Audit in an Inflationary Economy
August 16, 2022
What is inflation
Inflation refers to an increase in the prices of goods and services in an economy. An inflationary environment is characterized by rising costs and a gradual decline in the value of money.
Inflation in the UAE and GCC context
The central banks in the UAE, Saudi Arabia, Bahrain, Kuwait and Qatar raised their benchmark borrowing rates after the US Federal Reserve doubled down and aggressively raised its key interest rate to tame surging inflation and restore price stability. Inflation in the Emirates is projected to reach 5.6 per cent in 2022, according to the latest data from the Central Bank of the United Arab Emirates.
The Impact of inflation on business
For a business, inflation can reduce profits by increasing direct costs and lowering customer demand for discretionary goods and services. The three key drivers being :
- Decline in customer purchasing power
- Higher borrowing cost
- A threat of wage inflation
Audit During Inflationary Periods
An inflationary economy requires auditors to be more vigilant and focused during audits.
For audits to be successful, auditors must understand how inflation impacts the business undergoing audit.
The key focus areas include:
- Fraud Triangle
The Fraud Triangle is a framework commonly used in auditing to explain the reason behind a fraud. The Fraud Triangle outlines three components that contribute to increasing the risk of fraud: (1) opportunity, (2) incentive, and (3) rationalization. All three aspects of the triangle may be aggravated by inflationary periods, therefore additional fraud risk factors have to be identified.
- Revenue recognition and trade receivables
Businesses may be reviewing pricing and costing structures to pass on increased costs to the customers. Where long-term contract accounting applies under IFRS 15, a substantial change in the cost base may alter revenue recognition. Customers may struggle to settle payments which would increase debtor days and increases the risk of bad debts.
Emphasis must be placed on revenue recognition and on ensuring it is in accordance with IFRS 15.
- Investments
Inflation can lead to volatility in the markets. Changes in the market values of a business’s investments can result in realized or unrealized gains or losses. Concerns about inflation may also cause a company to revise its investment strategy possibly requiring new methods of accounting or special disclosures.
Auditors should be more vigilant in checking such changes in investment strategy.
- Short-term and long-term loans
During periods of inflation, some businesses might decide to convert variable-rate loans into fixed-rate loans or apply for additional credit to lock in fixed-rate loans before the next rate hike. Some may even restructure their debt.
As per IFRS 9, a gain or loss at the date of the modification would be recognized regardless of whether the change in terms are considered substantial.
The auditor should verify that there is strict IFRS 9 compliance in the case of debt restructuring.
- Inventory valuation
The auditor should carefully verify if the company has changed its inventory valuation method and if so, should comment on such change and as well as on the appropriateness of the accounting method followed for valuing closing stock.
- Going Concern assumption
A businesses’ ability to continue as a going concern must be evaluated by management every reporting period. Substantial doubt exists if it is probable that the business will be unable to meet obligations as they become due within the next 12 months after the financial statement issuance date. Rising inflation can cause businesses to doubt their long-term viability if they are unprepared to handle the effects.
To assess the Going Concern assumption, the auditor should evaluate the management's future plans and determine whether such plans are feasible and likely to improve the business’s situation.
Audits thus play an important role during periods of inflation in both ensuring compliances and, by helping drive an effective response to the macroeconomic challenge without ‘bending the rules’, enhancing operational performance at a vulnerable time. Auditors, on their part, must pay extra attention to the specific circumstances and exigencies of an inflationary economy and marketplace.