Accounting and auditing concerns amid rising prices

GLOBALLY, several countries have reported high inflation, the Philippines included, amid the Covid-19 pandemic, supply chain disruptions and the ongoing war in Ukraine. As of June, inflation had hit a four-year high of 6.1 percent, the Philippine Statistics Authority recently reported.

Businesses are likely to be significantly affected — a cause for concern for various stakeholders. Accountants will play a key role in assisting them in making informed decisions during this time of economic difficulty by providing timely, relevant and reliable information. Financial statements are more likely to be impacted by rising prices, and some items that will be affected include:

Going concern disclosures. In preparing financial statements, management must evaluate whether the business can continue as a going concern — whether it can continue operating indefinitely. With rising commodity prices, operating costs are expected to increase, which may cause additional financial burdens. Without proper planning on how to respond, there may be material uncertainties that cast significant doubt as to an entity’s ability to continue as a going concern. These uncertainties should be disclosed in financial statements.

Sources of financing. As a way to slow inflation, central banks have increased interest rates. The Bangko Sentral ng Pilipinas has so far increased its key interest rate to 3.25 percent. If the entity has any existing variable-rate borrowings or leases, finance costs will increase as a result of the rate hike. Likewise, businesses may violate some conditions attached to financing agreements and/or default on payments. These violations may warrant disclosure in financial statements and may also affect the classification of the borrowing as current or noncurrent. It will also be more expensive for businesses to enter into new financing arrangements.

Inventory valuation. Under PAS 2, entities may use either the first in, first out or weighted average cost formulas in determining the cost of inventories that are ordinarily interchangeable. In periods of rising prices, the valuation method used will affect the net income and ending inventory reported in financial statements. Furthermore, some inventory items may become slow-moving due to decreased demand as a result of increased prices and may cause the entity to record losses due to inventory write-down.

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Changes in foreign exchange rates. Foreign exchange (forex) rates may also be affected by high inflation. In businesses that have significant foreign currency-denominated items, incomes may significantly be affected by substantial forex changes. Companies may consider entering into hedge transactions to mitigate some of the currency risk exposure.

Fair value of investments. Inflation fears can create panic in the stock market and may cause increased stock price volatility. Higher volatility will cause entities to report volatile unrealized gains or losses in their financial statements.

Impairment of assets. Increased interest rates as a result of inflation may be considered in determining whether an asset may be impaired, meaning its value in financial statements may be overvalued. Furthermore, entities may find it more difficult to create cash flow projections needed in determining the recoverable amount of assets that may be impaired due to rising expenditures and sales projections as a result of demand changes. Businesses may consider the use of multiple scenarios in developing cash flow projections to incorporate economic uncertainties. Entities can also use higher discount rates in calculating recoverable amounts.

Disclosures related to financial instruments. PFRS 7 requires the entity to disclose information regarding risk exposures arising from financial instruments, including market risk, currency risk brought about by forex changes, interest rate risk and price risk. Businesses should provide adequate information that will enable users to evaluate the nature and extent of the risks by providing both qualitative and quantitative disclosures.

Inflation can have pervasive effects on financial statements. Both financial statement preparers and auditors should be mindful of possible financial statement implications. External auditors must consider the effects of inflation, as well as increased pressure and motive for management to engage in fraud as a result, in risk assessment procedures and develop further audit procedures that will be able to respond to risks to achieve a high-quality audit.

Alger Tang is a faculty member of the Acpapp Academy, a reviewer of ICARE Accountancy Review and a special guest lecturer at Chiang Kai Shek College. The views and opinions in this article are the author’s and do not represent those of these institutions.

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