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Finance

Federal Funds Rate: Potential Accounting Effects of a Rate Change

Kara Peterson  

Kara Peterson  

For months, investors have been betting on whether the Federal Reserve will change its target range for the federal funds rate. The target range is currently 2.25 percent to 2.50 percent.

Federal Funds Rate

In June, Federal Reserve Chairman Jerome Powell left the door open to cut the federal funds rate. The move sent analysts and investors into a tizzy, scrutinizing every move of the Fed to pinpoint the date, time, and amount of a possible rate cut. The next meeting of the FOMC is scheduled for July 30-31. Testimony by Powell before Congress on Wednesday strengthened expectations of a 25-basis point cut at the July meeting.

Many watching the federal funds rate are interested in the trajectory of the economy.  Accounting professionals, however, also may be wondering about the potential accounting effects of a rate cut. In fact, we’ve asked this question ourselves:

If the Fed does cut rates, what are some potential accounting effects?

Below are a few possible accounting effects to keep in mind. As you analyze your particular facts and circumstances, you may identify other effects as well.

Valuations

A federal funds rate cut can affect the valuations of numerous assets and liabilities. For instance, a rate cut generally increases stock prices. Keep in mind, though, that investors try to anticipate future actions of the Fed. Therefore, you’ll typically see a bump up in the stock market starting even before a rate cut happens.

You should also look closely at places where you use discount rates for valuations.  Your discount rates will need to be adjusted. For instance, you may measure assets and liabilities at fair value using a discounted cash flow technique under Topic 820, Fair Value Measurement. Also, the discount rate is a key assumption used to measure a pension obligation under Topic 715, Compensation—Retirement Benefits.

If you have derivatives, these may also be affected. In particular, derivatives tied to interest rates or foreign currencies (such as an interest rate swap or a foreign currency swap) may be impacted.

Impairments

Impairment analyses generally involve comparing an asset’s carrying amount to its fair value. An asset’s fair value may be impacted by a rate cut. In turn, this can affect whether the asset is impaired and the amount of any impairment recorded.

Also, consider available-for-sale debt securities. Prior to adopting Accounting Standards Update (ASU) No. 2016-13, Financial Instruments—Credit Losses (Topic 326), you generally have to separate an other-than-temporary impairment into two parts:

  1. The credit portion. This is the impairment due to changes in the issuer’s credit. You record the credit portion of the impairment in earnings.
  2. The non-credit portion. This is the impairment due to other factors (such as changes in interest rates). You record the non-credit portion of the impairment in other comprehensive income.

A federal rate cut would imply that a portion of the other-than-temporary impairment is due to changes in interest rates and must be recorded in other comprehensive income.

Debt

If you have variable-rate debt, you are likely hoping for a rate cut. A rate cut will help alleviate your interest payments.

If you are stuck with a fixed interest rate, a rate cut might prompt you to renegotiate the terms of your debt. For instance, you may ask to switch from a fixed to a floating rate or request a lower interest rate. If your creditor agrees to revised terms, you must account for the debt restructuring according to Topic 470, Debt. The exact accounting depends on whether the restructuring is considered a troubled debt restructuring, a modification, or an extinguishment of the debt.

You might also be looking to refinance your debt soon if you have a balloon payment approaching. A rate cut would help you get a better interest rate when you refinance.

Foreign currency matters

A federal funds rate cut in the U.S. generally would make U.S. bonds less attractive compared to investments in other countries. This can weaken the U.S. dollar, at least temporarily.  Over time, a weaker U.S. dollar can make U.S. products less expensive for customers abroad, increase U.S. product demand, and move exchange rates back the other direction.

Foreign currency transactions are accounted for under Topic 830, Foreign Currency Matters. Changes in foreign exchange rates must be captured when applying Topic 830. If you have limited foreign currency transactions, it is appropriate to translate each one using the exchange rate in effect on the day of the transaction. If you have many foreign currency transactions, it may be impractical to do this. Therefore, Topic 830 allows use of a weighted average exchange rate for the period.

Income taxes

Changes to the amounts recorded in an entity’s financial statements may have tax implications. For instance, changes in investment valuations affect realized or unrealized gains or losses, which ultimately impact deferred tax assets and liabilities.  Therefore, entities must ensure that any tax effects of a rate change are appropriately reflected.

Disclosure

A federal funds rate change may warrant disclosure in your financial statements. The degree of disclosure depends on the nature and materiality of a rate change to the financial statements. It may be appropriate to provide disclosure in not only annual but also interim periods. The disclosures might appear in various parts of an entity’s SEC filing. In addition to the footnotes, an entity also might consider disclosure in its risk factors, quantitative and qualitative disclosures about market risk, management’s discussion and analysis, or business description (such as for a financial institution).

Brace yourself for the coming weeks as we continue to watch the Fed’s decision on interest rates. Analysts and investors will remain on the edge of their seats, sniffing for clues to predict the outcome of the July FOMC meeting. Although many currently expect a 25-basis point rate cut, could we be in for a 50-basis point cut? Or none at all? If market forces shift in the coming weeks, all bets are off!

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