As consumers, the current environment of higher interest rates affects us in several ways. One of the obvious ways is for potential homebuyers, who are keenly aware of 30-year mortgage rates that are far higher now than several years ago. But how do higher rates affect accounting practitioners and their business clients?
Bob Durak, CPA, CGMA, has a few answers in the latest episode of the Journal of Accountancy podcast. Durak, director–Audit and Accounting Technical Services at AICPA & CIMA, together as the Association of International Certified Professional Accountants, also explains the role that the Center for Plain English Accounting (CPEA) plays in assisting small to midsize firms with new or less obvious risks related to interest rates.
Hear more about why fraud could rise along with interest rates, what high rates might have to do with revenue recognition, and more about a recent CPEA report that details the current rate environment.
What you'll learn from this episode:
- Background on home mortgage rates from about 30 years ago.
- The other types of interest rates that are important for practitioners and for the organizations they advise.
- Why auditors should be aware of high interest rates as part of audit engagements.
- One main goal of the Center for Plain English Accounting.
- What higher interest rates have to do with the potential for fraud.
- Interest-rate considerations for revenue recognition and lease accounting.
Play the episode below or read the edited transcript:
— To comment on this episode or to suggest an idea for another episode, contact Neil Amato at Neil.Amato@aicpa-cima.com.
Neil Amato: Welcome back to the Journal of Accountancy podcast. This is your host, Neil Amato. Whether you're listening as a consumer or as a practitioner, chances are the high interest rate environment we're now in is something that affects you. Here to talk more about that current environment is Bob Durak. Bob is director–Audit and Accounting Technical Services at AICPA & CIMA. He's a CPA who holds the CGMA designation. Bob, first, welcome to the Journal of Accountancy podcast.
Bob Durak: Great to be here, Neil. Thank you.
Amato: Let's set the stage first a bit about interest rates so people understand the overall environment, what exactly are the rates we're talking about, and what have they been doing recently and also a broader look at, I guess, how they've changed compared to what we've been seeing longer-term?
Durak: Well, I guess we all are aware, Neil, that interest rates are much higher than they have been, and they are rising. We're really looking at interest rates across the spectrum here, a variety of different interest rates. The Federal Reserve has been raising their rates for quite a while now and that, of course, has the impact of making all other rates increase as well. They're doing that to combat inflation, to corral inflation and bring that under control. I think inflation right now is running about 8%. Some say there are signs that inflation is cooling. Others say that the inflation looks to be stubborn. So I think it's fair to say that the Fed will continue to raise interest rates in this year, 2023, for a while. We are looking at a high interest rate environment and rates rising into the near future as well. Just to give some perspective, as you were mentioning in your question, many of us look at mortgage rates. I think 30-year fixed mortgage rate right now is about 7%. Back in 2021, it was around 3%. So we're looking at more than a doubling of interest rates in the marketplace.
Now it's not just mortgage rates, too; it's rates on business loans. They've also increased significantly compared to the past. And going back 30 years ago in 1993, mortgage rates, I think, were comparable to today, about 7%, but if you go forward 10 years from there, so 2003, rates were about 5%; 2013, rates are around 4%. Like I said, just in 2021, we're looking at 3% rates.
So for many, many years, we have been living in a very low interest rate environment. Some would say artificially low interest rate environment, and what I see is management at many companies and CPA practitioners, auditors as well, really not being familiar with the impacts and with the challenges of rising interest rates because we just haven't been living through them. What are the financial reporting impacts of rising interest rates and the audit risks involved with rising rates? So these are all important considerations.
Amato: That's a good intro to the topic. When I think of interest rates rising, as you said, I think about mortgage rates for buying a house. Car loan rates — for many years it was like 0.9% was high; you could get 60 months no interest if you were buying a car. But that's my focus, which may not be another person's focus, a CPA's focus. Are there other impacts, other rates out there that maybe I'm not thinking about or the audit risks related to those rising interest rates compared to say, five years ago?
