04 Aug How rising inflation is impacting the financial statements
The ongoing supply chain issues, mainly due to the Covid-19 pandemic, along with the rising cost of fuel, energy, and raw materials, because of the Russian invasion of Ukraine, are having adverse effects on most companies around the world. Many of those companies are forced to pass on the increased costs to consumers, albeit reluctantly.
According to the World Economic Forum, inflation rates have doubled in 37 of 44 advanced economies over the past two years. For the current year, the European Economic Forecast report is estimating inflation to reach a new record high of 8.3% with Cyprus experiencing an expected inflation of 7%.
Rising inflation is having a significant impact on the financial performance and position of companies. The areas that are most affected are:
- Profit margins
- Pricing structures
- Going concern disclosures
- Risk and cash flow forecasting
- Debts including variable-rate loans
- Business rent
With this in mind, two questions are important: What is the impact of inflation on financial statements? How can a company deal with rising inflation?
1. Increasing cost requires revisiting and restructuring the existing business model
Most companies around the globe were adversely affected by Covid-19 and are expected to face difficulties in dealing with inflationary increases. During the last couple of years, they made substantial use of their cash reserves to survive something that negatively impacted their financial position.
Companies will not pass on any inflationary increases and, most probably, will try to absorb the price hike themselves using their remaining cash reserves. But this strategy will not last long. If the cost cannot be passed on to customers, their profitability and cash flow will clearly be destroyed.
Things are expected to be challenging enough for companies operating in a highly competitive environment and a B2C model where individuals have less disposable income with reduced purchasing power, as they did not have to push through price increases before.
Companies can do this in a very simple way. They need to apply a holistic approach strategy by making a “root and branch” review of the entire business.
As far as the company cannot control or change what is happening externally, it should look internally to survive. In turbulent times where few things can be done, it is important to focus on what can be controlled.
Companies need to look at ways to make their business model leaner to be better able to absorb inflationary pressures.
Companies must look at existing supply contracts and talk to suppliers. It is important to renegotiate costs and lock in better prices to avoid future climbs, especially for those companies that are heavily reliant on purchases or sales in foreign currencies as the exchange rates are expected to be affected by the current condition.
A revised agreement that captures the current conditions will be beneficial for both parties as a decrease in the business’ sales will cause a decrease in the volume of purchases for the supplier. Probably, sharing the additional cost could be a good idea here.
Furthermore, companies must analyse every aspect of their business from the cost side, revenue, overheads (due consideration must be given to that), and pricing to give themselves the best opportunity to withstand all these inflationary pressures. If companies manage the cost that they can control, this can enhance their ability to maintain their margins.
Key takeaway: Renegotiate existing contracts, enhance efficiencies, and cut internal costs to maintain margins on profit and loss statements.
2. Revisit the pricing model and maintain customer confidence
Another important effect of the current economic conditions has to do with companies and consumer confidence. This is clearly starting to take a tumble. This will only make things more difficult when companies are trying to forecast profit and loss and cash flows.
They must review their pricing model. To be efficient they need to engage with their customers and talk to them. They must make this conversion happen. Through this communication, they will help them understand the reasons for the increases and find a common solution. Sharing this increase could be a win-win solution.
Honesty is important when establishing business relationships. It is vital for companies looking to overcome this to be open and honest with customers about the reasons why prices need to increase.
Additionally, if considered necessary, they may need to re-price any no-profitable work or operations so if the work is lost, it does not have a significant impact on other operations.
Also, companies will need to put a lot of energy into the budgeting and cash flow process that supports going concern assumptions.
Key takeaway: Revisit pricing strategies and be honest with customers on reasons for price increases.
3. Going concern issue
It is important for the company directors to be aware that, by signing accounts, they are stating (and thus confirming) that the company will continue as a going concern for the next 12 months.
In terms of going concern disclosures, it’s about balance sheet strength and the ability to withstand the erosion of the bottom line. During the Covid–19, they went through a torturous period taking a lot of debt to survive. The rising inflation coupled with the expected rise of interest rates will make the debt more difficult to manage, something that will lead to an increase in businesses with going concern issues.
The current economic environment embeds a lot of uncertainties, something that requires auditors to undertake increased work to test whether the going concern assumption is sensible. They will be asking directors for far more evidence to support that assumption than usual.
Directors, on the other hand, are expected to produce budgets and cashflows for at least that period and these will need to be stress tested. Rising inflation only increases the risks behind these assumptions.
Key takeaway: Be prepared to put more work into going concern statements.
4. Financial reports relevancy
It is well known that financial reports mainly include historic information and transactions that already happened. For this reason, rising inflation can quickly make this information irrelevant to users of those reports. Thus, it is important that the management of the companies considers the impact of inflation in their strategic reports, providing this information to the stakeholders and making them aware of the future risk and business impact.
Furthermore, there are certain items in the financial reports like cash and accounts receivable that are recorded at their historic cost rather than at market value and therefore lose their purchasing power when inflation rises.
High inflation, therefore, impacts cash-rich companies and those with long credit terms.
Key takeaway: High inflation may affect the relevance of financial information. Directors need to reflect on the changes and risks of this abnormality in their strategic report in order to inform their stakeholders.
Companies must deal with these unusual inflationary pressures. The duration of this situation is currently unknown and certainly uncontrollable. But the current economic outlook is already affecting and is expected to affect most companies around the world and their reported financial information. It will be prudent for them to balance these inflationary pressures between their suppliers and customers to smooth the impact on their margins and thus on their going concern financial statements.
Companies must not overreact to these conditions. They need to be reform themselves and evolve. This is an excellent opportunity to learn the lessons that can be derived and adjust to a more sustained business mode, one that will help them not just overcome this difficult period but grow and explore any available opportunities that are out there.
Accountancy Programmes Leader at EIMF
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