CPA AFR: ACCOUNTING FOR INFLATION-IAS 29

ADVANCED FINANCIAL REPORTING

ACCOUNTING FOR INFLATION-IAS 29

Overview

IAS 29 Financial Reporting in Hyperinflationary Economies applies where an entity’s functional currency is that of a hyperinflationary economy. The standard does not prescribe when hyperinflation arises but requires the financial statements (and corresponding figures for previous periods) of an entity with a functional currency that is hyperinflationary to be restated for the changes in the general pricing power of the functional currency.

IAS 29 was issued in July 1989 and is operative for periods beginning on or after 1 January 1990.

 Objective of IAS 29

The objective of IAS 29 is to establish specific standards for entities reporting in the currency of a hyperinflationary economy, so that the financial information provided is meaningful.

Restatement of financial statements

The basic principle in IAS 29 is that the financial statements of an entity that reports in the currency of a hyperinflationary economy should be stated in terms of the measuring unit current at the balance sheet date. Comparative figures for prior period(s) should be restated into the same current measuring unit. [IAS 29.8]

Restatements are made by applying a general price index. Items such as monetary items that are already stated at the measuring unit at the balance sheet date are not restated. Other items are restated based on the change in the general price index between the date those items were acquired or incurred and the balance sheet date.

A gain or loss on the net monetary position is included in net income. It should be disclosed separately. [IAS 29.9]

The restated amount of a non-monetary item is reduced, in accordance with appropriate IFRSs, when it exceeds its the recoverable amount. [IAS 29.19]

The Standard does not establish an absolute rate at which hyperinflation is deemed to arise – but allows judgement as to when restatement of financial statements becomes necessary. Characteristics of the economic environment of a country which indicate the existence of hyperinflation include: [IAS 29.3]

• the general population prefers to keep its wealth in non-monetary assets or in a relatively stable foreign currency. Amounts of local currency held are immediately invested to maintain purchasing power;
• the general population regards monetary amounts not in terms of the local currency but in terms of a relatively stable foreign currency. Prices may be quoted in that currency;
• sales and purchases on credit take place at prices that compensate for the expected loss of purchasing power during the credit period, even if the period is short;
• interest rates, wages, and prices are linked to a price index; and
• the cumulative inflation rate over three years approaches, or exceeds, 100%.

IAS 29 describes characteristics that may indicate that an economy is hyperinflationary. However, it concludes that it is a matter of judgement when restatement of financial statements becomes necessary.

When an economy ceases to be hyperinflationary and an entity discontinues the preparation and presentation of financial statements in accordance with IAS 29, it should treat the amounts expressed in the measuring unit current at the end of the previous reporting period as the basis for the carrying amounts in its subsequent financial statements. [IAS 29.38]

Disclosure

• Gain or loss on monetary items [IAS 29.9]
• The fact that financial statements and other prior period data have been restated for changes in the general purchasing power of the reporting currency [IAS 29.39]
• Whether the financial statements are based on an historical cost or current cost approach [IAS 29.39]
• Identity and level of the price index at the balance sheet date and moves during the current and previous reporting period [IAS 29.39]

The discussion on income and capital has shown that income or profit is the amount an enterprise earns after maintaining its capital.

The capital to be maintained depends on the measurement approach used by the enterprise. The approaches include:

• Historical cost approach (nominal capital maintenance)
• Financial capital maintenance (adjusted for inflation)
• Physical capital maintenance.

This yields three methods of accounting that is:

• Historical cost accounting.
• Current purchasing power.
• Current cost accounting method.

Historical cost accounting

This is the conventional accounting approach. It is the generally accepted method of accounting. According to this approach, income is the increase in net worth (assets-liabilities) based on their cost of acquisition and before any distribution in form of dividends.

Limitations of Historical Cost Accounting (HCA)

Although accounting transactions are measured in monetary terms, money is not a uniform measure of value especially in periods of changing prices. The following are some of the shortcomings of historical cost accounting.

(a) Valuation of fixed assets

Historical cost states fixed assets at the cost of acquisition. Such values of assets are not realistic, as they bear no relation to actual values of benefits to be derived from the use of the assets.

(b) Consistency violation

Items included in the balance sheet may not be consistently valued in terms of the unit of measure. For instances whereas the assets, particularly fixed assets and stock, are valued at historical costs, the liabilities as well as monetary assets are valued at current realizable or payable amounts. Moreover, comparison of accounting figures over a period of time based on HCA is not possible in times of rising prices.

(c) Depreciation

One of the purposes of depreciation is to provide funds for the replacement of assets. HCA depreciation does not provide for adequate replacement fund because it is based on the HC of acquisition rather than replacement values. Thus the depreciation based on historical cost of fixed assets is not an adequate measure of the value of the assets consumed during a given period.

(d) Holding gains vis-à-vis operating gains

HC accounting does not distinguish between holding gains and the profits from business activities. Holding gains are the benefits arising from holding goods for sale during times of rising price. That portion of gross profit for the year, which is ‘holding gains’, is not disclosed under historical cost accounting method.

(e) Gains and losses on monetary items

A business may gain as a result of obtaining credit at times of increasing prices. Similarly, it would lose in terms of purchasing power if it sells on credit in terms of rising prices. Historical cost accounting fails to disclose the gains on holding net monetary liabilities, or losses on holding net monetary assets.