Durak: Well, it's funny to talk about auto loans. The last time I bought a car, I had 0% financing for 60 months. I've been looking lately knowing that I have to buy something soon. Maybe sticker shock is too strong of a term, but definitely I'm looking at not 0% anymore, definitely a rise in those rates.
My focus in my job with the AICPA, with the Association and with the Center for Plain English Accounting has me focused on the CPA practitioners who are serving clients, serving entities, generally medium-sized entities or small-sized businesses. And, listen, if you're in the construction industry, if you're in the real estate industry, then mortgage rates are certainly an important factor. They're going to impact your business, the volume of your business. If you are in the auto dealership industry, well, auto loan rates are certainly going to impact your business there.
But for the majority of the entities that our members in the Center for Plain English Accounting serve, we're looking at business loans. Those rates have increased. It ultimately depends on an entity's nature and circumstances and the type of loan. But those rates in many cases now are hitting double digits. They're at 10%, perhaps higher, and certainly that's sticker shock for a lot of entities out there. When you start getting into double digits, company's management certainly take notice. So we're talking about interest rates across the spectrum, but certainly focused more on the rates on business loans.
Amato: You mentioned the Center for Plain English Accounting. Do you want to tell listeners a little bit more about what that organization is and what its goals are?
Durak: Sure, and I'll try to be brief with it. The Center for Plain English Accounting, the CPEA, is — guess you'd call it a national office for CPA firms that don't have national offices. So we act as a national A&A resource center for our member firms. Our member firms are regional and local size firms and plenty of sole practitioners as well. We provide technical A&A advice to them. So if they have an issue, a question on an accounting matter or an auditing matter that they're dealing with at a client, they can submit it to us and we'll give them a written response back to that technical inquiry. We also issued reports every month on technical topics. We try to be, as the name indicates, plain English. We try to provide practical examples and illustrations and make things easier to understand compared to sometimes the very complex wording in an accounting or auditing standard, and we also do webcasts throughout the year for CPE credit. We have a website and you just Google CPEA or the Center for Plain English Accounting at AICPA. You'll be able to find us there and get more information about joining.
Amato: That's great. Thank you, Bob, for that little side trip. What would you say are some of the impacts and audit risks related to rising interest rates or simply high interest rates compared with the previous environment?
Durak: Yeah, well, that's exactly where we're focused at the CPEA on helping our members is really what are the specific impacts of a rising interest rate environment? Because if you think about a practitioner going out to a client and conducting an audit, well, part of their job is to consider external forces and how those forces are impacting the client or the entity.
That's just part of gaining an understanding of the entity in their business environment and conducting a proper risk assessment, and certainly, rising interest rates is an external force that can be a significant factor at many companies. Really it's a major financial consideration that needs to be evaluated, and what we find, too, is that for the medium-sized businesses and entities, for the smaller-sized businesses, they are often more vulnerable to rising interest rates because they don't have the financial flexibility that larger entities may have. But to get more into the specifics here, one of the first areas that comes to mind is debt, and many entities have floating rate debt. As interest rates rise, all their interest costs go up and it becomes more difficult to service that debt. Ultimately, that can lead to a squeeze on cash flows. Practitioners need to be aware of that and see if that perhaps is going on at their clients or at the entities they're serving.
Also, many entities need to get new financing. It's common for entities to continue the operations of their business to get financing, and the interest rates are much higher now, so it's not as easy to access cheap financing, and so those costs are going up. I think it's important when you're at an entity just to consider what kind of debt they have on their books and how these rising interest rates may be impacting them. Another area that comes to mind is the valuation of investments. We know that when it comes to measuring investments or derivatives, often that involves interest rates. Many fair value measurements are based on interest rates. So is the measurement being performed on that investment or on that derivative taking into account the current interest rate environment? Are they reflective of the prevailing rates, or are they really looking at using rates that haven't been updated in some time? Also impairments, sometimes entities have to conduct tests of impairment of assets. That often involves looking at discounted cash flows. OK, well, take a look at that discount rate that's being used there. Is it reflective of the current interest rate environment, or is it outdated and does it need to be adjusted to reflect what interest rates truly are?
