Common errors in the interest rate sensitivity analysis
Common errors in the interest rate sensitivity analysis
IFRS 7 Financial Instruments: Disclosures requires disclosure about market risk.
What is market risk?
IFRS 7 defines ‘market risk’ as comprising three types of risk: currency risk, interest rate risk and other price risk (refer to the table below for definitions).
| Risk |
Definition |
|
Currency risk |
The risk that the fair value or future cash flows of a financial instrument will fluctuate because of changes in foreign exchange rates. |
|
Interest rate risk |
The risk that the fair value or future cash flows of a financial instrument will fluctuate because of changes in market interest rates. |
|
Other price risk |
The risk that the fair value or future cash flows of a financial instrument will fluctuate because of changes in market prices (other than those arising from interest rate risk or currency risk), whether those changes are caused by factors specific to the individual financial instrument or its issuer or by factors affecting all similar financial instruments traded in the market. |
What disclosures are required about market risk?
IFRS 7, paragraph 40, requires entities to disclose the following information about market risk:
- Sensitivity analysis: This is required for each type of market risk to which the entity is exposed at the end of the reporting period. Entities must show how profit or loss and equity would have been affected by changes in the relevant risk variable that were reasonably possible at that date (both positive and negative changes).
- Methods and assumptions: Which ones were used in preparing the sensitivity analysis?
- Changes from the previous period: What were the changes to methods and assumptions used, and the reasons for such changes?
This article focuses on common errors we see in practice when entities prepare their interest rate sensitivity analysis.
Common errors
#1: Sensitivity must be based on the entity’s year-end exposure to interest rate risk for each class/type of financial instrument, not the average exposure during the reporting period.
#2: The sensitivity impact on profit or loss and equity must be based on a reasonably possible change in the relevant risk variable (market interest rates). Therefore, the change in the risk variable used in the sensitivity analysis should not necessarily be the same from year to year, particularly given more volatile interest rate movements.
#3: When determining a reasonably possible change in the relevant risk variable, entities must consider changes over the period until the entity next presents its disclosures (usually 12 months).
#4: Only fixed rate instruments are sensitive to interest rate risk. Hypothetical movements on fixed rate instruments should, therefore, not be included in the interest rate sensitivity analysis.
Example
XYZ Limited has the following financial instruments in its balance sheet at 30 June 2026 (year-end):
|
|
$ |
Interest rate |
Fixed or variable |
|
Cash |
200,000 |
2% |
Variable |
|
Term deposits |
300,000 |
5% |
Fixed until 30 September 2026, then a variable rate of 3% |
|
Deposits at call |
400,000 |
3% |
Variable |
|
Bank overdraft A |
3,000,000 |
7% |
Variable |
|
Bank overdraft B |
500,000 (average balance drawn during the year was $200,000) |
8% |
Variable |
|
Bank loans |
10,000,000 |
5% |
Fixed for two years |
XYZ Limited considers a 50 basis points (0.5%) change to market interest rates to be reasonably possible over the next 12 months.
XYZ Limited discloses the following interest rate sensitivity analysis in its 30 June 2026 financial statements.
|
|
Impact on profit or loss |
Impact on profit or loss |
|
|
$ |
$ |
|
Cash |
1,000 |
(1,000) |
|
Term deposits |
1,500 |
(1,500) |
|
Deposits at call |
2,000 |
(2,000) |
|
Bank overdraft A |
15,000 |
(15,000) |
|
Bank overdraft B |
($1,000) |
$1,000 |
|
Bank loans |
(50,000) |
50,000 |
Analysis
The above interest rate sensitivity disclosures are only correct for cash and deposits at call. Corrected sensitivity disclosures for term deposits, bank overdrafts and bank loans are shown below.
|
|
Initial calculations |
Impact on profit or loss |
Impact on profit or loss |
|
Cash |
Correct |
1,000 |
(1,000) |
|
Term deposits Note 1 |
Incorrect |
1,125 |
(1,125) |
|
Deposits at call |
Correct |
2,000 |
(2,000) |
|
Bank overdraft A Note 2 |
Incorrect |
(15,000) |
15,000 |
|
Bank overdraft B Note 3 |
Incorrect |
($2,500) |
$2,500 |
|
Bank loans Note 4 |
Incorrect |
N/a |
N/a |
Note 1: Term deposits
These are at a fixed rate until 30 September 2026, after which they revert to a variable rate. The sensitivity calculation of $1,500 is incorrect because it assumes a 0.5% change over the next 12 months as a whole (see common errors #3 and #4). The correct sensitivity calculation is as follows:
$300,000 X 0.5% X 9/12 months = $1,125
Note 2: Bank overdraft A
The amount disclosed for sensitivity of 0.5% X $3,000,000 = $15,000 is correct. However, the direction of the profit or loss impact is incorrect. That is, if there is a 50 basis points increase in market interest rates, the impact on the interest expense in profit or loss would be a $15,000 reduction in profit; if there is a 50 basis points decrease, the interest expense would be $15,000 lower, thereby increasing profit.
Note 3: Bank overdraft B
The amount disclosed for sensitivity of 0.5% X $200,000 = $1,000 is incorrect because it has been based on the average exposure during the year instead of the year-end exposure (see common error #1). The correct sensitivity calculation is as follows:
$500,000 X 0.5% = $2,500
Note 4: Bank loans
Bank loans bear a fixed interest rate for two years. Therefore, no sensitivity needs to be disclosed because there would be no impact on profit or loss if the market interest rate moved by 0.5% in the next 12 months.
What if interest rate changes are more volatile?
In our example, at 30 June 2026, XYZ Limited considers a 50 basis points (0.5%) change to market interest rates to be reasonably possible over the next 12 months.
To avoid common error #2, XYZ Limited should carefully consider whether this assumption is valid, particularly considering that there have already been two 25 basis points increases in February and March 2026, with more expected given current geopolitical events.
Need help
Preparing IFRS 7 disclosures can be complex. Please reach out to IFRS & Corporate Reporting experts for help.