Nexia Ebner Stolz

Effects of the Low-Interest Phase on Annual Financial Statements

Persistently low money market interest rates are also affecting companies’ accounting and annual financial statements, at least indirectly.

Inte­rest rates have now remai­ned at a his­to­ri­cally low level for almost a decade, as a con­se­qu­ence of the expan­sionary mone­tary policy adop­ted by cen­tral banks. Since com­pa­nies use inte­rest rates to cal­cu­late the time value of money, for example when mea­su­ring receivab­les, and to pre­sent the results of pro­fi­ta­bi­lity cal­cu­la­ti­ons in their acco­un­ting and their annual finan­cial sta­te­ments, the inte­rest rate level has a not insig­ni­fi­cant effect on the mea­ning­ful­ness of these repor­ting instru­ments. Even though there is no direct cau­sa­lity bet­ween money mar­ket inte­rest rates and dis­co­unt rates, lower money mar­ket inte­rest rates effec­ti­vely cause dis­co­unt rates to fall as well.

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Write-downs due to impair­ment tes­ting to become less likely

In IFRS con­so­li­da­ted finan­cial sta­te­ments, annual impair­ment tes­ting is para­mo­unt for the mea­su­re­ment of good­will and tra­de­marks, which are not amor­ti­zed (impair­ment-only approach). In impair­ment tests, the car­rying amo­unt of the assets in ques­tion is com­pa­red with the pre­sent value of the future cash flows expec­ted to be deri­ved from these assets, with a dis­co­un­ted cash flow (DCF) method being used to cal­cu­late the pre­sent value. The lower the inte­rest rate used to dis­co­unt the cash flow that is rele­vant for the mea­su­re­ment, the hig­her the pre­sent value and the more unli­kely impair­ment los­ses become. The cause-and-effect rela­ti­onship out­li­ned above affects all assets repor­ted on the assets side of the sta­te­ment of finan­cial posi­tion whose mea­su­re­ment is based on a cal­cu­la­tion of the pre­sent value. Except for the assets that are usually mea­su­red at fair value in IFRS acco­un­ting (for example, invest­ment pro­perty), the upper limit for the mea­su­re­ment is the (amor­ti­zed) cost of the asset in ques­tion. 

App­re­cia­tion of reti­re­ment bene­fit obli­ga­ti­ons merely defer­red

Low dis­co­unt rates also impact on the mea­su­re­ment of lia­bi­li­ties and pro­vi­si­ons car­ried at their sett­le­ment amo­unt. It is nor­mally long-term reti­re­ment bene­fit obli­ga­ti­ons that are affec­ted to the grea­test extent by inte­rest rates. Pen­sion pro­vi­si­ons rise by an average of around 15% when the dis­co­unt rate falls by one per­cen­tage point. 

Law­ma­kers took acco­unt of the expec­te­d—and in some cases disa­strous—­fi­nan­cial char­ges ari­sing from the per­sis­tently low inte­rest rate level, resol­ving on February 18, 2016 to change the way in which the actua­rial inte­rest rate is cal­cu­la­ted for dis­co­un­ting pen­sion pro­vi­si­ons recog­ni­zed in accor­dance with the Ger­man Com­mer­cial Code: This now uses the average inte­rest rate for the last ten years rather than for the last seven years. As a result, the rele­vant dis­co­unt rate as of Decem­ber 31, 2016 is now 4.01% (ten-year average) ins­tead of 3.24% (seven-year average). The drain on equity impe­ded by poli­cy­ma­kers that results from the lon­ger cal­cu­la­tion period is sub­ject to a res­tric­tion on dis­tri­bu­tion, howe­ver.

This mea­sure merely ser­ves to defer the inte­rest rate-rela­ted app­re­cia­tion of the reti­re­ment bene­fit obli­ga­ti­ons; it does not neu­tra­lize it. Assu­ming inte­rest rates remain con­stant in the future, pen­sion pro­vi­si­ons recog­ni­zed in accor­dance with the Ger­man Com­mer­cial Code will con­ti­nue to rise because the average inte­rest rate for the last ten years will nevert­he­less fall over time. This effect may be delayed furt­her if poli­cy­ma­kers again extend the period for cal­cu­la­ting the average inte­rest rate.

In IFRS finan­cial sta­te­ments, howe­ver, no cor­res­pon­ding inte­rest rate-rela­ted char­ges are recog­ni­zed because the dis­co­un­ting is still per­for­med on the basis of prime fixed-income mar­ket yields.

Defi­ned con­tri­bu­tion plans lead to plan­ning relia­bi­lity

To limit the costs of reti­re­ment bene­fit plans and regain plan­ning relia­bi­lity, in the future com­pa­nies could eit­her exer­cise grea­ter res­traint in awar­ding new con­tracts for pen­sion funds or inc­rea­sin­gly move over to defi­ned con­tri­bu­tion plans in which the emp­loyer makes a fixed con­tri­bu­tion to the com­pany pen­sion. Unlike in a defi­ned bene­fit plan, a spe­ci­fied payout is not gua­ran­teed, which gives the enter­prise plan­ning relia­bi­lity in rela­tion to future pen­sion costs.

Acco­un­ting poli­cies may lead to dis­tor­ted pre­sen­ta­tion in the annual finan­cial sta­te­ments

A low or fal­ling inte­rest rate level does not affect the assets and lia­bi­li­ties sides of the sta­te­ment of finan­cial posi­tion in equal mea­sure. On the one hand, the pre­sent values of expec­ted cash out­f­lows inc­rease, lea­ding to hig­her pro­vi­si­ons that are recog­ni­zed as an expense but do not affect the cash posi­tion. On the other hand, apart from cer­tain excep­ti­ons under IFRSs, the rising pre­sent values of expec­ted cash inf­lows as a con­se­qu­ence of fal­ling inte­rest rates are not per­mit­ted to be shown through (amor­ti­zed) cost. This affects com­pa­nies because, all other things being equal, the situa­tion pre­sen­ted in the finan­cial sta­te­ments under Ger­man com­mer­cial law wor­sens and, for instance, finan­cial coven­ants are lin­ked to finan­cial ratios even though the dete­rio­ra­tion in the situa­tion is not neces­sa­rily a ref­lec­tion of the assess­ment of the com­pany’s posi­tion from a com­mer­cial per­spec­tive.

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