Other areas that come to mind are defined benefit plans. Maybe a lot of companies don't have defined benefit plans anymore. But for those that do, we know that many of the amounts and calculations that go into a defined benefit plan are based on interest rates. Do those amounts, do those calculations properly reflect what the interest rates are today? Just overall, I'd say there are plenty of estimates that go into financial statements and into the accounting records, and often those estimates are based on assumptions about the interest rate environment and what interest rates may do in the future. Take a look at those estimates. Take a look at those assumptions. Are they up to date with what's going on today in the interest rate environment? Those are just some of the areas that we're looking at, Neil.
Amato: How do rising interest rates potentially have an effect on the prevalence of fraud in an organization?
Durak: Yeah, we've addressed that in a report we issued not that long ago on this very topic. If you think about some of the things that I've said already, where you've got an entity where rising interest rates are putting a cash flow squeeze on them. Their debt is getting more expensive. It's harder to get financing.
Even beyond that, maybe there's pressure on them because their sales or their revenue may be dropping because their customers are under pressure as well from these rising interest rates. Maybe their customers can't afford the financing that's involved when it comes to purchasing products and services. All of that can increase pressure on management, and we know from understanding fraud and why fraud is committed that increased pressure on management can become a fraud risk factor, and so if you're an auditor, if you're a practitioner, consider that on your engagements. Is the rising interest rate environment having such an impact, adding so much pressure to management, that it does in fact become a fraud risk factor that needs to be addressed in your audit procedures?
Amato: As I've mentioned, my focus is not necessarily a CPA focus because I'm not a CPA, so discussion of the intricacies of FASB Accounting Standards Codifications or ASCs is not super in my wheelhouse, but I've heard enough about ASCs related to revenue recognition and leases over the past few years to understand they are important. What do interest rates have to do with revenue recognition and lease accounting?
Durak: Well, we've been, for a number of years now, heavily involved with those two standards. The new revenue recognition standard some years ago was a big deal for so many of our members. Today the lease standard is taking up a lot of time at our end and for many of our members out there, but there are, in fact, interest rate considerations when it comes to revenue recognition and leases. The revenue recognition standard codified in section 606 of the FASB standards requires one to look at a contract and determine whether or not there's a significant financing component in that contract. Now, maybe in the past when that evaluation was done, it was determined that there is no significant financing component here. But today, similar contracts might have a different determination because interest rates have risen, and that may affect or change the determination of whether a new contract that's similar to those old ones now, in fact, may have a significant financing component.
I just would caution accountants, practitioners to keep an eye open for that when they're looking at contracts and making that significant financing component determination. Maybe it's not as easy and slam dunk as it was in the past. Maybe today because of these rising rates, you might in fact have a financing component there.
When it comes to leases with the new standard ASC Codification Section 842, there are circumstances when one has to remeasure a lease, and if you have to remeasure a lease, you're going to remeasure the lease liability, and you'll have to consider what the current discount rates are on that remeasurement date. Just make sure if that event is occurring and you're making that remeasurement that you are in fact using an appropriate discount rate that is reflecting what the current interest rate environment is today.
Amato: Good advice there, Bob. You mentioned earlier a report that's come out not too long ago. I'm wondering if, as a closing thought, you'd like to say more about that report, which we'll plan to put in the show notes, and also, anything else you'd like to close on. Thank you.
Durak: Yeah, I would, Neil, thanks. We did — not that long ago — the CPEA issued a report on rising interest rate A&A considerations, and that's just part of the monthly reports that we put out for our members. It goes into more detail about these topics that I've been discussing today. It also gets into other topics like going concern and how rising interest rates may impact your going concern evaluations as well. As far as just the closing thoughts, I would just emphasize to practitioners, to CPAs out there that we're not used to high interest rates and to rising rates and we may not be zeroed in and focused on their financial reporting impacts and on the audit risks they may present, so just this time of year and on these year-end engagements, pay a little more attention to what those risks could be, what those impacts may be. Consider those rising interest rates in a variety of financial reporting areas.
Amato: Bob Durak, thank you very much.