27th July 2022The impacts of rising inflation: the effect on financial statements
Financial statements look at historical information, thus rising inflation can quickly make the information contained in them increasingly irrelevant. It is, therefore, even more important for Directors to consider the impact of inflation in their strategic reports to ensure stakeholders are aware of the future risk and impact on the business.
In this short-article, Mandy Janes, Partner at HW Fisher, summarises some of the key concerns for financial statements and outlines what both accountants and clients should be doing to address these issues.
What are the key concerns for financial statements?
- Profitability and cash flow will clearly be impacted by inflationary increases if the increase in costs cannot be passed on in price rises 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.
- There could be impacts on long term contracts whereby a fixed price has been negotiated upfront and then costs to complete the project increase such that a project becomes unprofitable. It will be important to look at these on a line-by-line basis to establish whether any losses need to be recognised upfront.
- 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.
How are clients being affected?
- Clients in the property development industry are incurring increasing costs due to inflationary rises and thus expect much lower profit margins as a result. There is then an added risk that there may be no market for the sale of developed properties. Furthermore, the increase costs of freight have put pressures on the margins for those businesses importing goods, which has has resulted in a squeeze in margins that is unlikely to improve without price rises.
Next steps for accountants and clients
- Be agile and open to new ways of doing things to increase efficiencies, reduce costs or to extend revenue generating activities within the business.
- Look at the mix of work in the business and where necessary re-price non-profitable work on the basis that if the work is lost, it does not have a significant impact.
- Ensure inflationary price increases are put through every year as standard rather than waiting several years before having to put through a large increase.
- Be open and honest with customers on the reasons why prices will need to increase – if your customers are businesses, they will be having their own pressures and will probably understand.
If you are still unsure about the impact of these changes, please get in touch.