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.
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.