The diverse impacts of inflation on accounting
Heightened inflation is causing consumers and businesses significant concern. While data released for April 2022 indicated a slight decline from the 8.5% increase in the Consumer Price Index (CPI) seen the month prior, April’s CPI still represented inflation near a 40-year high. Consumers and businesses are feeling the pressure of inflation in their daily lives and operations.
Inflation impacts businesses’ reporting on several fronts, from assets and liabilities to the bottom line of revenue and expenses. Here’s a look at key inflation considerations and their impact on accounting:
Going concern considerations
An entity is required to evaluate whether there is substantial doubt about its ability to continue as a going concern for 12 months from the financial statement issuance date. Increased prices for the entity as well as consumer spending changes may result in lower profit margins and overall net losses.
An additional concern would be multiyear agreements an entity may have locked into that prevents the entity from further adjusting their prices received to better align with the increased inflationary costs. If substantial doubt exists about the entity’s ability to continue as a going concern, whether remediated or not, additional disclosure requirements come into play.
Heightened inflation (along with other current economic factors) has led to unprecedented bond market volatility. Entities with large portfolios of available for sale (AFS) securities have seen significant swings in unrealized gains/losses since December 2021, and these swings may be more drastic depending on the length of maturities held in the portfolio.
An option that entities may consider to reduce potential future volatility is the sale of AFS securities or transfer of the AFS securities to “held to maturity” (HTM) classification. However, additional considerations may need to be evaluated for this option, including: If an entity can no longer hold a security to maturity and sells the security, the sale may taint the rest of the HTM portfolio.
HTM securities will be evaluated under ASU 2016-13’s current expected credit losses (CECL) model for anticipated credit losses once the entity adopts the new standard set to be in effect for all remaining entities for periods beginning after December 15, 2022.
Inventory is required to be recorded at the lower of cost and either net-realizable value or market. The primary acceptable methods of determining cost are: first-in first-out (FIFO), average cost, last-in first out (LIFO), and retail inventory method. The selected method must be applied consistently from one period to the next. Some methods, like LIFO, may result in lower profit margins during periods of high inflation based on the associated costs used in determining the cost of goods sold.
Because the Federal Reserve raised its target federal funds rate in March and is expected to continue rate increases over the remainder of 2022, entities may want to refinance their variable-rate debt to lock in fixed rates rather than risking the potential for additional increases, which in turn lessens their purchasing power and margins. Accounting for loan refinancings or restructurings depends on whether it is a troubled debt restructuring, a modification or an extinguishment of the debt, which will further impact disclosure requirements.
As many long-term, multiyear lease agreements adjust required payments based on inflation, lessors must continue to evaluate leases for collectability and may need to consider recording or updating the allowance for credit losses as appropriate.
Some securities contain embedded derivatives intended to protect an investor from inflation. Entities must evaluate whether they have an embedded derivative and account for such a derivative separately from the host contract under Topic 815, Derivatives and Hedging. Keep in mind that inflation impacts interest rates and foreign exchange rates that many derivatives may have as indexes, which will impact their recorded values.
Foreign currency matters
Foreign currency transactions are required to be translated and recorded using the exchange rate in effect on the day of the transaction, and those exchange rates are influenced by inflation.
Revenue and expenses
Increasing costs for consumers means less discretionary income, which may affect the demand for an entity’s products (lower revenue) and also the customer’s ability to pay on outstanding receivables. An entity’s expenses will also increase, thus reporting entities should be prepared to explain signficant increases in expenses due to significant increases in costs such as material, transportation and labor costs.
Many of the aforementioned considerations may also have tax implications. For example, the AFS unrealized gains/losses changes noted above for a C corporation will have a direct impact on recorded deferred tax assets and liabilities.
Fair value measurements and impairments
The three approaches for measuring fair value under ASC Topic 820 include: market, income and cost. Each of these approaches is affected by significant inflationary changes as we are currently experiencing.
|Market||Price changes must be considered to ensure valuations are current.|
|Income||Changes in market participant assumptions must be considered for the expected cash flows and the discount rate used, to name a couple of examples. Cash flows may be expected to decline due to the compressed margins caused by additional inflationary costs and less discretionary income for customers to spend. Discount rates are typically higher during inflationary periods.|
|Cost||Current replacement cost must be considered, which will show increases due to high inflationary rates.|
A change in market conditions is a situation under FASB ASC 820-10-35-25 that may warrant a change in valuation technique or its application as an exception to the general requirement to apply the same valuation technique consistently each period. Since impairment evaluations often consist of comparing an asset’s recorded value to fair value, the aforementioned considerations for fair value changes due to inflation may impact impairment analyses.
Other valuations, such as pension and other postretirement obligations, fluctuate based on underlying values, which are more sensitive to change in an inflationary environment. Some examples include discount rates, as previously mentioned, health care cost trend rates, investment values, etc.
How Wipfli can help
Rising inflation has specific accounting implications for every organization. To find out how inflation may impact your financial reporting and what adjustments may be necessary, contact Wipfli.
Learn more about extensive Wipfli’s accounting and audit services.
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