All eyes are on the Fed to see if interest rates will reach their ceiling soon as inflation persists. In 2022, interest rates rose by a steep 4.25 percentage points. Interest rates are currently the highest since 2007. While interest rates are not expected to increase as steeply in 2023, inflation persists as consumer spending remains robust and low unemployment continues. Both inflation and rising interest rates have economic as well as accounting impacts.

Economic impacts

Inflation is when the overall prices of goods and services in the economy increase over a prolonged period because demand outweighs supply. The pandemic and the Ukraine war have directly contributed to the current inflation. During the pandemic, stimulus checks from the government boosted spending. However, supply could not keep up with demand due to supply chain disruptions. In addition, the Ukraine war impacted wheat, corn, and energy supplies, driving up the prices of those commodities.

The economy is still adjusting in the post-pandemic period. Many companies cut output or shut down during the pandemic and did not foresee the strong demand post-pandemic, which contributed to severe shortages for certain products and services. Those same companies can’t hire fast enough to meet the demand. On the flip side, some companies overestimated demand for their products or services after the pandemic and, as a result, have laid off many of their employees. These wild swings have made predicting how the U.S. economy will look harder.

Consumers have felt the pinch from inflation as the prices of common household goods (e.g., eggs and cars) and fuel/energy costs have skyrocketed. Meanwhile, their paychecks have not increased to offset the higher cost of living. Companies have also felt the pinch from inflation due to increased costs. If the company cannot pass on the costs to customers, its profits shrink. Increasing prices may also reduce demand for the company’s products.

To combat inflation, the Fed has raised interest rates, which is meant to reduce demand by increasing borrowing costs for debtors. Consumers have felt the effects of the increased rates as most credit cards have variable interest rates. The cost of buying large items on credit (e.g., house mortgages) has also significantly increased, putting a damper on the housing market. Increased interest payments significantly impact companies with variable-rate debt, which can lead to liquidity issues and potential debt covenant violations.

Although we have not seen the end of interest rate hikes, the recent increases are smaller and expected to stop soon. However, it will take some time before we see any effect on inflation. First, demand needs to decrease before the prices go down. Prices for certain items will stay high as long as supply chain issues and the Ukraine war continue. Until then, inflation and rising interest rates continue to cause volatility in the stock market. In addition, rising interest rates may impact stock prices negatively as future earnings are lower due to increased costs, valuations based on discounted future earnings are lower, general economic growth has slowed, and the returns for bonds and savings have become more attractive.

Accounting impacts

Rising interest rates directly impact the measurements of various items recorded at fair value, particularly those calculated using a discounted cash flow model. In addition, inflation and rising interest rates can trigger impairment considerations and modifications to agreements, which have accounting impacts.

Recurring Fair Value Measurement

There are certain assets and liabilities, such as derivatives, that are required to be recorded at fair value each period. Increased interest rates can significantly impact the fair value for these, with the changes in fair value recorded in the income statement. This can lead to significant volatility in earnings.

Initial Measurement

Rising interest rates can impact the initial measurement of the following items:

• Leases– The lease liability is measured as the present value of the lease payments, discounted at the incremental borrowing rate (or risk-free rate for private companies) at the commencement date. The higher the incremental borrowing rate, the lower the lease liability and right-of-use asset.
• Business combinations– In an acquisition of a business, the assets acquired and liabilities assumed are measured at fair value under ASC 805, Business Combinations, which interest rates and inflation could impact.
• Stock-based compensation– The risk-free rate is one of the inputs used in the valuation models for equity awards to measure the fair value at the grant date.
• Asset retirement obligations– Asset retirement obligations are initially measured at fair value, using a present value of expected cash flows discounted at a credit-adjusted risk-free rate when the obligation is incurred.

Subsequent Recognition

Inflation and rising interest rates should be considered in the ongoing measurement and recognition of the following that is not measured at fair value each period:

• Revenue– For companies that recognize revenue over time using a cost-to-cost measure of progress, increased costs due to inflation will affect the revenue recognized each period.
• Asset retirement obligations– Subsequent cash flow estimates should consider the impacts of inflation, which could result in changes to the timing and amount of cash flow estimates used to calculate the asset retirement obligation.
• Taxes– the realizability of a company’s deferred tax assets should be assessed on an ongoing basis to see if a valuation allowance is required. In determining whether a valuation allowance is required, the company should consider all available evidence (both positive and negative), emphasizing its past operating results, the existence of cumulative losses in the most recent years, and its forecast of near-term taxable income. In addition, its forecast of future income should be consistent with other forecasts used for goodwill impairment and going concern purposes.
• Postretirement obligations– Inflation and rising interest rates may affect the actuarial calculations of postretirement benefit obligations.

