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The effect of inflation on financial statements
2022 saw the rise of inflation in almost all major economies around the world. It reached over 10% in both the European Union and the UK in August 2022, with the US inflation rate being only marginally lower at 8.2%. In most cases, these were the highest inflation rates since the early 1990s. The rapid increase in inflation is the result of several factors, including fiscal stimulus measures made in response to the COVID-19 pandemic, the effects of the war in Ukraine, particularly on energy prices, and strong consumer demand for goods and services following the opening of borders and easing of restrictions put in place during the pandemic.
While Australian inflation is high, other major developed economies have been even more dramatically affected. US inflation reached 9.1%, while many European economies have seen inflation spike over 10%, with gas and other energy costs being a particularly significant factor due to the uncertainty around the supply of hydrocarbons from Russia, following the Russian invasion of Ukraine.
Given that similar levels of inflation have not been seen for over 30 years, many businesses and finance professionals will have limited experience of operating in such a high-inflation environment. In this article, we will consider the potential impact on financial reporting of changed inflation conditions.
Impairment Assessments
Most impairment assessments are based on forecasts of future cash flows, either in a fair value model or a value-in-use model Judgements and estimates used in impairment reviews to determine future cash flows should be based on current and forward-looking information. This will require more frequent and thorough review of key assumptions, particularly in areas relating to future cost estimates. Indeed, for some materials, such as microchips, it may be necessary for management to consider carefully whether they can be obtained at all, or whether supply-chain disruption will be a limiting factor on potential business growth.
Rapidly rising interest rates mean that the discount rate used in impairment assessments is also likely to need revision. Most discount rates are based on the weighted average cost of capital (“WACC”) and both the cost of debt and the cost of equity are likely to see some level of increase. Ensuring that the discount rate appropriately matches the cash flow is increasingly important. Nominal cash flows, which include the effects of inflation, must be discounted at a nominal rate, while real cash flows, which exclude the effects of inflation, must be discounted at a real rate.
Inflation assumptions are increasingly likely to have a material impact on impairment assessments, or indeed other areas of the financial statements. Where this is the case, disclosure should be provided about how assumptions relating to future levels of inflation have been determined, and the sensitivity of impairment assessments to changes in these assumptions.
Fraud Risks
The rising cost of living has placed many household budgets under significant financial pressure, particularly where wage increases have not kept pace with living expenses. This may lead to a greater risk of misappropriation of assets by desperate or disgruntled employees, a risk which has been heightened by the recent levels of high employee turnover experienced by many businesses. It may also mean that there is a greater incentive or pressure to meet budgets or performance hurdles, particularly where these are linked to bonuses. Inflation makes comparisons between periods more difficult, meaning that unusual or unexplained variances may not be noticed as quickly.
Directors should review their internal controls relating to fraud, and ensure they have robust systems and processes in place, noting any increased risks due to employee attrition.
Revenue
Pricing structures of contracts with customers might need to be reassessed in order to maintain profitability. In some industries, existing longer-term contracts could become onerous and should carefully be assessed under IFRS 15 Revenue from Contracts with Customers, particularly where the contract was quoted at a fixed price some time ago, and there is no ability to pass increased supplier costs through to the end customer. Where a contract is onerous, it may be necessary to bring forward the recognition of any loss expected on the contract.
There may also be an impact on the recoverability of debtors and the assessment of expected credit losses, as customers’ ability to pay may be reduced leading to an increased risk of default.
Other cost factors
Various operational costs such as employee expenses, fuel, gas and distribution costs may rise and reduce profit margins. Variable interest rates implicit in lease contracts could also lead to higher lease payments, which can also impact profitability.
Going concern
Any of the above items may have an impact on the going concern assumption of an entity or may increase the risk that a material uncertainty could be present.
Parent companies may be required to provide more support to other group companies impacted by the rise in inflation but may themselves have reduced capacity to provide support.
Increasing interest rates could lead to an increase in debt repayments, which could put a strain on some entities’ cash flow. Extra focus should be placed on covenants if it appears these may be breached, particularly ones related to interest cover or similar metrics. Where covenant breaches do occur, it is important to negotiate any waiver with the lender prior to the balance sheet date, or the debt will need to be classified as current.
The recoverability of deferred tax assets may also be impacted by changes to forecasts performed by entities.
More hedging arrangements may be entered into to mitigate risks of cash flow and assessing this may require the use of audit specialists. Greater inflation and interest rate volatility may have an impact on the effectiveness in hedging relationships. This may increase the likelihood of hedges not meeting the relevant effectiveness tests, which could generate income statement volatility.
If you have any questions, please contact your local RSM adviser.
