As a result of the COVID-19 pandemic, the conflict between Ukraine and Russia and other minor matters that have taken place over the recent years, Europe is experiencing high levels of inflation. As part of the audit process, auditors need to understand the impacts of this inflation.
The following are the key areas of the audit that will be affected:
At the planning stage of audits, inflation should be considered within the auditors’ risk assessment procedures. This assessment will vary from one entity to the other, and should also be re-assessed both throughout the audit, and at the completion of the audit. Auditors should consider the impact on the entity’s business model, for example in relation to interest rates and foreign exchange rates.
As part of the risk assessment under ISA 315 ‘Identifying and Assessing the Risks of Material Misstatement’, auditors need to understand the entity’s system of internal controls. This will enable the auditors to be in a position to determine if the entity’s system of internal controls is expected to anticipate changes in inflation.
Materiality and Testing Approach
Inflation impacts audit materiality, as the materiality benchmark (for example total revenue, total assets, earnings before interest and tax, and so on) can either decrease or increase due to inflation. In the case where inflation would have led to a decrease in materiality, auditors would be facing a situation where financial statements line items that were immaterial in previous audits, have now become material.
Auditors need to take inflation into consideration when:
- Performing the preliminary analytical review and the final analytical review; and
- Performing substantive analytical procedures, for example expectations.
Furthermore, it is important that auditors shall not deem all variances or anomalies to be resulting from inflation – the understanding of the entity and its environment including the entity’s internal control is crucial to identify and assess the risks of material misstatement.
Auditors shall also review the prior year’s testing approach and assess whether it will provide sufficient appropriate audit evidence for the current year’s audit.
The risk of fraud increases during periods with high inflation, as there is a greater risk that the three aspects of the fraud triangle, i.e. incentive, opportunity and realisation, are present. There may be greater pressure to commit financial reporting fraud for personal gains to meet targets or bonus thresholds.
Moreover, during periods with high inflation it is common that entities face a high staff turnover, as employees attempt to find more attractive remuneration packages. A high staff turnover might weaken the entity’s system of internal controls, which makes it more difficult to identify fraud.
Auditors need to do a detailed impairment assessment using the most up to date financial information. Such an assessment involves a lot of judgements and estimates.
Furthermore, impairment assessment might involve medium to long term inflationary assumptions, which is more complex as it involves a higher level of judgements and estimates.
Whilst performing the going concern assessment, both at the planning and completion stage, auditors need to take into consideration inflation.
Inflation is likely to increase the entity’s expenses and this might lead to reduced profitability. Moreover, if the entity’s major suppliers and customers went out of business, the entity would need to find other suppliers and customers, if possible. If the entity is not able to replace such suppliers and customers, the entity might need to change its business model.
When reviewing the entity’s budgets and forecast, auditors need to understand how Management have amended such budgets and forecast to factor in inflation and ensure that such assumptions make business sense.
Moreover, when an entity requires financial support from its parent entity, auditors need to obtain sufficient appropriate audit evidence that the said parent entity has the necessary financial resources to maintain its operations, and in addition provide financial support to all its group entities that are struggling.
Auditors need to assess the impact of inflation on the financial statements disclosures. Inflation might impact the subsequent events disclosure, going concern disclosures, sensitivity analysis, and so on.
Auditors must obtain written representations from Management that may support any other audit evidence obtained. It is important to highlight that representations on their own do not provide sufficient appropriate audit evidence.