Financial Reporting Considerations Related to Inflation, Supply Chain Disruptions, and Labor Shortages
By Mitesh Kalathiya, Senior, Assurance Services
The COVID-19 pandemic has disrupted everyone’s lives in more ways than one. On the individual level, people have suffered personal losses. On the other hand, companies have suffered financial and business operation challenges, including but not limited to labor shortages, supply chain disruptions, and inflation. The spread of COVID-19 and subsequent lockdowns around the world had a tremendous impact on the manufacturing industry and supply chain. At the same time, quite a few Individuals realized that a 9-5 job just doesn’t cut it anymore and decided to start their own businesses. This phenomenon is now referred to as the “Great Resignation”1 and has exacerbated supply chain disruptions. All these factors have a domino effect on the economy and individual companies.
The Great Resignation has led to a labor shortage and an unforeseen rise in the cost of labor. Companies are paying higher wages and bonuses to retain their existing workforce. The increased costs of retaining labor in any production environment have impacted the overall compensation structure. While companies are dealing with these extraordinary circumstances, they also need to consider the potential accounting implications of increased labor costs. Depending on how companies adjust their cost structures (increased hourly wage, retention bonuses, improved incentives, or other benefits), companies should consider the contractual terms of those arrangements and assess if the costs should be expensed at specific point in time or deferred over a period of time.
The costs of purchasing inventory and packaging material, plus freight costs and other related general and administrative costs are likely to increase because of inflation. With increased costs, profitability decreases unless companies increase prices to keep up with inflation. Companies may consider different strategies to diversify methods of investment and to access cash on hand to combat inflation. Companies should consider how changes to their cost structures and investments may impact their accounting and financial reporting. Leaders may also consider the applicable U.S. GAAP to determine if any investments involve derivatives and how they should be accounted for. Inflation also affects pension liability: when the discount rate increases, the recorded pension liability decreases. However, companies may need to record an additional liability for the actual pension obligation to be settled.
Supply Chain Disruptions
Supply chain disruptions have led to increased costs associated with moving goods (freight costs) through the supply chain. Companies should consider the effect the increased costs of inventory have on the cost of sales and overall profitability. As the cost of acquiring inventory increases, companies may consider transferring the increased costs to customers through higher selling prices.
To ensure appropriate reporting of finished goods on their balance sheets, companies should consider the point in time at which the buyer assumes ownership of the goods. Likewise, companies should consider when they assume ownership of the raw materials to ensure appropriate reporting on their balance sheets. Suitable cutoff procedures should result in revenue recognition in the appropriate period.
Companies should also consider the impact of supply chain disruptions on their ability to purchase raw materials due to a shortage of inputs used in the manufacturing process. Leaders should consider alternate sources of raw materials, or alternate processes to produce finished goods. It is important to consider how that might impact the costs of manufacturing, the overall cost structure, and forecasting.
With increased labor costs, inflation, and supply chain disruptions, companies will face significant challenges accurately forecasting expected costs and future profitability. Companies should consider the impact on costs structure and increased costs on the forecast and evaluate whether they can offset the increased costs with pricing adjustment. Companies may see a decline in revenue if they are unable to procure the resources required to produce and deliver goods.
Forecasts are used in a variety of accounting estimates, especially when it comes to assessing the following:
- Going-concern presumption;
- Goodwill or intangible assets; and
- Deferred tax.
Companies should consider whether the uncertainties will cause long-term or short-term effects, and how that will impact various accounting estimates.
Communication with Stakeholders
Companies need to evaluate how they communicate strategies related to the risks and uncertainties stemming from inflation, supply chain disruptions, and labor shortages. Public companies are required to consider the impact on MD&A disclosure in their Form 10-K. For many companies, the above issues may require the disclosure of known trends or uncertainties that could affect sales, net income, investment diversification, or liquidity. For example, supply chain disruptions may result in reduced sales volume, increased costs of sales, or increased working capital requirements, all of which may warrant disclosure in MD&A. Companies should consider disclosing the current and expected future effects of these matters on the business, and management’s expected response to these matters. Further, companies should tailor these disclosures to their specific situation and avoid generic descriptions of inflation, supply chain disruptions, and labor shortages.
21-2, financial reporting considerations related to inflation, supply chain disruptions, and labor shortages (December 2, 2021). DART. (2021, December 2). Retrieved March 14, 2022, from https://dart.deloitte.com/USDART/home/publications/deloitte/financial-reporting-alerts/2021/inflation-supply-chain-labor-shortages.