Gearing Up for 30 June reporting season: Impacts of current economic conditions

Inflation and rising interest rates may have a significant impact on your financial reporting this 30 June year-end. It is essential you start considering how this might impact the way you approach your financial reporting as it is likely that it will not be business as usual and there may be issues you may need to think about for the first time in a while.

IMPACTS OF INFLATION AND THE SLOWING ECONOMY

As Australia and the world emerges from COVID, consumer demand has been increasing. At the same time there has been supply of side pressures due to geopolitical circumstances. This has contributed to a perfect storm leading to an increase in inflation. Inflationary pressures may impact some short-term items in your financial statements, especially when combined with the pressures of rising interest rates starting to bite into customer demand.

Inventory - is your cost recoverable
It is likely that the cost of your inventory has been increasing with the supply chain pressures, but can you actually pass that increased cost on to suppliers, or has the recent dampening of consumer demand meant you are going to have to absorb those costs? It will be especially important this 30 June to test the net realisable value of your inventory and ensure that you can still recover the cost of your inventory once taking into account any further costs still needing to be incurred to complete and sell the inventory. If you cannot recover those costs, then an immediate write-down of that inventory will be required.

Onerous Contracts
It is also necessary to consider whether you have locked in any fixed-price contracts, that now due to increasing costs have become onerous to fulfill. In the current environment it is likely to be fixed price long-term service or sales contracts, such as house construction contracts, where costs are increasing that are most likely to be at risk. If these contracts are going to be loss making, then any assets associated with these contracts will need to be impaired and a provision for onerous contracts raised. Due to the changes in AASB 137 Provisions, Contingent Liabilities and Contingent Assets that are effective this year, when assessing if a contract is onerous you must include both incremental costs and an allocation of associated overheads related to that contract in making that assessment.

Inflation increase clauses in contracts
If your lease payments are linked to CPI, then the lease liability and right of use asset will need to be remeasured using the updated lease payments, resulting in an increase in your lease liability. Similarly, if your sales contracts contain inflation increase clauses, they will also need to be carefully considered. Any variable consideration arising from such clauses will either be attributable to work already completed and can be recognised immediately as income or may only relate to future performance obligations, and impact future revenue streams. This will depend on the specific facts and circumstances and could have a significant impact on your revenue recognition profile.

RISING INTEREST RATES

Debt covenants
Have you considered whether you will be able to meet your debt covenants this 30 June? Rising interest rates could make interest coverage ratios harder to achieve, and general changes in economic conditions may make other covenants more challenging as well. If there is a chance you will be in breach of your debt covenants at 30 June, start talking with your financiers now. If you are in breach of your debt covenant at 30 June, then the entire debt will need to be classified as current. If you are getting a waiver of the covenant from your financier, a formally documented, legally binding waiver must be received prior to 30 June, in order for the debt to still be able to be classified as non-current. Waivers received after 30 June will not impact the classification of the debt but will just be disclosed as a subsequent event.

Expected Credit Loss Provisions (Doubtful Debts)
The impact of rising interest rates along with the inflationary pressures, may mean that more customers are struggling to pay. This year it will be important to consider whether your expected credit loss provision (allowance for doubtful debts) is sufficient, given that it is meant to be forward looking at what losses you are expecting in the future. Historical defaults by clients may no longer be appropriate in the current economic conditions and adjustments may need to be made to your estimation model. 

Impairment testing
Current economic conditions are going to impact the calculation of your recoverable amount and therefore impairment in a number of ways. 

• Although rising interest rates are not an automatic indicator of impairment, requiring a detailed impairment test, it should be considered, especially if previous testing has shown that your recoverable amount is particularly sensitive to changes in interest rates. Overall changes in economic conditions should also be considered in determining whether this is an indicator of impairment. It is likely that more organisations will have to do a detailed impairment test this year

• The discount rates used in any modelling, both for a fair value less cost of disposal model or a value-in-use model, are likely to be increased. Although long-term interest rates have not been impacted as significantly as the short-term rates, they have still been increasing. Unfortunately, the increasing interest rates will decrease your recoverable amount, increasing the chance of an impairment.

• Short-term growth rates may be lower. If you are modelling out cash flows for the next 5 years, the growth rates and those short-term forecasts may be lower than they were last year. In particular if your expectation is a slow-down in the economy, it would be inconsistent to be expecting significant growth in the short-term. Long term, the growth rate that you include in your terminal value calculation may be unchanged, but it is still likely to result in a lower recoverable amount.

Even if the detailed impairment test shows that there is no impairment required, it is likely that more organisations will need to provide additional disclosures around the details of the impairment test, including the sensitivity of the recoverable amount to movements in interest rates. The reasonable possible change in interest rates may also be expected to be higher this year given the rapid rate at which rates have been changing.

Going Concern
Lower short-term growth rates, and rising inflation, may also have implications on your assessment of your ability to continue as a going concern as you forecast out expected performance for the next 12 – 18 months. Increasing interest rates also may impact your ability to refinance if you have debt due to mature in the near future potentially adding significant uncertainty to your ability to continue as a going concern. Where you do have significant uncertainty in  your ability to continue as a going concern due to the current market conditions, additional disclosures should be provided to explain why you are still concluding that the going concern assumption is appropriate.

Provisions and long-term liabilities
There are two elements that you will need to consider with any long-term provisions. Firstly, when discounting long-term provisions you should use an interest rate that matches the length of the provisions. Therefore, although short-term interest rates have risen sharply, there has not been such a significant increase in the longer-term rates. Discounting at a higher interest rates will result in a lower provision balance, but the increase in the interest rates might not be as significant as you were expecting. 

At the same time, it is likely that due to inflation, your forecast of costs that will be incurred to fulfil the obligation in the future may have increased. For example, your expectation of salaries when long service leave is taken, or the costs to restore a mine site in the future, is likely to be higher due to the impacts of inflation. Increasing cost forecasts will increase the provisions that you recognise. Given the high rate of inflation it is possible that the increased interest rates will not be sufficient to offset the increase in costs and overall the balance of these provisions may increase this year.

OTHER CONSIDERATIONS

In additions there may be other areas of your financial reporting that may be impacted by the current economic conditions for example;

• What is the impact on the fair value of other investments measured at fair value including investments in unlisted companies, investment properties etc? Rising interest rates are likely to increase the discount rates used in valuation models and it is unlikely to be justifiable that valuations have not moved since last June.
• Due to increased costs of new equipment and/or the expense of getting funding, the useful life of your equipment may now be extended if you intend to use it for a longer period before replacing it?
• What impact has economic conditions had on the likelihood of performance hurdles being achieved in a share-based payment or contingent consideration in a business combination?
• Are more narrative disclosures required to explain how the company is being impacted by the current economic conditions?

Further information