(f) Analysis and interpretation of accounts

Analysis of financial statements based on historical cost figures can give misleading and sometimes awkward results. For example, return on investments computation will be based on undervalued assets in the balance sheet and overstated profit in the profit and loss account.

(g) Cost of sales

In times of rising prices the cost of replacing goods sold is higher than the historical cost of sales. The conventional methods of determining cost of sales (e.g. FIFO, LIFO, etc) will result in an inadequate charge against sales revenue. The resulting profit figure is likely to be exaggerated.

(h) Taxation and dividend

The effect of undercharging depreciation and cost of sales is to overstate profits. This may lead to higher taxation than warranted. Moreover it may exaggerate the business ability to pay dividends and therefore lead to distributions of dividends or payment of tax out of capital rather than profits.

Current purchasing power (CPP) method

CPP is a method of accounting for inflation, which is based on general price level index(where price index is a system of numbers by which the prices of goods can be compared with what they were in the past), used as a deflator of the nominal value, arrived at using historical cost accounting. The objective of deflation is to maintain the purchasing power of capital to that at the beginning of the period. The assumption of CPP is that prices of individual items move (i) at the same direction and (ii) in the same rate (hence general price index number). For the purpose of CPP it is important to distinguish between two classes of items, monetary and non-monetary items.

Monetary items

These are those items, which are fixed by contract or by their nature and are expressed in money worth regardless of changes in price level. They include cash, debtors, loans, creditors and claims to specified amounts of money. Holders of monetary liabilities gain at the expense of the creditors during period of inflation. Those whom hold monetary liabilities gain at the expense of the creditors during period of inflation. Those who sell on credit lose in times of inflation unless payments are pegged to price level changes.

Non-monetary items

These are items whose value is not fixed in any way and therefore would not lose or gain as a result of inflation or deflation. Examples include assets and liabilities such as fixed assets, stock and shareholders equity. For instance, increase in price of stocks may not cause any loss, as at the time of sale value will compensate the loss in purchasing power.

Conversion of historical costs under CPP method

Under this method, expenditures and receipts made or received in shillings of ‘past purchasing power’ are converted into shillings of ‘current purchasing power’ by use of price indices. The conversion is effected using the following formula:

Converted amount   = actual amount         Current index number

Spent or                 X   index number at

Received (Ksh)            date of transaction

The conversion to current purchasing power is effected for all the balances appearing in the profit and loss account and balance sheet except monetary assets and liabilities. Monetary items including cash, debtors, creditors, accruals, repayments, etc, appear in the CPP balance sheet at the same value as which they appear in the historical cost accounting balance sheet. They represent the amounts realizable or payable, as the case would be.

Gains on holding monetary assets and liabilities

Gains or losses on holding monetary assets and liabilities result from stating the monetary assets and liabilities in the CPP balance sheet at the same value at which these are stated in the historical cost balance sheet in a period when the purchasing power of the currency is changing.

The above procedure requires that the dates of the transactions that change the net total monetary assets be identified. However, those transactions, which simply result in a change in the composition of net monetary assets, need not be considered. For example, purchase of goods on credit immediately reduces net monetary assets by virtue of the increase in creditors (stock is non-monetary asset) while subsequent payment of the debt has no effect on net monetary assets as it reduces cash and creditors by the same amount.

It is worth noting that a company’s net monetary assets are essentially made up of its current assets (excluding stock), current liabilities and its longer-term liabilities. The long-term liabilities would include debentures and other forms of loan capital. The rights of preference shareholders are usually fixed in money terms. This is so if they are entitled to a fixed dividend and to a fixed sum payable on the liquidation of the company. In such a case preference shares would be included in the long-term net monetary assets. The adjustment of historical cost value to current purchasing power value is based on the notion that profit can only be recognized if the purchasing power of capital is maintained.

Accounting for price level changes using CPP method involves the following steps.

• Convert the balance sheet items of year x₀ to the general price index at year x₀.
• Adjust the balance sheet converted in step 1 to general price index at the end of year x₁.
• Compute the monetary gain\loss.
• Convert the profit and loss for the year x ₁ to price index at end of year x₁.
• Convert the balance sheet of year x₁ to general price index at end of year x₁.

Advantages and disadvantages with CPP method

Advantages of CPP

1. The financial statement drawn under CPP method is objective in the sense that it does not depart from the principle of historical-cost based measurement.
2. Price level adjustments based on general price levels are verifiable by reference to the index used to measure changes in purchasing power of money.
3. Financial statements drawn on CPP methods are comparable because of the consistency of approach.

Weakness with CPP

1. CPP is based on the concept of general price index. There is actually nothing like a ‘general purchasing power’. Instead, firms and people see themselves as holding specific purchasing power.
2. There are computations (statistical) as well as interpretation (conceptual) limitations of using price index number. There are many types of index numbers that may be used yet there is no agreement on which provides the general price level index.
3. The income arrived at using CPP approach is rather meaningless. It does not represent the earnings potential of capital but rather an average (index) value. It does not explain strictly what the firms have actually earned.
4. General Price level indices assume that prices of different commodities change in the same direction and magnitude. In reality prices do not necessarily move in the same direction let along same magnitude.