What Impact Will Inflation Have on Your Client’s Company Financial Statements?
With inflation at its highest level in 40 years, business owners are reasonably concerned about how their businesses will be impacted. Knowing the effects inflation can have on the bottom line of a company can be crucial in preparing your clients for the sale of their business.
The Consumer Price Index (CPI), which looks at shelter, food, clothing, transportation, medical, dental, medication and similar goods and services that people need for living on a daily basis has rapidly increased by 8.3%, according to the most recent figures from the U.S. Bureau of Labor Statistics. Similarly, the producer price index. which gauges the rate of inflation prior to hitting consumers, has risen by 11% over last year, barely decreasing from March’s 11.2%, which was the highest increase for wholesale inflation on record.
As inflation continues, there are several major impacts that you may see in your client’s company. Overall, inflation often increases a company’s direct costs of production while lowering consumer demand for discretionary services and goods. In many cases, unless business owners can pass cost increases to their clients, they may spread past the company’s gross margin. Here’s how several other factors in your clients’ financial statements can be affected by the high rate of inflation we’re seeing.
- Debts: Does your client’s business have loans? If they have variable interest rates, their interest rate may fluctuate. The Federal Reserve has threatened to raise interest rates at the fastest rate in 40 years to reduce inflation. The federal rate was raised 0.5% in May, with additional increases expected over 2022. Companies with variable-rate loans should switch to fixed-rate loans or apply for additional credit to lock in lower rates before the rate is increased again, while others reduce debt. Depending on the restructuring approach, it can be reported as modification, extinguishment of debt or troubled debt restructuring.
- Inventory: Companies use a wide range of methodology to determine the cost of inventory, which can include first-in first-out (FIFO), last-in first-out (LIFO) and average overall cost. Given that the U.S.’s Generally Accepted Accounting Principles, or GAAP, measures inventory at the lower of either cost or market value/net realizable value, inflation can have an impact on the method that a business should choose. This in turn can impact your client’s company profits as well as their ending valuation of inventory. This process also causes a range of trickle-down impacts on tax liability.
- Investments: Inflation makes public markets more volatile. As market values change the value of a company’s investments, realized or unrealized losses or gains may result. This will impact the company’s deferred tax liabilities and assets under GAAP practices. Because there are greater concerns about how inflation can impact the market, companies may wish to revisit their investments and overall investment strategy. This shift may require a change to a new method of accounting or even specific or special disclosures in their financial statements.
- Overhead Expense: From lease agreements to service provider contracts, many company contracts may feature escalation clauses which have been tied to the CPI or similar inflationary measurements. If it does, a company may see increases in lease, contract or service payments. In a similar approach, other vendors or service providers may implement a rate increase during these already difficult times to protect their own profits, as their own overhead expenses increase during the inflationary periods.
- Going Concern Disclosure: Is the ongoing inflation creating a higher risk that your client’s company will be able to continue in the future? During each reporting period, your client’s company management will need to consider if there are doubts about their ability to continue operating successfully. If there are problems emerging that create substantial doubt that your client’s company will be able to meet its obligations on time over the next year, it’s time to have them revise their existing budgets. As inflation soars, companies that are unprepared to deal with the impact may fail.
- Goodwill: To properly estimate the fair value of goodwill that is acquired during a period of inflation, businesses using GAAP processes should be consistently applying the same valuation technique every period. However, assumptions underlying the fair value estimates can change with inflation. For example, market participants often use higher discount rates when in an inflationary period, due to expected revised cash flows as expenses rise, customer behavior changes and product pricing is modified, impacting goodwill estimates.
Debra Smith, CPA
Director of Marvin & Co., Albany, NY
Debra Smith, CPA is a Director at Marvin and Company and has over fifteen years’ experience in providing services to businesses, individuals and not-for-profit organizations. Marvin and Company is a Latham and Queensbury, New York firm of certified public accountants and consultants that has been providing accounting, audit and tax services to New York’s Capital Region since 1923 (www.marvincpa.com).