Financial Reporting in Hyperinflationary Economies (IAS 29)

International Accounting Standard 29: Financial Reporting in Hyperinflationary Economies

WHAT IS A HYPERINFLATION ECONOMY:

This is a term used to describe the extreme and uncontrollable increases in the general price level of goods and services in an economy. Due to rapid increase in prices, this leads to the erosion of the value of the currency. This means that the local currency is no longer a useful measure of value in that economy. In such economies, the population of that country may prefer not to hold its wealth in the local currency but rather in another stable foreign currency.

WHAT IS PURCHASING POWER PARITY (PPP):

This is an economic theory that determines an exchange rate between two currencies. The PPP is designed to ensure that the cost of goods and services is the same across different countries.

HOW DOES INFLATION IMPACT THE PURCHASING POWER PARITY?

When prices increase by inflation, a fixed amount of money can purchase fewer items thus reducing the value of the currency. This directly affects the exchange rate between countries. A country with high inflation is likely to have its currency depreciating in relation to other currencies.

FUNCTIONAL CURRENCY IN HYPERINFLATIONARY ECONOMY

A business located in Zimbabwe (which considered a hyperinflationary economy) will not have to apply IAS 29 if the business’ functional currency is of an economy that is NOT facing hyperinflation. An example: If the business is physically located in Zimbabwe, however all its revenue earned and costs are incurred primarily in South Africa, this business will not have to apply IAS 29. This is because its functional currency is not from a hyperinflationary economy. It is important to always remember that IAS 29 is not only linked to the physical location of the entity, but the functional currency of the entity drives the applicability of this standard.

WHY IS IAS 29: FINANCIAL REPORTING INHYPERINFLATIONARY ECONOMIES NECESSARY?

We are living in a world where many countries and currencies face hyperinflation. Economies such as Zimbabwe have been classified as hyperinflationary economies.

In an economy where hyperinflation prevails, the money in that economy loses purchasing power i.e. it can purchase fewer and fewer goods and services as inflation rises. For example, if you have an asset that cost FC1000[1]in 2023 and the inflation is 100% in the current year (2024), the very same asset would cost FC2000 in 2024. In simple English, you need double FC during2024 to purchase the very same asset due to the hyperinflation. If we continue with the example let’s assume we have two entities, entity A and entity B. Entity A purchased the asset during 2023, while entity B purchased the same asset in 2024. The financial information of the entities is no comparable and is misleading. It may appear entity B has a higher asset base compared to entity A. This is not the case, the carrying amount of the assets in entity B is solely driven up by inflation.

From the example above comparing the reporting from a financial position (balance sheet) and an operating position (comprehensive income) in years of hyperinflation (2024) to earlier periods (2023) with no hyperinflation may give misleading information. Specifically, information that is not useful for decision making purposes.

HOW DO WEAPPLY IAS 29: FINANCIAL REPORTING IN HYPERINFLATIONARY ECONOMIES?

IAS 29 does not prescribe a rate for a currency to be classified as a hyperinflationary, but the standard does give some guidance or indicators of hyperinflation. A very indicative indicator is if the cumulative inflation rate over a three-year period approach or exceeds 100%.

We all know that from time to time, prices may increase or decrease based on technology, demand and supply etc. This is normal. BUT in some economies the increase in pricing is at a rapid and uncontrollable rate such that it affects the purchasing power of the currency. In this article we will be focusing solely on the negative changes in pricing and the financial reporting implication of this.

IAS 29 required that current year and comparative information is restated using a general pricing index (GPI). I know you may be wondering what is a GPI and where one can get this information? To simplify, the GPI is like what we refer to as the consumer price index (CPI). This is the price for a wide range of goods and services. This index can be obtained from institutions that track the statistics of an economy.

Once you have established that an entity operates with a hyperinflationary functional currency we need to follow the following steps:

1)      Select of the most appropriate GPI (this may be at various points – we will discuss this shortly)

2)      Restate of the statement of financial position

3)      Restate of the statement of changes in equity

4)      Restate of the statement of comprehensive income

5)      Calculate of the gain or loss on the net monetary position

6)      Restate of the statement of cashflows

7)      Restate comparative information(i.e. the prior years)

STEP 1: SELECTION OF THE MOST APPROPRATE GPI

This is considered straight forward as some of this information is readily available such as the CPI etc.

STEP 2: RESTATEMENT OF THE STATEMENT OF FINANCIAL POSITION

In this section, I will start off by explain what happens in anon-hyperinflationary economy as a base for understanding and appreciation of accounting implications in a hyperinflationary economy

Non-Hyperinflationary economy

Generally, companies prepare their financial statements using the historic price basis for example: cost or cost less depreciation. Usually, companies do not go and adjust/restate these amounts in response to increase or decreases in the general pricing level that is normal.

Of course, this will be different for assets held on the fair value model such as land or investment property which would be adjusted for any changes in their fair value(should the accounting policy allow).

For assets such as inventory, an entity could report the balance based on the current price i.e.net realisable value (the estimated selling price less estimated cost to make the sale) at the end of the reporting period.

Hyperinflationary Functional Currency

a)      Monetary items such as cash, trade receivables, loans etc are not restated. Why is this?

It is because they are already recorded at the unit current at the end of the year. What do I mean? If you have FC3000 in your bank account at the end of the year, that is what you will have at the beginning of the year – we cannot increase/decrease the amount of money in the bank account due to inflations. What it does mean however is that the purchasing power of the FC3000 in the next period will be much less – you won’t be able to buy as many goods or services with that amount going forward – the currency has lost value.

