watermark for interest rates is uncertain, but businesses should plan for further rate rises and proactively consider and manage the issues that arise.

The 30 June 2023 Australian financial reporting season presents interesting challenges and surprises, including potentially significant asset write downs and the effects on going concern and solvency. The ability of directors to clearly articulate and disclose the factors currently impacting their businesses is critical to users’ understanding and investor confidence.

At LNP Audit & Assurance, we understand the importance of effective financial management and transparent reporting. We have a team of highly skilled professionals who are dedicated to helping businesses navigate through the complexities of the financial landscape. We have the knowledge and experience to assist you every step of the way. To learn more, contact us at 1300 551 266 or email us at info@lnpaudit.com.