Financial Reporting Considerations Related to Inflation, Supply Chain Disruptions, and Labor Shortages
Introduction
Since early 2020, companies have had to grapple with unprecedented operational
and financial challenges. Now, as companies look to navigate the “new normal”
while the economy emerges from COVID-19, additional uncertainties cloud not only
the overall economic picture but also the outlook for individual companies.
Inflation, supply chain disruptions, and labor shortages are all affecting an
increasingly large number of companies in different industries to varying
degrees. If a company’s business model and operations are affected, its
accounting and financial reporting are likely to be as well.
This publication takes a strategic look at financial reporting and accounting
challenges related to inflation, supply chain disruptions, and labor shortages
that companies may face both individually and collectively as the economy
emerges from the COVID-19 pandemic.
Forecasting
Throughout the COVID-19 pandemic, many companies have faced
significant challenges related to forecasting as a result of the ongoing
uncertainties associated with the pandemic. Even as the pandemic diminishes in
intensity, it is causing what some consider to be lingering ill effects,1 such as inflation, supply chain disruptions, and labor shortages. These
effects continue to make forecasting particularly challenging in the current
environment.
One of the many consequences of COVID-19 has been pent-up demand for a variety of
goods and services. However, many companies are having difficulty satisfying the
demand because of labor shortages and a disrupted supply chain — with goods in
transit stuck on boats either at ports or out at sea (if they have even been able to
make it that far in the supply chain). For some industries, supply chain disruptions
may also involve the shortage of key components needed for production, such as
microchips for auto manufacturers. Faced with the additional challenge of inflation
trends unlike any witnessed in the past 25 years, companies are trying once again to
develop forecasts amid a number of uncertainties.
As cost structures change with higher inventory and freight costs
and pressure to increase employee compensation, companies should (1) consider how
they expect the altered cost structures to continue into the future and (2) evaluate
whether they will be able to offset any increased costs with pricing adjustments.
Companies may see a significant decline in revenues if they are unable to procure
resources needed to produce and deliver goods and services.
Inflation, supply chain constraints, and labor shortages all affect a company’s
forecasts. Such forecasts are used in a variety of accounting estimates, including,
but not limited to, those related to the assessment of (1) goodwill or other
long-lived assets for impairment, (2) whether valuation allowances related to the
recovery of deferred tax asset balances are needed, and (3) liquidity and the
appropriateness of the going-concern presumption. In developing forecasts and
assessing the related accounting implications, companies should consider whether the
effects of the uncertainties are short-term or long-term and how that determination
will affect various accounting estimates.
Inflation
Although the effects of inflation vary by company, there are some common topics that
companies should evaluate when considering how recent inflationary trends may affect
their accounting and financial reporting.
Because inflation is most likely driving up costs of acquiring goods/inventory and
related packaging materials, as well as employee wages, companies should consider
whether they can pass along those increased costs to their customers. See the
Supply Chain Disruptions section for considerations related to costs
capitalized as part of inventory.
Companies may also have increased costs associated with long-term revenue contracts
that they may or may not be able to pass along to their customers. If a company is
unable to raise its prices under a revenue contract, the company’s estimated
profitability on the contract may decline or result in a loss on the contract.
Companies should consider the potential accounting implications of reduced or
negative profitability on a revenue contract, including the period in which to
record a loss if applicable.
Inflation may result in renegotiating long-term contracts, such as leases or
long-term supply agreements, which in turn may have potential accounting
implications. For example, depending on the terms, a modification to a lease
contract may require a company to reassess the classification and measurement of the
lease.
In addition, inflation may lead to an increase in interest rates and corresponding
declines in the value of fixed-rate financial assets. Companies should also consider
potential impacts on estimated credit and loan loss reserves.
As companies review their investment strategies in light of recent inflation, they
may consider making different types of investments or moving away from holding
excess cash on hand. For example, a company may consider investing in gold, digital
assets (such as cryptocurrencies), or Treasury Inflation-Protected Securities as a
hedge against inflation. Companies contemplating such investments should consider
the complex accounting and financial reporting that may result from holding them.
For example, inflation-indexed debt securities are subject to specific interest
recognition guidance under U.S. GAAP and should be evaluated to determine whether
they contain any derivative that is required to be accounted for separately for
accounting purposes.
Further, certain companies should monitor the appropriateness of the discount rate
used to measure any pension-related liabilities, particularly since even a seemingly
small change in the discount rate can affect a company’s pension liability
significantly. For example, higher interest rates may lead to decreases in pension
liabilities and required employer contributions. However, such decreases may be
offset by higher employee wages, which are further discussed in the Labor Shortages section.