The only exception to this is monetary instruments such as index linked instruments/bonds. These would need to be restated based on the terms of the various agreements.

b)     Assets at current price:

Inventory may not need to be restated if it is recorded at current price i.e. NRV - net realisable value (the estimated selling price less estimated cost to make the sale) at the end of the reporting period. This is because the NRV already considers the purchasing power at the end of the reporting period.

If an asset for example land, has been revalued at the end of the current year, the restatement is not necessary as the carrying amount of the land would have considered the purchasing power i.e. the GPI at year end.

c)      Assets at historical price

What do we mean by assets at historic price? These are assets that are carried at cost or cost less depreciation which we commonly refer to as non-monetary assets.

These non-monetary assets need to be restated at the end of the current reporting year. Why is this? Recall that when we record the purchase of an asset, the cost and the depreciation (depreciation which is based on the cost) are expressed on amounts current on the date they were purchased. These amounts both cost and depreciation need to be restated based on the change in the GPI from the date they were acquired till the end of the current reporting period. The following formula would be applied

[1] FC means functional currency

In many organisations, this may not be possible due to the poor retention of purchase related documents. In such instances, an expert should be engaged to provide an independent assessment of the value of the non-monetary item to affect the restatement.

It could also happen that the GPI is not available for earlier periods as required by this standard. In these instances, the movements between the hyperinflationary economy currency and a relatively stable currency can be used to estimate the general pricing adjustment.

Lastly if the asset for example, land has been subsequently revalued after its purchase, let’s say in the middle of the current financial year, the restatement of this asset would be calculated from the date of the valuation to the end of the current financial year. This is because some time would have passed since the valuation of the asset.

There is a strong relationship between interest rates and inflation. Reserve banks generally increase interest rates in response to increase in inflation. This is done to control the inflation rates. From this, the restatement of assets that previously had interest capitalised (like qualifying asset’s in IAS 23: Borrowing Costs) are impacted because we cannot restate both the asset and the liability. The borrowing costs are not capitalised to the asset and rather expensed. This means we need to remove all the capitalised borrowing costs before we apply the changes in the GPI to these specific assets.

What about the impact on deferred tax?

Some of these restatements may result in changes in the carrying amount of the assets, while the tax bases could remain these same. Any such changes in temporary difference are dealt with in accordance with IAS 12:Income Taxes.

STEP 3: RESTATEMENT OF THE STATEMENT OF CHANGES IN EQUITY

All components of equity (except for retained earnings and the revaluation surplus) will be restated using the same principles as above. Share capital will be restated from the day the contribution was made by applying the changes in the GPI.

The restatement of retained earnings is considered a balancing figure. This will be the balancing figure after the restatement of the items in the statement of financial position. This means that the overall impact of the restatement will be recognised in retained earnings.

If the application of the changes in the GPI in determining the closing balance of an asset result in a revaluation gain, this revaluation gain is recognised and accepted. HOWEVER, the revaluation at the beginning of the earliest period of application must be eliminated.

STEP 4: RESTATEMENT OF STATEMENT OF COMPREHENSIVE INCOME

All amounts in the statement of comprehensive income must be restated based on the change GPI. The change in the index is applied to the incomes and expenses from the date they arose / first recognised.

It may not be practical to track the daily GPI for incomes and expenses. We would thus need to use our judgement and determine whether a weekly or a monthly GPI is most appropriate. If the inflation increases drastically between periods etc, it may not be practical to use an average and we would need to consider other avenues to fairly represent the financial information.

STEP 5: CALCULATION OF THE GAIN OR LOSS ON THE NET MONETARY POSITION

In a hyperinflationary economy, an entity holding more monetary assets compared to monetary liabilities loses its purchasing power as the net monetary position can purchase fewer and fewer goods and services. The contra applies to an entity that holds more monetary liabilities compared to its monetary assets because this entity gains purchasing power. The above aspects are only valid so long as the monetary assets and monetary liabilities are not linked to a pricing level. The net monetary gain or loss is calculated by analysing the items that cause changes to the monetary assets or monetary liabilities. The net monetary gain or loss then multiplied by the change in the GPI. This can be complex and impractical exercise because an entity could have numerous transactions that impact the monetary assets and monetary liabilities. As such we cannot look to the individual transactions to determine this gain or loss.

To determine this gain, we can consider the weight average of net monetary assets for a specified period multiplied by the changes in the GPI for that specified period.

This gain orloss on the monetary position is included in profit or loss.

STEP 6: RESTATEMENT OF THE STATEMENT OF CASHFLOW

IAS 29 does not provide any clear guidance on the restatement ofcashflows, all items in the statement of cashflow must be restated to thecurrent unit at the end of the reporting period using the GPI at the end of theyear. There is a risk that this approach may result in the cashflows disclosedon the statement not being equal to the actual cashflows. A preparer offinancial statements would have the three options below for the restatement.These options enable effect of the cashflows being shown as a reconciling item.

As such in practice the statement of cashflows can be restated as follows:

STEP 7: RESTATEMENT OF COMPARATIVE INFORMATION

The application of IAS 29 requires full retrospective restatement. This means we need to restate the financial statement as though the economy has always been a hyperinflation economy. This means we would need to restate the statement of financial positions and two statements of comprehensive incomes. All comparative amounts must be restated using the unit current (GPI) at the end of the current reporting period. See steps below that guide the retrospective adjustment to financial statement.

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