Business and Industry

Inflation: Q&A with an internal audit expert

Editor’s note: The following article originally appeared in the online edition of Financial Management magazine, a publication of the Association of International Certified Professional Accountants. It is reprinted with permission.

BY NEIL AMATO

High inflation leads to concerns about how organizations price products, but it can have several “second- or third-order effects” that organizations should consider and attempt to mitigate through risk management. Richard Chambers was the president and CEO of The Institute of Internal Auditors for 12 years before stepping down in March 2021. Now, he continues to advocate for the internal auditing profession as a senior adviser at AuditBoard. Chambers and Financial Management’s Neil Amato had a conversation recently about inflation and risk. Here is an edited version of that interview.

Inflation in the u.S. Hit 7% in late 2021, the highest year-over year change in almost 40 years. How do you think finance risk managers should react to higher-thannormal inflation?

Richard Chambers: Well, it’s a point that continues to resonate within our profession, that there just isn’t a lot of experience of operating in this environment. If you think about it, it’s been 40 years. I call myself a Jurassic auditor. I have a few Jurassic buddies, and we’ve been talking a lot about what it was like back then. What were the challenges and the issues? I came into this profession even earlier than the high-water mark for inflation. I came in in 1975, and we were already battling inflation that far back, and it only got worse. At one point, it actually went up to 13%. As bad as things are right now, they’re not as bad as they were back then.

But the point is, there’s just not a lot of experience in facing these kinds of risks. I think it behooves us to draw on whatever information we can as to what we might expect. Assessing risk is always as much art as it is science, and there’s a lot of subjectivity that goes into it. No one is going to have a precise, scientific answer of what the risks are that we’re going to face, but there are some pretty good indicators based on history.

Besides that rise in the cost of so many things that consumers see, such as prices at grocery stores or hotels, what are the risks for organizations posed by high inflation that maybe we haven’t thought about?

Chambers: Well, the obvious overarching risk is margin. When you have surging costs and prices, you’ve got an immediate challenge there to the margins that you need to have to maintain profitability and to create value on behalf of your shareholders and stakeholders. Really, it’s almost from that monolithic risk that inflation presents to companies that all other risks flow. Some of the things that I’ve been talking about within the financial management community is our own ability to effectively budget and forecast. Budgeting and forecasting is a very critical responsibility that falls on financial managers. How do you

budget when prices are surging and costs are growing at almost unprecedented rates? It requires you to have a much more forward focus as you look at what the economists are forecasting. What are they saying we’re likely to encounter in the months ahead? Then budgeting, of course, is more of a periodic effort, but forecasting is almost continuous, so you have to recognise the risk there. The CFO and their teams are at a disadvantage just as the auditors are, because we may have audited or they may have undertaken their responsibilities during a healthy economy, maybe even recessionary periods, but inflationary periods offer us some different experiences. Then beyond that, just managing the surging costs and other expenses. The early stages of this inflationary cycle presented some really extraordinary price increases, but the deeper we go into the cycle, I think the more pervasive some of their price increases are likely to become.

I think management, guided by advice from financial managers, needs to make strategic decisions when it comes to things like talent. What are we going to do about retaining talent in the face of inflation, when other companies maybe are being more aggressive at raising salaries and creating a more enticing environment for our talent? We have to be careful about that.

I can remember all the way back in the day when cost-of-living increases were very much a norm. In fact, I remember that the federal government in 1980, I think it was, gave us two 6% cost-of-living increases in less than 12 months. It had to do that because of the way the prices were growing. Management needs advice from financial managers on raw materials purchased, management of infrastructure, and I think even, eventually, capital. There are a lot of things that I think we have to be mindful of as financial managers and the advice that we need to be able to give those who we serve. I could get into a lot more detail on some things like debts and leases and rental agreements and hedging and budgeting and so forth, but those are, at a very high level, some of the things that I think financial managers need to be concerned about — and the auditors, too.

How should pricing decisions be determined? Do companies have to actually say, “We might need to take a hit so that we don’t have to raise our prices too much.” Is that the art and science thing that’s going on right now with high inflation?

Chambers: Well, absolutely. Most guidance out there, most experts are quick to advise against blanket, across-the-board price increases. Because first of all, it just fuels more inflation, but even more to the point of the success of a company, if you’re seen as being too aggressive in raising prices, it will have a detrimental effect on your customer relationships. You have to really look at, what are the services or goods that we’re selling where the price of raw materials is increasing the most aggressively?

You need to be thinking in terms of margins on a more finite basis rather than, I’ve got to maintain a margin for my entire company. You need to be saying, “These are the things that we’re providing where prices or cost of raw materials or the cost of our third-party services are going up most rapidly.” That’s where you need to focus on price increases.

Are there other factors that you think are important to mention regarding pricing decisions?

Chambers: I would say that one should be cognisant of forecasts regarding raw materials. Let’s say we’re talking about pricing of a manufactured product. If all indications are that the price surge is not going to be long term and we’re just seeing a spike in it, then I think you have to be more judicious about increasing your prices. That’s where you may, as you alluded to a few minutes ago, “take a hit” as far as you may have a period where your margins on that particular product or service aren’t going to be as great. But you have to also be mindful that the economists who are out there are really in many ways not even in agreement on this inflationary cycle. What I recommend is this idea of triangulation. I’d be looking at several sources, and I wouldn’t be dependent upon any single one.

