How rising inflation is impacting the preparation of financial statements

The rising cost of fuel, energy and raw materials along with ongoing supply chain issues, are having adverse effects on businesses, many of which are having to pass on increased costs onto consumers, albeit reluctantly.

Rising inflation and the increased cost of living are also having a significant impact on financial statements, particularly in the following areas:

• Profit margins.
• Pricing structures.
• Going concern disclosures.
• Risk and cash flow forecasting
• Debts including variable-rate loans.
• Business rent.
• Investments.

We spoke to several accountants across the UK to find out more about the issues at play and their tips and advice for dealing with rising inflation.

Revisit pricing strategies, renegotiate existing contracts and cut internal costs

Frank Ofonagoro, MD Quantuma

Rising inflation is having a fundamental impact on financial statements.

Businesses that have been affected by covid-19 and whose cash reserves and balance sheet are not particularly substantial will be unable to pass on any inflationary rises. They may try to absorb the increases themselves with existing cash reserves. But their margins are likely to get absolutely destroyed by this strategy.

In terms of going concern disclosures, it’s about balance sheet strength and the ability to withstand erosion of the bottom line. We’ve just come out of pretty torturous period due to Covid-19 with a lot of businesses taking on a lot of debt. This, coupled with interest rate rises and rising inflation will make debt more difficult to manage and will led to an increase in businesses with going concern issues.

A lot of clients are also telling us they’re worrying about having conversations about price increases with customers and are seeing it as a last resort, preferring instead to cut costs internally.

Businesses should instead adopt a ‘root and branch’ review of their entire business and take a holistic approach.

Next steps: I’d advise the following as a holistic approach strategy

• Look at ways to make the business as lean as possible to be better able to absorb inflationary pressures.
• Review pricing models by engaging with customers and having those conversations.
• Look at existing supply contracts to renegotiate costs and lock in better price.

Businesses need to encompass every aspect of their business from the cost side, revenue, overheads and pricing to give themselves the best opportunity to withstand what is hopefully medium-short term inflationary pressures.

Verdict: Adopt a holistic approach to inflationary pressures: revisit pricing strategies, renegotiate existing contracts and cut internal costs where possible.

Be prepared to put more work into going concern statements

Martin Longmore, Partner, Monahans

Directors signing off their accounts need to be aware that in doing so, they are implicitly stating that the company will continue as a going concern for the next 12 months.

Because of the uncertainty inherent in the economy currently, auditors are having 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 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.

Inflation is also having an impact on:

• Business and consumer confidence – which is clearly starting to take a tumble. This will only make life more difficult for directors and auditors when they are trying to forecast profit and loss and cash flows over the next 12 months.
• Supply chains. These have been under significant pressure over the past few years due to COVID-19 and Brexit and are now being exacerbated by the impact of inflation.
• Payroll costs and employee retention. Companies are finding it hard enough to retain staff in an increasingly competitive jobs market, let alone hire more workers to plug skills gaps. The focus now is headline rates of pay which is driving up costs.

Next steps:  Businesses should look to lock in prices as much as possible to avoid any future hikes (particularly exchange rates if heavily reliant on purchases or sales in foreign currencies).

Additionally, companies will need to put a great deal more work into the budgeting and cash flow process that supports going concern assumptions.

Verdict: Be prepared to put more work into going concern statements.

Be honest with customers on reasons for price increases and be open to new ways to increase efficiencies

Mandy Janes, Partner, HW Fisher

Financial statements look at historical information, thus rising inflation can quickly make this information increasingly irrelevant. It is therefore important for directors to consider the impact of inflation in their strategic reports to ensure stakeholders are aware of the future risk and business impact.

Profitability and cash flow will clearly be impacted by inflationary increases if the increase in costs cannot be passed on to customers. Many businesses have not had push-through price increases before and will find this challenging, particularly in highly competitive markets and for B to C businesses where individuals have less disposable income.

Certain items such as cash and accounts receivable are held at historical value rather than market value and therefore lose their purchasing power as inflation rises. High inflation, therefore, impacts cash-rich businesses and those industries with long credit terms.

Next steps:

• Be open to new ways of doing things to increase efficiencies, reduce costs or to extend revenue-generating activities within the business.
• Where necessary re-price any non-profitable work so if the work is lost, it does not have a significant impact.
• Ensure inflationary price increases are put through every year as standard.
• Be open and honest with customers on the reasons why prices will need to increase.

Verdict: Be honest with customers on reasons for price increases and be open to new ways to increase efficiencies or reduce costs.

Annie Makoff is a freelance journalist and editor.