How the economy is impacting financial reporting

Our economic climate is changing, and so too is how we must approach the preparation of financial reports for upcoming reporting periods.

Changing conditions means that the preparation of financial reports will not simply be a rollover of the estimates used in the preparation of the previous financial report.

Many key estimates will need to be revisited with consideration to:

• High interest rates
• High inflation (in Australia, we have not seen these levels since the 1990s)
• Wage pressure due to labour shortages
• Supply chain issues.

This is against the backdrop of ESG and a drive to sustainability.

Interest rates

The significant increase in interest rates has a direct impact on the application of accounting standards, and particularly in estimates that require the use of discounted cash flow projections.

For entities using the VIU model to determine the recoverable amount of an asset, including goodwill and intangible assets, the increase in interest rates means that the discount rate in the VIU model increases.

It would be incorrect to have used a discount rate of 10% last year and in prior years, and to continue to use the same 10% discount rate in 2023. The risk-free rate has gone up, and the world has become more uncertain. Preparers and auditors will need to carefully consider the appropriateness of the discount rate used in VIU models.

Discount rates are used extensively in determining the fair value of assets. They are important when determining the value of provisions, including make good provisions and lease liabilities. The increase in interest rates has a direct impact on these assets and liabilities and could be material to an entity’s December 2023
financial reports.

Inflation

The economy has changed very quickly, with consumer confidence and sentiment changing also. There is significant uncertainty as to where the economy will go. The Reserve Bank is striving to reduce inflation by reducing demand.

Will this trigger a recession? When will the consequences of the Reserve Bank’s actions impact the economy?

Many companies are struggling. This should be reflected in an entity’s December 2023 financial report, with potentially larger bad debt provisions, impairment of goodwill, a reduction in the value of investments etc. Many entities will be very much incentivised to be aggressive or very optimistic when making accounting estimates.

It’s difficult for entities to raise finance at the moment, and that includes either being able to raise equity or to borrow money. This of course has an immediate impact on going concern, and again represents an incentive to show the performance of an entity in a very positive manner.

Wage pressure

We have inflation, we have labor shortages, so we have wage inflation. This impacts impairment assessments, may give rise to onerous contracts, and again may impact going concern.

Supply chain issues

If a business cannot get the raw materials, key components or the required labour, it is not likely to complete the contract on time. This increases the risk of penalties and onerous contracts and increases the risk of incorrect revenue recognition under AASB 15. It also increases the risks around going concern.

There is also a high probability that the costs to complete a contract will increase, even if the contract can be completed on time. If an entity tendered on a fixed price contract and didn’t lock in the materials and cost of labour, the margin and profitability of that contract is going to be squeezed.

The culmination of all of these factors makes it reasonable to predict that many companies (with perhaps the exception of the major supermarkets and the major banks) are going to be less profitable in upcoming reporting periods.

This of course is extremely relevant when considering the cash flow projections that will be used to support the recoverable amount of goodwill, and assessing whether there is a material uncertainty as to the ability of an entity to continue as a
going concern.

Careful consideration required

Entities need to give careful consideration to the current environment and how it impacts their ongoing reporting requirements.

The current economic environment will have a direct impact on:

• Financial reporting
• The application of accounting standards
• Making accounting estimates
• The risk of bias when making accounting estimates, and
• Uncertainty as to going concern.

For any assistance with preparing your financial reports, please contact your local PKF Audit representative.