Financial Reporting in Hyperinflationary Economies

Concepts, Rules, and Examples

Hyperinflation and Financial Reporting

Hyperinflation is a condition that is difficult to define precisely, as there is not a clear demarcation between merely rampant inflation and true hyperinflation. However, in any given economic system, when the general population has so lost faith in the stability of the local economy that business transactions are commonly either denominated in a stable reference currency of another country, or are structured to incorporate an indexing feature intended to compensate for the distortive effects of inflation, this condition may be present. As a benchmark, when cumulative inflation over three years approaches or exceeds 100%, it must be conceded that the economy is suffering from hyperinflation.

Hyperinflation is obviously a major problem for any economy, as it creates severe distortions and, left unaddressed, results in uncontrolled acceleration of the rate of price changes, ending in inevitable collapse as was witnessed in post-World War I Germany. From a financial reporting perspective, there are also major problems, since even over a brief interval such as a year or even a quarter, the income statement will contain transactions with such a variety of purchasing power units that aggregation becomes meaningless, as would adding dollars, francs, and marks. This is precisely the problem discussed earlier in this chapter, but raised to an exponential level.

In a truly hyperinflationary economy, users of financial statements are unable to make meaningful use of such statements unless they have been recast into currency units having purchasing power defined by prices at or near the date of the statements. Unless this common denominator is employed, the financial statements are too difficult to interpret for purposes of making management, investing, and credit decisions. Although some sophisticated users, particularly in those countries where hyperinflation has been endemic, such as some of the South American nations, including Brazil and Argentina, and for certain periods nations such as Israel, are able to apply rules of thumb to cope with this problem, in general modifications must be made to general-purpose financial statements if they are to have any value.

Under international accounting standards, if hyperinflation is deemed to characterize the economy, a form of price level accounting must be applied to the financial statements to conform with generally accepted accounting principles. IAS 29 requires that all the financial statements be adjusted to reflect year-end general price levels, which entails applying a broad-based index to all nonmonetary items on the balance sheet and to all transactions reported in the income statement and the cash flow statement.

Restating Historical Cost Financial Statements under Hyperinflation Conditions

The precise adjustments to be made depend on whether the financial reporting system is based on historical costs or on current costs, as described in IAS 15 and explained earlier in this chapter. Although in both cases the goal is to restate the financial statements into the measuring unit that exists at the balance sheet date, the mechanics will vary to some extent.

If the financial reporting system is based on historical costing, the process used to adjust the balance sheet can be summarized as follows:

1. Monetary assets and liabilities are already presented in units of year-end purchasing power and receive no further adjustment. (See the appendix for a categorization of different assets and liabilities as to their status as monetary or nonmonetary.)

2. Monetary assets and liabilities that are linked to price changes, such as indexed debt securities, are adjusted according to the terms of the contractual arrangement. This does not change the characterization of these items as monetary, but it does serve to reduce or even eliminate the purchasing power gain or loss that would have otherwise been experienced as a result of holding these items during periods of changing general prices.

3. Nonmonetary items are adjusted by applying a ratio of indices, the numerator of which is the general price level index at the balance sheet date and the denominator of which is the index as of the acquisition or inception date of the item in question. For some items, such as plant assets, this is a straightforward process, while for others, such as work in process inventories, this can be more complex.

4. Certain assets cannot be adjusted as described above, because even in nominally historical cost financial statements these items have been revised to some other basis, such as fair value or net realizable amounts. For example, under the allowed alternative method of IAS 16, plant, property, and equipment can be adjusted to fair value. In such a case, no further adjustment would be warranted, assuming that the adjustment to fair value was made as of the latest balance sheet date (although IAS 16 only demands that this be done at least every three years). If the latest revaluation was as of an earlier date, the carrying amounts should be further adjusted to compensate for changes in the general price level from that date to the balance sheet date, using the indexing technique noted above.

5. Consistent with the established principles of historical cost accounting, if the restated amounts of nonmonetary assets exceed the recoverable amounts, these must be reduced appropriately. This can easily occur, since (as discussed earlier in this chapter) specific prices of goods will vary by differing amounts, even in a hyperinflationary environment, and in fact some may decline in terms of current cost even in such cases, particularly when technological change occurs rapidly. Since the application of price level accounting, whether for ordinary inflation or for hyperinflation, does not imply an abandonment of historical costing, being a mere translation into more timely and relevant purchasing power units, the rules of that mode of financial reporting still apply. Generally accepted accounting principles require that assets not be stated at amounts in excess of realizable amounts, and this constraint applies even when price level adjustments are reflected.

6. Equity accounts must also be restated to compensate for changing prices. Paid-in capital accounts are indexed by reference to the dates when the capital was contributed, which are usually a discrete number of identifiable transactions over the life of the enterprise. Revaluation accounts, if any, are eliminated entirely, as these will be subsumed in restated retained earnings. The retained earnings account itself is the most complex to analyze and in practice is often treated as a balancing figure after all other balance sheet accounts have been restated. However, it is possible to compute the adjustment to this account directly, and that is the recommended course of action, lest other errors go undetected. To adjust retained earnings, each year's earnings should be adjusted by a ratio of indices, the numerator being the general price level as of the balance sheet date, and the denominator being the price level as of the end of the year for which the earnings were reported. Reductions of retained earnings for dividends paid should be adjusted similarly.

