For many months, companies have been grappling with uncertainties and challenges resulting from the COVID-19 pandemic. As we approach the end of 2021, operational issues, particularly related to supply chain disruptions, labor shortages, and inflation, continue to be front and center for many companies, and could have significant accounting and reporting implications. As companies look to prepare their annual financial statements, these macroeconomic events will certainly need to be considered and will likely have impacts, of varying degrees, on many companies in various industries.
Supply chain disruption is prevalent throughout both the United States and the world. This disruption is increasing the costs associated with moving goods through the supply chain. Additionally, some companies are unable to source raw materials to make their product. Labor shortages may impact their ability to make, sell, and deliver their products, or at a minimum, drive increases in labor costs. Further adding to the issue, sourcing materials from new suppliers or shipping in new ways may make supply chain operations more complex and introduce new costs into the system, potentially reducing margins.
A company’s response to these macroeconomic events determines the impact, and in turn, the financial reporting implications. As companies manage their operations to best address these challenges, the following areas may warrant additional accounting and reporting consideration:
Net Realizable Value of Inventory
As indicated above, the cost of inventory may increase as a result of additional costs to move product, changes in sourcing arrangements or shipping methods, or higher compensation costs to retain existing or new labor. Companies should consider whether these costs drive up the cost of the inventory such that adjustments based on the expected net realizable value of the inventory are warranted. This may be the case if cost increases are not or cannot be passed on to the customer through higher selling prices.
Long-term revenue contracts may need to be evaluated for potential loss if increased costs associated with a contract cannot be passed along to the customer. If a company is unable to raise prices under a revenue contract, the estimated profitability on the contract may decline or result in a loss on the contract. Companies will need to consider the accounting implications, including the appropriate period to record the loss.
Inventory and Revenue Cutoff
In the past, companies may have had short in-transit times for receiving inventory from vendors, as well as shipping product to customers. With the supply chain disruptions and labor shortages, these in-transit timeframes may be significantly longer which could have material impacts on the timing of recognizing purchased inventory and revenue. Companies should consider the point in time at which they, as the buyer, actually assume ownership of the goods purchased to ensure appropriate recording of raw materials, finished goods, and supplies on their balance sheets. Likewise, companies will need to ensure they have robust internal controls and procedures in place to ensure revenue is recognized in the appropriate period based on when the required performance obligations are satisfied, and this may be upon delivery at the customer site.
Abnormal Production Capacity
Labor shortages may force companies to operate at reduced capacity. Accordingly, consideration should be given to whether indirect costs (e.g., rent and depreciation) historically capitalized into inventory would be required to be expensed as a period cost because of abnormal production levels.
Inflation may cause companies to consider renegotiating certain long-term contracts, such as supply agreements or lease agreements. However, changes in such arrangements may have potential accounting implications because of modifications in terms. In the example of a lease agreement, a company may be required to reassess the classification and measurement of the lease.
Companies may experience changes in financial ratios that impact existing debt covenants requiring certain ratios. Breaches of debt covenants may make debt callable on demand and could require long-term debt to be reclassified to current debt on the balance sheet.
Forecasting and Cash Flow Projections
Given the unpredictability and uncertainty discussed above, companies should consider reassessing their assumptions utilized in forecasting and cash flow projections, which are relied upon in many areas in U.S. GAAP (e.g., impairments of long-lived assets and goodwill, realizability of deferred tax assets, going concern assessment). A company’s specific facts and circumstances will dictate whether revisions to models are necessary, however, it is important to ensure assumptions being used reflect all current developments.
With the annual financial reporting season upon us, getting a jump start on potential impacts will be beneficial to ensuring timely and accurate reporting.
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