I think that’s a good rule, multiple sources of information. We remain in a high-inflation environment. What are the risk mitigation strategies organizations should embrace if they haven’t started doing them already?

Chambers: All risks really should emanate from your organization’s objectives. What are the enterprise objectives? Then, look at what those risks are likely to be. I think we also have to be mindful of the second- and third-order effects of inflation. Talent management — clearly, we’re already starting to see some pressure there as we’re in the midst of the Great Resignation, and we’re still trying to get back to office work from our COVID experience. But I think as the cost of living increases, people are going to be seeking to maintain their own purchasing power. I think we will see more pressure on wages in the coming weeks and months than we maybe have already seen. Supply chain disruption — our suppliers are going to be facing the same kind of challenges that we do. Let’s say I’m at an enterprise in financial management. I need to be recognizing that our suppliers are going to be facing the same headwinds with inflation we’re facing, and we’re already seeing a supply chain disruption from the COVID years. What’s going to happen when our suppliers are not able to get raw materials

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at affordable prices and they’re going to be impacted on their production? I think fraud is another interesting second- and third-order risk. As you start to see pressure on your employees in terms of their cost of living and the kinds of pressures that come with that, I think you tend to have an environment where there’s maybe a little more enticement to cut corners and maybe do some things fraudulently. I would say fraud risk is another risk that I would be looking toward on the horizon.

Capital market volatility — certainly, we’ve already started to see that, and this really is an event that I think is likely to create another set of risks entirely. As policymakers increase market rates as early as next month, that’s going to put another degree of pressure in terms of overall pricing in the market. Those are some other things that I would be thinking about.

Who benefits from high inflation?

Chambers: I think inflation has a double-sided coin. Obviously, it creates challenges and risks, but it also creates opportunity. Revenues will likely be going up across the board because of price increases and so forth. Even in the public sector — I spent a good deal of my career in the public sector — tax revenues are often tied to prices, salaries, all kinds of metrics that will be going up. It’s not uncommon to see revenues for public-sector agencies going up as well. Of course, their costs are going to also be going up. What you hope is that your costs aren’t going up more rapidly than the revenues that are being generated. I would say from an individual standpoint, the pressure comes on your prices going up. That can be mitigated by your salaries going up, but there’s often a lag time between when those happen. The same then extends into the corporate sector. You have to try to stay as far ahead of the inflationary pressures as you can. But if everybody’s doing that, then it’s a self-fulfilling prophecy and just generates more inflation.

Talent management is one of those second- or thirdorder effects that maybe people aren’t thinking about. What do they have to be doing besides being ready to offer more pay to their workers?

Chambers: When it comes to talent management, we have to be thinking about the fact that money isn’t the only incentive. I’m watching with fascination as some companies are being really hard-line on their return-to-the-workplace requirements while others are maintaining a lot more flexibility. If I’m making a decision as an employee between where I’m working and someplace else and maybe my company is willing to offer me a cost-of-living increase, the other company maybe it’s not as aggressive on that, but I’m going to weigh everything. I’m going to say, “OK, I don’t have to do as much travel to the workplace. That saves costs, saves me fuel and commuting expenses.” All of those things factor in. I think the mistake that any company would make at this point is looking at talent management very onedimensionally. It really is far more complex than just how much you pay people.

If inflation starts going back down, what kind of changes should organizations make? Are they undoing things, or what is different when it’s going the other way that it has been?

Chambers: It will happen. It’s not a matter of if. Inflation will go down. Question is how long this inflationary cycle is going to last and how much pain we’re going to endure until it gets back under control. But I would think that as we go through this inflationary cycle, we will start to learn more about some of the fundamentals of our business.

I think those things that we learned, the wisdom that we derive from the marketplace and how consumers behave, and how welloiled our own internal operational mechanisms are, I would hope that we can use that after the inflationary cycle to be more efficient and more effective and make wiser decisions. There are so many facets to this that it really is a fascinating topic. I think it is starting to get attention. Although, I think a lot of people are still dealing with what they consider to be the more immediate risks, but we’re clearly well into an inflationary cycle that we haven’t seen the likes of in a long time.

I guess it’s possible that those organizations that have been hesitant to bring people back to the office but are now seeing their building rents going up, they may actually go back to remote work. I don’t know if you’re hearing any examples of that, but it seems like a realistic thing right now.

Chambers: We’ve seen a lot of companies during the pandemic make the decision to change their fundamental workplace model. I’ve seen companies giving up leases on their workplace and telling everybody they’re going to be working virtual. Commuting costs have always been a part of any personal or family budget. Once those are down, that takes a bit of the pain out of the inflationary cycle. But as I said earlier, there are still so many other factors that go into employee satisfaction and comprise good talent management and strategy. Neil Amato is a senior editor with the Association of International Certified Professional Accountants.