Cost of living and inflation increases – why & how should the external auditor respond?

The principal role of the external auditor is to review the entity’s financial information and report on their findings.

To do this, a key activity of the audit process is assessing the overall business risks affecting their client’s financial information and responding to these identified business risks with appropriate audit procedures.

We have all heard and seen recently in the media, there are some key immerging risks facing all clients now and over the next 18 months that will need to be carefully considered and responded to by the external auditor in their planning phase.

These are how the costs of living (and including increases in energy prices) and higher levels of inflation will impact your client. It has been a while for the effects of inflation to be a target on the auditors planning agenda, as in the UK, we have been living with relatively low levels of inflation for some time.

However, inflation rates are increasing significantly as well as the associated costs of living increasing as well. These issues may well be mitigated to some extent by Government policy, nevertheless it will be prudent to have these matters within the planning phase of auditors.

Inflation and the cost-of-living increases will affect clients differently.

Suppose for example your client is in the hospitality industry. In this sector, these two issues will have a significant impact on input costs (energy prices) but also will potentially affect future revenue streams of the client, with many customers reducing their discretionary spending in the hospitality area during this period of time.

Key areas where increases in inflation and cost of living increases affect Auditors

Review of business plans and associated Going Concern

The external auditors must carefully consider how inflation and the cost of living (including energy price increases) will impact their client’s business plans and models.

What will happen to input costs such as energy costs, how will this affect your client’s margins, and how will sales be impacted for example?

These macro-economic effects will affect each industry differently, requiring the auditors to carry out more rigorous considerations, responses, and testing within their audit files.

Impact on impairments and their analysis

Should the UK economy enter a recession which is not beyond the realms of probability given the rising inflation rates, significant cost of living effects, associated interest rate increases, this will have a considerable impact on the client’s calculations on potential impairment calculations in property plant and equipment as well as in intangible assets, such as goodwill.

Current assets such as stock values could also be negatively impacted if write-downs are needed where future sales of the holding stock items are reducing, for example in the retail industry.

Valuation of financial instruments

During inflationary times, the value of fixed-rate instruments such as bonds decreases over time as inflation causes Central Banks to increase their interest rates in the economy, making the payments from fixed-rate bonds less desirable than newly created ones.

Other effects are that the discount rates used in financial models increase, affecting unlisted instruments' valuations negatively, which will negatively impact the client’s balance sheets.

Therefore, care will be needed to be exercised by auditors in reviewing any assumptions used in valuations undertaken.

Landlords and investments properties

Commercial properties tend to provide landlords with a high-income return than the residential property. But that’s providing your client’s tenants remain, and rents can be increased regularly to keep pace with inflation, and where your client has leverage within their property portfolio that interest rates don’t get too high.

With the economic slowdown, interest rates increasing and potentially tenants’ profits are decreasing there will undoubtedly be a shift out of the commercial sector by landlords, which may negatively impact the underlying values of your client's properties within their portfolio.

Landlords may be under pressure not to increase rents if their tenant’s businesses are struggling, which could force landlords to decrease the rents received from their properties.

These considerations will need to be considered by the external auditors during their planning phase, during their audits, and in their conclusion section on potential risks and how they have been responded to.

Client borrowings

Where your audit client borrows from financial institutions, the external auditor will need to consider how interest rate increases will impact borrowing costs.

Does the client, for example, have fixed rate borrowings? In which case, when do these fixed-rate contracts come to an end? What will be the new interest rate payable by your client, or if they are variable, what-if scenarios will need to be developed to assess the impact of certain interest rates coming into effect – a sort of stress testing analysis should be carried out and how will increases in interest rates affect your client’s business.

Imports and exports

Where your audit client is in the import and/or export business, the external auditor will need to consider how inflation will impact your client.

Generally, exports tend to increase during higher inflationary times, and imports tend to decrease as inflation on the country's exchange rate takes effect.

Accordingly, if your client is primarily an importer of goods and services, how will this impact future purchases, will the client have to import from new markets, and how will this impact the overall risk to the organisation?

In summary and the above considerations are by no means exhaustive, the external auditor will need to be more diligent in considering the overall business risks more carefully over the next 18 months to ensure that they have addressed all the business risks associated with inflation and cost of living carefully and responded accordingly.

Mercia have in their current Audit Update and Topical Issues courses included many of the points highlighted in this article to help you prepare meaningful and impactful audit planning meetings for your next audit.