Financial Reporting Considerations
This tax season, it is important to consider the implications of inflation and rising interest rates. Areas of consideration include impairment or valuation analyses, which depend on discounted cash flow models. As a result, developing estimates for future cash flows becomes more difficult and it is important not to rely on historical trends with uncertainty on the horizon.
Inflation has driven up the cost of raw materials, wages, and transportation costs. Companies should consider how to pass the cost along to the customer. In some cases, companies will not be able to raise the sales price. Companies may have a long-term fixed price contracts which may not allow them to pass these costs along to the customer. It can result in the write down of inventory to the lower of cost or market if the company is on LIFO or retail inventory method, or the lower of cost or net realizable value. A factor to consider under a long-term revenue contract is the potential for a negative probability on that said contract.
Inflation and rising interest rates can affect the fair value of all types of financial instruments. Banks should consider whether the borrowers are less likely to pay back their loans. Lenders should take into consideration that prepayment risk may also be higher on floating-rate debt. Banks should assess their loans and whether to revise those pools of loans and measure expected credit losses. Companies should show qualitative and quantitative information about the allowance for credit losses.
When companies use a discounted cash flow approach to measure fair value of an asset or reporting unit, a higher discount rate will decrease fair value. More assets will be at risk than the prior year. Forecasting cash flows should be considered when inflation is a factor. Inflation can cause a company’s costs to increase. Increased costs lead to compressed margins and profits and results in the decrease of the fair value for said asset.
During a business combination the acquirer will typically recognize the assets and liabilities bought at fair value. It can be tricky developing estimates for future cash flows and using the proper discount rates. To use the proper discount rate, business should reflect the weighted-average cost of capital of the business and not the WACC of the acquired business. The WACC calculates the company’s discount rate based on the cost of debt and cost of equity. The cost of debt is reflected based on the assumed target capital structure. The cost of equity is usually calculated using the capital asset pricing model. It starts with the risk-free rate and adjusts for market risk, company risk, and other risk factors. When the risk associated with cash flows is higher, the risk premium applied will be higher. In result, this drives up the cost of equity. When the federal reserve increases interest rates due to inflation, increasing the risk-free rate and affecting the WACC.
With inflation, it may lead to companies hedging interest rate risk. Management should consider the requirements under ASC 815 before concluding with the proper decision and accounting treatment.
Businesses may struggle with repaying debt due to inflation and the rising interest rates. Options under this circumstance include renegotiating debt terms such as payment terms, interest rates, or debt covenants. ASC 470, Debt, should be considered when deciding proper classifications of debt upon a covenant violation or default. Other areas to consider as well include expected debt refinancing, defaults, and modifications and extinguishments.
Supplier finance programs may be in use under companies during times of inflation and rising interest rates. This allows a supplier the option for access to payment in advance of an invoice due date that is paid by a third-party finance provider or other intermediary based on invoices that the buyer has confirmed as valid. The buyer will; 1) Enter into an agreement with the provider to start the program 2) Purchases goods and services from suppliers with a promise to pay later 3) notifies the finance provider of the supplier invoices it has confirmed valid. Suppliers may ask for payment in advance from the finance provider for the confirmed invoices. Both parties will benefit with the buyer having the opportunity for longer payment terms and the supplier can finance receivables at lower interest rates and is able to collect funds instantly. The proper accounting and presentation are an important aspect that needs to be considered by management. Additional coordination with the purchasing and treasury functions may be needed. The proper disclosure of the existence of the arrangements is important and ASU 2022-04, Disclosure of Suppliers Finance Obligations, should be referenced for the most recent requirements. Companies should disclose the following: Reliance on these programs to manage cash flow, material impacts on the balance sheet, statement of cash flows or liquidity, material terms of the programs, guarantees by subsidiaries or the parent, material risks to the company if the program ends, amounts payable related to these programs at the end of the reporting period.
With higher interest rates, it can affect a lessee’s borrowing rate which is used in calculating the right-of-use asset and the lease liability. Private lessees may choose to use the risk-free rate as a substitute for the incremental borrowing rate. An increase in the risk-free rate will decrease the lease liability and right of use asset. The management should be considerate in deciding the correct risk-free rate and not assume that prior year’s rates still apply.
Companies should consider how inflation affects the estimate to complete the performance obligation when recognizing revenue over time under ASC 606. With changing inflation, management should consider modifications to changing payment terms and discounting prices. Management should consider the contract that already includes inflation adjustments. A change in price under the terms of the contract is not a modification but a change in transaction price.
Inflation can lower demand and increase cost leading to lower margins and profits. Management needs to consider the proper risk-free rate to use when determining the fair value of an option for share-based payments. If management changes share-based payments to make vesting conditions easier, they need to determine the appropriate accounting for the modifications under ASC 718.
All evidence should be reviewed to decide whether to recognize a valuation allowance for deferred tax assets. ASC 740, Income Taxes, allows management to consider sources of taxable income. Management should be careful when evaluation where to recognize a valuation allowance.
Companies that receive government grants and aid need to determine proper accounting and assess whether the disclosure requirements of ASC 832 apply. These requirements are for periods after December 15, 2021, but early application is allowed.
ASC 275, Risks and Uncertainties, requires disclosure of risks and uncertainties that will have an impact on the financial statements. Companies should be considerate when estimating in preparing financial statements or concentrations in the company’s operations. If it is possible that significant estimates will change, then disclosure should be added. Under certain concentrations with higher risk to the financial conditions or results of operations, it is required to present an incremental disclosure under ASC 275. With concentrations in areas affected by macroeconomic trends, disclosures of potential near-term impact should be disclosed. If a company is hard hit by inflation, management should consider their ability to continue as a going concern.
Rising interest rate and inflation can affect SEC filings. Registrants should describe its business and how it operates. Discussion of recent events, competition, regulation, and seasonality should be included as well. Inflation and rising interest rates along with other worldly factors may change the business and how it operates, strategy, engagement with customers, or its approach to supply chain. Disclosures should address these changes. Risk factors should include material risks that a registrant may face. Management should disclose information about the risk factors that address economic conditions, inflation, rising interest rates or geopolitical matters. Companies that experience material effects to date, or reasonably expect a material impact in the future should include robust discussions of these circumstances. A company must disclose its exposure to market risks and how they manage these risks.
Determining the discount rate is complex and often requires a specialist’s assistance. The risk-free rate is the starting point. When the federal reserve raises interest rates for inflation, the risk-free rate will increase. The difference between nominal vs real discount rates is simply nominal includes the effects of inflation and real excludes the effects of inflation. Subtracting the inflation rate from the nominal rate will provide the real rate. Nominal cash flows are typically higher than real cash flows. This is why it is important to match the type of cash flows to the correct type of rates.
Inflation and rising interest rates can affect financial reporting depending on the company and industry. Over reliance on the past and carefully determining estimates for future cash flows and other financial instruments are key with uncertain times.