Deflating inflation
CORINA D. MOLINA
Clearly, the “adulting” process has gained a fixation from almost everyone, be it from acting all focused and serious in an executive meeting to the downright mundane daily routine of making home-cooked meal that is an upgrade from fastfood take-out.
While some are apprehensive of the process, others take joy and pride in stepping up the game that normally involves creating monthly (or even daily) cash flows and accounting for each peso difference.
Categorically, a high percentage of these cashflows do not consider the impact of inflation, the effect of which in the past years was negligible.
Economically speaking, inflation is just but one contributor to the greater scheme of higher costs in today’s daily spending. But for accounting and auditing purposes, inflation may play a bigger role than we give it credit for.
Circle of influence
All companies have differing business practices that can translate to a diverse application of inflation in forecasts and financial information analyses.
Cited below are few considerations that management, accountants and even auditors may not want to lose sight of either when reviewing financial statements and cash flows or designing audit procedures.
1. Financial statement analysis. A quick and mechanical look at the current year financial statements alone might provide an artificial insight that a company either had a good or bad year. Taking into consideration the impact of inflation, our analysis should consider the following:
a. Revenues and operating costs. Wide variability in inflation might work both ways for a company but most of the time, management introduces certain adjustments to prevent regular customers from looking for more affordable alternatives. Changes may include adjusting sales prices and inventory packaging to avoid substantial revenue loss. Additionally, there could be operating costs that due to significant increase were inappropriately capitalized to manage bottomline. As a review consideration, any shift in business plans and accounting treatment should always be supported by a sound business rationale, trend analysis, and applicable accounting standards.
b. Quality of earnings. If the company adjusted its selling prices to recover in full or partially the cost increases due to inflation, then where would we attribute the higher than normal profit it posted for the year? Instinctively, we will look for any change and update in the company’s inventory costing. An entity that has a high level of inventory stocks in the prior year and that uses first-in, first-out costing method would most likely benefit from the current inflation rate hike. This is mainly due to the lower cost of older inventory stocks that have been sold and have flowed through the company’s income statement in the current year. With no other business update to support the positive bottomline, one may conclude that the company did not realize any organic growth. Rather, it only posted a consequential profit from inflation. Management may need to revisit business plans and short and long-term forecasts so as not to be confounded by a curveball hiding behind a temporary market gap.
2. Discounted cash flows. Whether the cash flows are used for impairment test or for budgets and forecasts, inflation will need to be prudently considered in key assumptions. Also, one of the common pitfalls is the inclusion of inflation rate twice. To jog our memories, if real discount rate (excluding inflation rate) is used, cash flows for revenues and expenses should use current prices (not adjusted for inflation). In contrast, the use of nominal discount rate (as is) will mean expressing the cash flows using future estimated prices or adjusted for inflation (i.e., future cash flows). Regardless of the method used, the calculated net present value should be similar. One thing to keep an eye on is the probability of lower headroom from discounted cash flows during period of inflation hikes, which might require additional audit consideration. For budgets and forecasts, without due justification for increased prices, higher costs and spending would only mean leaner buffer to weather any immediate or unforeseen working capital requirement.
3. Asset retirement obligation. Same rule applies for inflation rate when calculating for the decommissioning cost – no double counting. Additionally, the use of future cash flows will be more reflective of the projected cost since decommissioning estimate is spread over a number of years until the end life of a specific asset. Higher inflation rate will translate to increased decommissioning cost, so caution should be exercised more specifically in adding cost estimates that are still too uncertain as of reporting date (e.g., technological advancements that are still to be firmed up).
4. Valuation for business acquisition and combination. Factoring in inflation rates in valuing a business should be done with prudence. Based on a PwC publication on business combinations, there could be circumstances where a company will not be able to pass on inflationary price increases due to certain market and economic considerations. Additionally, investors are more likely to waive projected profit that is merely based on inflation.
Consequently, review of business model valuation should be assessed for reasonableness moreso when both revenues and costs have been equally adjusted for inflation as this may suggest manufactured growth.
There are other areas for consideration (i.e., availment of new loans during inflation hike may not be so sound) when analyzing financial data that is greatly dependent on market variables. One could only exercise sound judgment and professional skepticism when analyzing trends and ratios and consequently drawing out conclusions from these to avoid common pitfalls and hit-or-miss insights.
Good word for today
Despite all the inflation buzz, the good word for today is that we are still far from being a hyperinflationary economy that would warrant use of PAS 29, Financial Reporting in Hyperinflationary Economies. Definitely, still a good day.
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Corina D. Molina is an Assurance Director at Isla Lipana & Co., a member firm of the PwC network. For more information, please email markets@ph.pwc.com. This content is for general information purposes only, and should not be used as a substitute for consultation with professional advisors.
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