With economies firing back up from their COVID malaise, we are experiencing an environment of low unemployment and high inflation – interesting times. These factors have combined to create an uncommon feature in the US markets – a persistent inverted yield curve. In layman’s terms, this means that short-term interest rates are higher than long-term interest rate expectations, a temporary situation that goes against a core principle of finance; the longer into the future you want to secure a return, the higher the required rate of return.
Kuo Ning Ho, Director at SLM Corporate, an independent consultancy that specialises in valuation matters, observes that “currently one-year treasuries are priced to yield approximately 100 basis points more than the 10-year US treasuries” – meaning that the interest return for a 10-year investment bond is 1% lower than those for a one-year investment.
Normally yield curves increase as the maturity horizon expands – this stands to reason – a bond is effectively a bet on inflation and the potential for an inflation break-out is more probable over a longer period. However, under the current economic climate, we are now living through that inflation break-out and the markets are betting that this inflation will be tamed in a period beyond a one-year maturing fixed interest security.
So how does this economic situation play out in the world of financial reporting and accounting standards, including here in Australia? Here are my observations:
Provisions and long-term liabilities
Provisions and long-term liabilities are perhaps the most easily explainable in an inverted yield curve environment. The discount rate applicable should match the expected timing of the cash outflow. So a liability maturing in three years from reporting date should be analogous to market pricing for three-year interest bearing securities.
The weighted-average cost of capital calculation used in a discounted cashflow analysis applied in impairment testing
The risk-free rate is applied in the Capital Asset Pricing Model (CAPM) formula, which supports the weighted average cost of capital calculation which serves as the discount rate applied to cashflows used in an impairment calculation. It impacts both the value of debt and the value of equity used in the CAPM formula. So, the interesting matter here is that a discounted cashflow analysis is an in-perpetuity calculation. So how would an inverted yield curve impact this calculation – should separate discount rates be applied for each year of the calculation? “The standard discounted cashflow model doesn’t allow you do to this. It is built for a single discount rate applied to be the cashflows with a time factor,” Kuo Ning points out. “The selected risk-free rate reflects the reality of alternative investment choices at that particular point in time. If the yield curve is inverted when you are making an investment decision for the long term, then the lower rate forms part of your investment decision making.”
As such, practitioners applying impairment in-perpetuity calculations should apply the best available proxy, using the longest dated risk-free bond priced by the market appropriate to the asset as part of the CAPM calculation.
Hybrid financial assets, derivatives and share-based payment arrangements
In many cases, these fair values are the outcomes of sophisticated simulation models. Yes, the risk-free rate is an input into these models, so some impact is relevant. My advice however is for CFOs to turn to trusted valuation professionals for determining what impact is applicable to their fair valuation.
The recession is not yet here, and may even not arrive, however it has effectively been priced in by markets and therefore now has a tangible impact on fair valuation assessments made in financial statements right now through the inverted yield curve. RBA-quoted cash interest rates in Australia have moved by 3% in the last 12 months – however this does not necessarily translate to a wholesale movement in 3% for discount rates applied in accounting estimates and judgments. The impacts are much more nuanced and should be tailored appropriately to the time horizons underpinning those accounting estimates and judgments. Smart financial reporting practitioners should consider advancing conversations with their auditors and external specialists to determine what impacts may apply to their financial reporting process in this new inflationary environment.