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The Thomas Howell Ferguson Blog

How Inflation Could Affect Your Financial Statements

Business owners and investors are understandably concerned about skyrocketing inflation. Over the last year, consumer prices have increased 8.3%, according to the latest data from the U.S. Bureau of Labor Statistics.

The Consumer Price Index (CPI) covers the prices of food, clothing, shelter, transportation, medical services, and other goods that people buy for day-to-day living. This increase was 0.2% smaller than the figure for the period ending in March, which was the highest 12-month increase since December 1981.

Meanwhile, the producer price index (PPI) is up 11% over last year. This was also 0.2% smaller than the figure for the period ending in March, which was the largest increase on record for wholesale inflation. PPI gauges inflation before it hits consumers.

Inflation Key Impacts

For your business, inflation may increase direct costs and lower customer demand for discretionary goods and services. This leads to lower profits — unless you’re able to pass cost increases on to customers. However, changes to gross margin are not the only possible effects. Below are seven other possible impacts of today’s high rate of inflation on your financial statements.

1. Inventory

Inventory is measured at the lower of cost and market value, or net realizable value, under the U.S. Generally Accepted Accounting Principles (GAAP). Methods that companies use to determine inventory cost include average cost, first-in, first-out (FIFO), and last-in, first-out (LIFO). The method you choose affects profits and the company’s ending inventory valuation. There also might be trickle-down effects on a company’s tax obligations.

2. Goodwill

Companies that use GAAP are supposed to apply consistent valuation techniques from period to period to estimate the fair value of acquired goodwill. However, the assumptions underlying fair value estimates may need to be revised as inflation increases. For instance, market participants typically use higher discount rates during inflationary periods and might expect revised cash flows due to rising expenditures, changes in customer behaviors, and modified product pricing.

3. Investments

Inflation can lead to volatility in the public markets. Changes in the market values of a company’s investments can result in realized or unrealized gains or losses, which impact deferred tax assets and liabilities under GAAP. Concerns about inflation may also cause a company to revise its investment strategy. This may require new methods of accounting or special disclosures in the financial statement footnotes.

4. Foreign Currency

Inflation can affect foreign exchange rates. As exchange rates fluctuate, companies that accept, hold, and convert foreign currencies need to ensure they’re capturing the correct rate at the appropriate point in time.

5. Debts

If your company has variable-rate loans, interest costs may increase as the Federal Reserve raises interest rates to counter inflation. The federal funds rate was increased 0.5% by the Fed in May. Throughout 2022, these rates are expected to increase further. Businesses might decide to convert variable-rate loans into fixed-rate loans or apply for additional credit now to lock in fixed-rate loans before the next rate hike. Others may restructure their debt.

6. Overhead Expenses

Long-term lease agreements may contain escalation clauses tied to CPI or other inflationary measures, which leads to increased lease payments. Likewise, vendors and professional service providers may increase their prices during times of inflation to preserve their own profits.

7. Going Concern Disclosure

Each reporting period, management must evaluate whether there’s substantial doubt about the company’s ability to continue as a going concern. Substantial doubt exists if it’s probable that the entity will be unable to meet obligations as they become due within 12 months of the financial statement issuance date. Soaring inflation rates can become the downfall of companies that are unprepared to counter the effects, creating doubt about their long-term viability.

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