As companies plan year-end financial reporting, it’s important to consider the implications of inflation and rising interest rates, which can affect financial reporting in many ways, as discussed below. Many of the financial reporting areas affected involve impairment or valuation analyses, which often hinge on discounted cash flow models. As a result, developing estimates of future cash flows and related inputs (e.g., discount rates) may be more challenging than in prior periods. Management also should avoid over-relying on historical trends in these uncertain times.
Key financial reporting considerations include those listed below.
Inflation can increase in the cost of raw materials, wages, energy to product goods, and fuel costs for transportation. If sales prices don’t increase correspondingly, for example, due to long-term fixed-price contracts, or demand decreases for non-essential goods (or changing to lower priced goods), companies may be required to write down inventory to the lower of cost or market if using LIFO or retail inventory method, or the lower of cost or net realizable value for all other methods.
2. Financial Instruments, including trade receivables
Inflation and rising interest rates can affect the fair value of all types of financial instruments. All companies should disclose qualitative and quantitative information about the allowance for credit losses (e.g., allowances for bad debts or doubtful accounts), including estimates and assumptions.
3. Impairment of non-financial assets
When companies use a discounted cash flow approach to measure fair value of an asset or reporting unit, a higher discount rate decreases fair value. Therefore, companies may have more assets at risk for impairment than last year, due to the increase in interest rates. Management also should carefully consider forecasted cash flows. Inflation may cause a company’s costs to increase. If sales prices don’t increase correspondingly, for example, due to long-term fixed-price contracts, or demand for the company’s goods and services decreases due to higher prices, then margins and profits may compress, which decreases the fair value of the asset.
4. Business combinations
In a business combination, the acquirer recognizes most acquired assets and liabilities at fair value, with some exceptions. Management may determine the fair values using a discounted cash flow technique. It is important to carefully estimate future cash flows and use an appropriate discount rate in times of inflation and rising interest rates.
Inflation may lead companies to hedge interest rate risk. As the accounting can be complex, management should consider requirements before concluding on the appropriate accounting treatment.
Companies may struggle to repay their debt because of inflation and rising interest rates. Management may renegotiate debt terms, including payment terms, interest rates, or debt covenants.
7. Supplier finance program obligations
These programs (also referred to as reverse factoring, payables finance, or structured payables arrangements) allow a buyer to offer its suppliers the option to be paid for confirmed valid invoices by a third-party finance provider before the invoice due date. Management needs to determine the appropriate accounting and presentation for these programs. Good controls are critical to ensure that the accounting and financial reporting functions are aware of the existence and terms of the programs, which may require increasing coordination with the purchasing and treasury functions. Companies also should appropriately disclose the existence of these arrangements.
Higher interest rates can affect a lessee’s incremental borrowing rate (IBR), which it uses to measure the right-of-use asset and lease liability for a new lease or upon certain modifications. Management should be careful to determine the right IBR (or risk-free rate) for each new or modified lease, and not just assume that the rates used for prior leases still apply. Variable lease payments also affect the measurement of right-of-use assets and liabilities. Variable lease payments that depend on an index or a rate are included in the lease payments and are initially measured using the index or rate at the commencement date.
9. Revenue recognition and loss (onerous) contracts
Some companies that recognize revenue over time measure progress toward satisfying the performance obligation using input methods. Those companies should consider how inflation affects the estimate to complete the performance obligation, which affects the percent complete and therefore, the revenue recognized.
10. Employee benefits
Inflation can affect actuarial assumptions used in measurement of defined benefit plans and other long-term employee benefits. For example, higher interest rates on corporate bonds typically lead to higher discount rates in actuarial valuations, which decreases post-retirement obligations. Assumptions about future salary increases and health care costs also should be reassessed considering inflation. Management also should consider how inflation and rising interest rates affect future funding requirements.
11. Share-based payment
The risk-free rate is one of the inputs to option-pricing models. In times of rising interest rates, management needs to determine the appropriate risk-free rate to use when determining the fair value of an option for measuring share-based payment expense.
12. Taxes and realizability of deferred tax assets
Management must evaluate all available evidence to determine whether to recognize a valuation allowance for deferred tax assets. It can be even more difficult than normal to project future taxable income in times of rapid inflation. As a result, management should carefully evaluate whether to recognize a valuation allowance.
13. Government grants and assistance
Companies that receive government grants and assistance need to determine the appropriate accounting and assess whether the disclosure requirements of government assistance apply.
14. Risks and uncertainties
Risks and uncertainties can stem from the nature of a company’s operations, the use of estimates in the preparation of the financial statements, or significant concentrations in a company’s operations. Inflation and rising interest rates affect many company’s operations, though the extent varies. If it becomes known prior to the issuance of the financial statements that it is at least reasonably possible that significant estimates will change in the near future and the change would be material, companies should add disclosure. Companies may have concentrations that present greater risk to the financial condition or results of operations, such as customers, suppliers, geographic locations, and products.
15. Going concern
If a company is particularly hard-hit by inflation with respect to cash flow forecasts, or has floating-rate debt, management may need to consider its assessment of the company’s ability to continue as a going concern.
Inflation and rising interest rates can affect financial reporting in many ways, depending on the company and industry. Management should avoid over-reliance on the past. Rather, these uncertain times call for careful judgments and estimates of future cash flows and other inputs into the financial statements.