The drumbeat of inflation news has grown increasingly louder in recent months, and recent geopolitical events threaten an even more ominous roar in the months ahead. The Federal Reserve’s preferred measure of U.S. inflation rose in February to 7.9%, hitting a new 40-year high, as the Russia/Ukraine conflict, strong consumer demand, and supply constraints drove price increases. The personal-consumption-expenditures index measure of core inflation rose by 5.2% in January from a year earlier — the largest 12-month increase since 1983.
Recent articles have drawn attention to the fact that today’s corporate financial managers, risk management professionals, and internal auditors have little experience operating in an inflationary environment. Other articles have suggested areas where internal auditors should focus their attention in assessing and monitoring burgeoning inflation risks.
Each industry and enterprise faces unique challenges and opportunities in an inflationary environment. As purveyors of assurance and advice, internal auditors should keep their eyes open for inflation-related risks. Here are 10 areas internal audit should have on the radar where there may be new or emerging risks in the months ahead.
1. Enterprise Debt
Internal auditors should be cognizant of the company’s debt agreements. They may contain variable interest rates that could negatively impact the company’s bottom line with rising inflation and interest rates. Methods may need to be employed to consolidate debt or restructure the debt and obtain a more favorable interest rate for existing debt.
Similar to the above risk there could be floating/variable interest rates for various leases that could negatively impact the company’s bottom line. Strategies should be considered for how to reduce negative effects, such as buying the leased asset, restructuring leases, etc.
3. Rental agreements
These may warrant analysis by internal auditors to discern inflationary impacts. Again, issues of interest rates may exist, but there may also be cost caps that will reduce impacts of rising inflation on the agreements.
4. Spare Parts in Inventory
Internal auditors may want to examine where the company obtains the replacement parts that they use. For example, airlines may use a third party to hold inventory that they in turn charge the company to replace parts in the future rather than the cost of the part they had on-hand. Are there cost caps for the spare parts? What levels of inventory should be held given future rising costs?
Internal auditors should understand the risks and benefits of hedging. Be it fuel, currency, or other commodities, hedging could be useful in inflationary periods for managing the cost of fuel and other commodities for which prices are surging.
A constant reassessment of budgeting initiatives should be employed during inflationary periods, and internal auditors should ensure the assumptions and processes are consistently applied across the enterprise.
7. Payroll Costs
Rapidly rising payroll costs can present significant challenges to the bottom line.If the company uses third party vendors, internal audit can examine what safeguards or caps exist to limit the impact of inflationary increases in payroll expenditures, including benefits costs of the related employees.
8. Pension Programs
Rising interest rates impact the funding of defined pensions programs. Internal audit can look into whether the managers are experienced in managing funds in periods of high market volatility and an inflationary environment, and whether they are closely monitoring how pension funds are invested.
9. Construction Costs
Internal auditors should be aware of whether major projects are on a lump sum or cost-plus arrangement. Clearly if they are on a cost-plus approach, rising inflation could make budgetary pressure intense. If entering into new construction agreements, the evaluation should also include caps if the cost-plus approach is utilized. If the company changes from cost-plus moving forward, they will also need to have strong change controls measures in place to avoid cost creep.
During times of high inflation, pricing methodologies must be reevaluated. Is the company using methods to ensure that pricing of products or services incorporates the higher costs of inflation in their pricing methodologies? Is the company able to pass these higher costs to their customers or are there price caps that cause the company to absorb more of these inflationary costs on its own bottom line?
No one knows how deep the current inflationary cycle may go, or how long it may last. As internal auditors, we must always keep our eyes on the risks, and adapt our audit plans accordingly. These are just a few areas that should be on internal audit’s radar as we help our organizations navigate the most significant inflationary environment in four decades.