How Rising Interest Rates and Inflation May Affect Financial Reporting

External market conditions may affect the amounts reported for certain items on the financial statements, including profits, loans, leases, investments and intangible assets. Estimates and disclosures for various items may be affected by current (or projected) interest rates and market prices. Here’s a look at how accounting estimates are calculated and how auditors evaluate these calculations. In today’s uncertain markets, financial statement preparers must look beyond historical figures when making estimates and disclosing matters in the footnotes.

Understanding the Effects

The most obvious effects of rising interest rates and inflation may be seen on a company’s income statement. These factors can increase expenses, such as interest expense, cost of goods sold, salaries, shipping, supplies and rent. In some situations, declining profits may lead to impairment losses and going concern issues. Lesser-known effects are seen on a company’s balance sheet and in its footnote disclosures.

Current interest rates and expected rates of inflation are often factored into amounts reported for certain assets and liabilities. For example, Accounting Standards Codification Topic 326, Credit Losses, requires a timelier report of losses from soured loans under the current expected credit losses (CECL) model, compared to the prior expected loss model. Private companies are required to implement the CECL model in 2023. It calls for companies to estimate credit losses for all loans and outstanding accounts receivable (not just on those accounts that are past due as of the reporting date). These losses may be based on historical experience, current market conditions and reasonable forecasts of future economic conditions.

Looking to the Future

Credit losses and other accounting estimates may be based on subjective or objective information (or both) and involve some level of measurement uncertainty. Some estimates may be easily determinable, but many are inherently subjective or complex.

Other examples of accounting estimates include allowances for doubtful accounts and impairments of long-lived assets. Fair value measurements are another type of accounting estimate. Under U.S. Generally Accepted Accounting Principles (GAAP), a fair value measurement represents “the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date.”

Many estimates are based on assumptions about what’s expected to happen in the future. For example, the fair value of an asset is based on what investors would pay for it — and investors are interested in the return on investment (a forward-looking metric). Historical performance is only relevant to the extent that similar results are expected in the coming years. If not, management may need to look beyond historical trends when estimating the asset’s value.

Auditing Estimates

Accounting estimates and fair value measurements involve a high degree of subjectivity and judgment and may be more susceptible to misstatement. Therefore, they require more auditor focus.

Auditing standards generally provide three approaches for substantively testing accounting estimates and fair value measurements. First, they may evaluate the reasonableness and consistency of management’s assumptions, as well as test whether the underlying data is complete, accurate and relevant.

Second, auditors may develop their own independent estimates, using management’s assumptions (or alternative assumptions). Then they can compare their analysis with what’s reported by management on internally prepared financial statements.

Third, auditors may review subsequent events or transactions to gauge the reasonableness of estimates. Events or transactions that happen after the balance sheet date, but before the date of the auditor’s report, can help confirm (or refute) management’s estimates.

Specialists may be called in to help make complex, subjective estimates. For instance, actuaries might determine employee benefit obligations, engineers might evaluate obligations regarding environmental remediation, and appraisers might estimate the value of intangible assets or real estate.

Getting It Right

Today’s uncertain market conditions present financial reporting challenges. If you’re unsure how to account for rising interest rates or inflation, contact Kirsch CPA Group for help navigating the rules.

We can help you tackle business challenges like these – schedule an appointment today.

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