Modification of Agreements and New Agreements

As a result of rising interest rates and inflation, many companies may decide to modify their agreements or enter into new agreements or arrangements as follows:

• Debt– Companies may refinance their variable-rate debt for fixed-rate debt. Any changes to the terms of existing debt will need to be assessed as a debt modification under ASC 470-50. For details on the accounting for the different types of debt modifications, see our article “Accounting for Debt Modifications.”
• Stock-based compensation– If an equity award has a performance condition tied to earnings, it may be impacted by inflation and rising interest rates. If the performance condition becomes unrealistic, the company may modify the equity award to make it easier to vest. See our article “Accounting for Share-based Payments” for further detail on modifications of share-based payment awards.
• Leases– Companies may have lease payments tied to an index such as the consumer price index. As a result of inflation, companies may want to amend their lease agreements so that the lease payments are fixed. See our article “ASC 842 Overview” for further detail on lease modifications.
• Revenue– Increased costs due to inflation and rising interest rates may cause companies to pass on those costs to their customers. If the company has a contract with the customer, it may amend the contract to change the pricing or scope. Contract modifications can affect the timing and amount of revenue recognition. See our article “ASC 606 Overview” for further detail on contract modifications.
• Derivatives– Companies may decide to enter into an interest rate swap to hedge interest rate risk. To receive hedge accounting treatment, very specific criteria need to be met. See our article “Accounting for Cash Flow Hedges” for details on how to qualify for hedge accounting treatment.
• Supplier finance programs– Companies may enter into supplier finance programs with third-party intermediaries to manage their payables. These programs are essentially a reverse factoring arrangement and allow the companies to extend the payment terms for their payables while also giving suppliers the option to collect payments for confirmed invoices from the third party before the due date.  The company must evaluate whether to classify payables subject to the supplier finance program as trade payables or debt. ASU 2022-04, Liabilities- Supplier Finance Programs, also requires certain disclosures related to these programs.

Impairment Considerations

Inflation and rising interest rates can also trigger impairment considerations as follows:

• Goodwill and indefinite-lived intangibles– Companies need to evaluate goodwill impairment on an annual basis or when there is an indicator of impairment. Given the uncertainty in the market, increased interest rates, lower stock prices, and inflation, an interim impairment analysis may be required. In addition, the company may decide to do a quantitative goodwill impairment analysis by comparing the reporting unit’s fair value to its carrying value. The fair value will need to consider the impacts of inflation on the projected cash flows as well as a higher discount rate due to higher interest rates.
• Long-lived assets– If an impairment indicator exists, companies will first need to evaluate the recoverability of the asset group’s carrying value based on the undiscounted future cash flows, which need to consider the impacts of inflation. If the carrying value is not recoverable, the company will need to calculate the fair value of the asset group by discounting future cash flows. The discount rate used will be impacted by higher interest rates. A higher discount rate will decrease the asset group’s fair value, potentially leading to the recognition of an impairment loss.
• Inventory– Inflation can increase the cost of raw materials, energy to produce goods, and fuel costs to transport the materials. If sales prices don’t have a corresponding increase, inventory may need to be written down to lower of cost or market or net realizable value.
• Equity method investments and equity securities– Equity method investments should be monitored to see whether the carrying amount is recoverable. If the impairment is other-than-temporary, the company should write down the carrying value to fair value. In addition, equity securities without a readily determinable fair value measured using the measurement alternative under ASC 321, Investments- Equity Securities, must perform a qualitative impairment analysis each reporting period. An impairment should be recorded if the qualitative assessment indicates impairment and the fair value is less than the carrying value.
• Trade receivables– Collections of receivables may be more at-risk due to inflation. This will need to be considered when evaluating the allowance for credit loss under ASC 326, Financial Instruments- Credit Losses.

Presentation and Disclosure

Lastly, inflation and rising interest rates affect the presentation and disclosure of certain items:

• Risks and uncertainties– ASC 275, Risks and Uncertainties, requires companies to include qualitative disclosures around risks and uncertainties in the near term that can significantly impact the financials.
• Violation of debt covenants– If a debt covenant is violated due to a company’s inability to make the required payments or a waiver is obtained, the Company must assess whether the debt should be classified as current or non-current on the balance sheet and make incremental footnote disclosures.
• Going concern– Companies should update their going concern analysis by revising their forecast for the effects of inflation and rising interest rates in determining if it has sufficient capital to last the next twelve months and update its disclosure as necessary under ASC 205-40, Presentation of Financial Statements- Going Concern.