Inflation risk for internal auditors
A short practical read for internal auditors – assurance in an inflationary environment.
Inflation is the general increases in prices which has the effect of lowering the value of money. In most of the last 40 years, we have had a relatively low inflationary environment which has had a fairly benign impact on the economy. High inflation often results from shocks to the economy, most recently from the war in Ukraine, the covid pandemic and a sudden change to the labour supply.
Higher prices will often lead to higher wages which in turn result in higher costs and therefore even higher prices resulting in the price-wage spiral. For individuals this means they often have less real disposable income. For businesses this causes uncertainty in costs, prices and demand which makes business planning and investment challenging. This is accentuated as most business leaders have little or no experience of how to react to a higher-inflationary environment.
The Role of Internal Audit
Just as many business leaders have not operated in a high-inflation environment, internal auditors typically have little or no experience of auditing in such an environment. Internal auditors need to understand the additional risks it brings and how it changes the existing risk landscape. It will inevitably impact all organisations and internal auditors need to consider this context in evaluating their findings and agreeing management actions.
It is likely that inflation will be a consideration in audit engagements rather than a single audit. This is because it will impact most or all areas of a business – from sales to cost of production to support costs. Management should be updating risk assessments to reflect the changing risks and planned audit engagements should be reprioritised if the change in the external environment materially changes the risk profile.
Similarly controls which are adequate in “normal” times may be insufficient in a high inflation environment, for example where annual or quarterly reviews would be too late in identifying inflationary impacts. Internal auditors should discuss with management how their approach to issues such as business planning, staff retention, pricing and cost management has changed.
It is important for internal auditors to understand what the business is concerned about.
Key Risks & Controls
The underlying risk resulting from inflation is greater financial uncertainty. Some of the impacts of inflation and the risks this presents are described below along with some potential controls to mitigate the risks.
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Risks |
Potential controls and mitigation |
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Board Increased complexity puts pressure on existing governance and risk management frameworks with the potential for poor decision making. |
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Business planning & performance management Business planning becomes more difficult due to uncertainty of income and costs. This may mean performance deteriorates and actual results deviate significantly from the plan. In turn the management of financial and operational performance becomes more challenging. |
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Supply chain Costs further up the supply chain increase. This may also cause shortages of required materials and products if suppliers fail at any point in the chain (a risk which is increased with uncertainty and particularly where inflexible contracts are in place). |
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Debtors Customers may pay later than usual due to cash-flow challenges. Customers are also more likely to fail due to financial unpredictability resulting in bad debts. |
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Interest rates Borrowing and lease costs could increase as interest rates typically rise in times of high inflation. |
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Cash flow As a result of the above (costs rising, higher interest rates, slower payments, etc) cash balances deteriorate making it more difficult to pay amounts as they fall due. |
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Employee retention/satisfaction Inflation causes increased costs for employees – mortgages, rent, fuel, day-to-day essentials etc. Under-inflation pay rises may result in staff leaving and dissatisfaction among others. |
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Customer retention/satisfaction If prices increase, customers may look for cheaper or lower quality alternatives (note this could also be an opportunity). |
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Fraud The motivation to commit fraud is greater when staff and others feel less financially secure, and when there is rapid change (eg in prices) it may be easier to by-pass control processes |
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Conclusions
High inflation is relatively new to most business leaders and similarly to most internal auditors. Just as all businesses need to adapt to higher inflation, internal audit needs to adapt to the changing risk landscape that it brings. An ongoing re-evaluation of key risks and the appropriate internal audit response is required.
Internal audit need to challenge whether existing controls are still adequate to mitigate this changing and enhanced risk. In many situations, heightened reliance will be needed on these existing controls, which may mean they need to be performed more regularly or with greater precision, along with a greater focus by the business on close, ongoing engagement with stakeholders.
References
A beginner’s guide to inflation – everything you need to know | MoneyWeek
Inflation is Back! What Should Internal Auditors Do Now? – Richard Chambers
Inflation | McKinsey & Company