Supply Chain Disruptions
Supply chain disruptions have been well publicized of late. For
example, it has been reported2 that since the manufacturers, suppliers, and distributors in a supply chain
are interconnected, “disruption in one part of the chain [has] a ripple-down effect
on all parts of the chain” and “ultimately [affects] consumers and economic
growth.”
For many companies, such disruption is significantly increasing the
costs associated with moving goods through the supply chain. If the higher costs are
included in inventory, companies should consider whether these costs drive up the
cost of the inventory in such a way that adjustments based on the expected net
realizable value of the inventory are warranted. This determination is likely to
vary by industry and by company given (1) the use of different types of materials,
(2) diversity in suppliers, and (3) a company’s ability to transfer cost increases
to its customers through higher selling prices.
While the goods are making their way through the disrupted supply chain, companies
should consider the point in time at which the buyer actually assumes ownership of
the goods to ensure appropriate reporting of raw materials, finished goods, and
supplies on their balance sheets. Companies that may have had only immaterial
amounts of goods in transit because of historically short transit times may find it
necessary to implement more robust accounting processes and internal controls to
appropriately capture their inventories (some of which may be physically held by
third parties). Likewise, companies should ensure that suitable cutoff procedures
result in revenue recognition in the appropriate period.
In addition, companies struggling to obtain certain products that are inputs to
finished goods, such as microchips, may consider adjusting their manufacturing
processes to use different inputs or manufacture the products differently. Companies
should consider whether the need to use alternate raw materials or processes affects
the warranties offered and the accounting for those warranties. Changes to the terms
and conditions of warranties, the expected life of the product, or expected warranty
claims may differ by product type; such differences, combined with increased
material and labor costs, could affect the related warranty accounting.
Labor Shortages
Labor shortages may manifest themselves in the form of employee turnover, departures,
and demands for higher wages at all levels of the organization. As costs of
retaining labor increase in a production environment, companies should consider how
these increased labor costs affect the cost of inventory and whether these higher
costs can be offset by price increases as companies sell these goods to their
customers. Companies should also consider the potential accounting implications of
including increased costs in inventory, as discussed in the Supply Chain Disruptions section.
To address the employee demands for increased compensation, many companies are
revisiting their compensation structures. Adjustments may take the form of increased
hourly wages, retention bonuses, improved incentive compensation or stock
compensation, or other benefits. Companies should consider the accounting
implications of these changes in compensation structure. For example, if a company
provides retention bonuses to employees, the company should consider the contractual
terms of those arrangements and assess during what period those bonuses should be
recognized. In addition, certain companies may need to consider changes in their
workforce and the related compensation structure when evaluating assumptions used to
measure their pension liability.
In response to a shortage in labor, some companies may be forced to operate at a
reduced capacity. In such a case, companies should consider whether there are costs
that have been capitalized into inventory historically but should be expensed
currently because of abnormal production levels (e.g., indirect costs such as rent
and depreciation).
Further, with federal vaccine mandates issued and scheduled to go into effect in
January 2022, certain companies should consider what actions they will (or may) be
required to take because of the mandates and whether the mandates will exacerbate
the labor shortage and affect the considerations discussed above. Any departure of
employees as a result of the mandates may put a strain on production and delivery
forecasts and could pose additional challenges related to employee compensation,
including termination benefits.
Increased turnover and the shortage of employees may also put stress on a company’s
internal control environments. As employee responsibilities shift, companies should
assess whether the appropriately skilled and trained individuals are in place to
effectively design, implement, operate, and monitor controls, including controls
related to information technology.
Communication With Stakeholders
In addition to considering potential accounting-related impacts of inflation, supply
chain disruptions, and labor shortages, companies will need to evaluate their
communication strategies related to such risks and uncertainties. While private and
public companies alike will need to comply with the disclosure requirements under
U.S. GAAP, public companies will also need to consider the SEC’s reporting
requirements, including required disclosures about trends and uncertainties in the
business, risk factors, and MD&A sections of filings. For many companies, these
issues may require disclosure in MD&A of known trends or uncertainties that
could affect sales, net income, or liquidity. For example, supply chain disruptions
may result in lower sales, increased costs, or increased working capital
requirements, all of which may warrant disclosure in MD&A. Companies should
consider disclosing the current effects of these matters on the business, expected
future impacts, and how management is responding. Further, companies should tailor
these disclosures to their specific circumstances and avoid generic boilerplate
descriptions of inflation, supply chain disruptions, and labor shortages.