7. IAS 29 addresses a few other special problem areas. For example, the standard notes that borrowing costs typically already reflect the impact of inflation (more accurately, interest rates reflect inflationary expectations), and thus it would represent a form of double counting to fully index capital asset costs for price level changes when part of the cost of the asset was capitalized interest, as defined in IAS 23 as an allowed alternative method. As a practical matter, interest costs are often not a material component of recorded asset amounts, and the inflation-related component would only be a fraction of interest costs capitalized. However, the general rule is to delete that fraction of the capitalized borrowing costs which represents inflationary compensation, since the entire cost of the asset will be indexed to current purchasing units.

To restate the current period's income statement, a reasonably accurate result can be obtained if revenue and expense accounts are multiplied by the ratio of end-of-period prices to average prices for the period. Where price changes were not relatively constant throughout the period, or when transactions did not occur ratably, as when there was a distinct seasonal pattern to sales activity, a more precise measurement effort might be needed. This can be particularly important when a devaluation of the currency took place during the year.

While IAS 29 addresses the cash flow statement only perfunctorily (its issuance was prior to the revision of IAS 7), this financial statement must also be modified to report all items in terms of year-end purchasing power units. For example, changes in working capital accounts, used to convert net income into cash flow from operating activities, will be altered to reflect the real (i.e., inflation adjusted) changes. To illustrate, if beginning accounts receivable were $500,000 and ending receivables were $650,000, but prices rose by 40% during the year, the apparent $150,000 increase in receivables (which would be a use of cash) is really a $50,000 decrease [($500,000 x 1.4 = $700,000) - $650,000], which in cash flow terms is a source of cash. Other items must be handled similarly. Investing and financing activities should be adjusted on an item-by-item basis, since these are normally discrete events that do not occur ratably throughout the year.

In addition to the foregoing, the adjusted income statement will report a gain or loss on net monetary items held. As an approximation, this will be computed by applying the change in general prices for the year to the average net monetary assets (or liabilities) outstanding during the year. If net monetary items changed materially at one or more times during the year, a more detailed computation would be warranted. In the income statement, the gain or loss on net monetary items should be associated with the adjustment relating to items that are linked to price level changes (indexed debt, etc.) as well as with interest income and expense and foreign exchange adjustments, since theoretically at least, all these items contain a component that reflects inflationary behavior.

Restating Current Cost Financial Statements under Hyperinflation Conditions

If the financial reporting system is based on current costing (as described earlier in the chapter), the process used to adjust the balance sheet can be summarized as follows:

1. Monetary assets and liabilities are already presented in units of year-end purchasing power and receive no further adjustment. (See the appendix for a categorization of different assets and liabilities as to their status as monetary or nonmonetary.)

2. Monetary assets and liabilities that are linked to price changes, such as indexed debt securities, are adjusted according to the terms of the contractual arrangement. This does not change the characterization of these items as monetary, but it does serve to reduce or even eliminate the purchasing power gain or loss that would have otherwise been experienced as a result of holding these items during periods of changing general prices.

3. Nonmonetary items are already stated at year-end current values or replacement costs and need no further adjustments. Issues related to recoverable amounts and other complications associated with price level adjusted historical costs should not normally arise.

4. Equity accounts must also be restated to compensate for changing prices. Paid-in capital accounts are indexed by reference to the dates when the capital was contributed, which are usually a discrete number of identifiable transactions over the life of the enterprise. Revaluation accounts are eliminated entirely, as these will be subsumed in restated retained earnings. The retained earnings account itself will typically be a "balancing account" under this scenario, since detailed analysis would be very difficult, although certainly not impossible, to accomplish.

The current cost income statement, absent the price level component, will reflect transactions at current costs as of the transaction dates. For example, cost of sales will be comprised of the costs as of each transaction date (usually approximated on an average basis). To report these as of the balance sheet date, these costs will have to be further inflated to year-end purchasing power units, by means of the ratio of general price level indices, as suggested above.

In addition to the foregoing, the adjusted income statement will report a gain or loss on net monetary items held. This will be similar to that discussed under the historical cost reporting above. However, consistent with IAS 15, current cost income statements already will include the net gain or loss on monetary items held, which need not be computed again.

To the extent that restated earnings differ from earnings on which income taxes are computed, there will be a need to provide more or less tax accrual, which will be a deferred tax obligation or asset, depending on the circumstances.

Comparative Financial Statements

Consistent with the underlying concept of reporting in hyperinflationary economies, all prior-year financial statement amounts must be updated to purchasing power units as of the most recent balance sheet date. This will be a relatively simple process of applying a ratio of indices of the current year-end price level to the year earlier price level.

Other Disclosure Issues

IAS 29 requires that when the standard is applied, the fact that hyperinflation adjustments have been made be noted. Furthermore, the underlying basis of accounting, historical cost or current cost, should be stipulated, as should the price level index that was utilized in making the adjustments.

Economies Which Cease Being Hyperinflationary

When application of IAS 29 is discontinued, the amounts reported in the last balance sheet that had been adjusted become, effectively, the new cost basis. That is, previously applied adjustments are not reversed, since an end to a period of hyperinflation generally means only that prices have plateaued, not that they have deflated to earlier levels.