TFL Vsebine / TFLGlasnik

1 Introduction

In the last two years in the covid-19 and post-covid-19 pandemic era and geopolitical tensions, we hear the word inflation more often than in the last ten to fifteen years. With the annual growth rates rising near or over 10 per cent in recent months, mainly due to energy and food price rises, inflation is becoming more important than in times of low inflation rates or even deflation.

Inflation is important for the economy because it could affect accounting and financial statements. We were not discussing inflation in the last decade due to low or negative rates. In low inflation rates, financial statements provide meaningful financial information. In higher inflation rates, financial information should or has to be adjusted for inflation.

Organisations prepare financial statements in accordance with International financial reporting standards (IFRS). Because of the importance of inflation, inflation is also defined in IFRS, more accurately in International Accounting Standard 29 - Financial Reporting in Hyperinflationary Economies (IAS 29). However, IFRS does not consider inflation in preparing the accounting information in accounts, but they consider hyperinflation and set up the principles and rules to account for in an inflationary environment and economy.

Financial statements with adequate adjustment to inflation reflect the financial position and performance of business enterprises. Furthermore, unadjusted financial statements can be meaningless or misleading under inflationary conditions.

In 1989 International Accounting Standards Committee (IASC) issued the first International accounting standard for a hyperinflation environment and set up the framework for meaningful and uniform financial reporting in inflationary economies. IAS 29 specified the adjustment requirements and has become operative for financial statements covering periods beginning on or after 1st January 1990 (Goldschmidt, 1991, p. 1).

In 2016 International Accounting Standards Board (IASB) conducted research to assess requests to eliminate or reduce a cumulative inflation rate threshold in IAS 29 due to higher inflation rates in Latin America and other high-inflation countries. IAS 29 identifies the cumulative inflation rate for hyperinflation. The research also assesses requests to modify the procedures for reporting the adjustments resulting from restating the financial statements due to hyperinflation. The concern of stakeholders was that the financial position and performance of organisations which accounts under International financial reporting standards (IFRS) could be distorted in countries with medium or long-term high inflation. (IASB, 2022a)

In the paper, we present the definition of inflation and its impact on financial statements. We also present accounting in hyperinflationary economies as inflation has been rising in recent months and has exceeded annual growth rates of 10% (mainly due to energy and food price increases).

2 Literature review

Literature about inflation in accounting research is scarce due to the some extremes of high inflation in the last decades. The Phillips curve is a theory of inflation where the rate of change of prices in an economy depends on the amount of slack in the economy. When the economy operates below (above) capacity, inflation is likely to be low (high) (Bermingham et al., 2012, p. 2).

Due to the increase of inflation in the 1950s, one of the first articles on the impact of inflation on financial statements dates back to 1959 when after the Second World War, the prices rose substantially (Corbin, 1956, p. 73), where the net income was distorted upwards, and balance sheet assets varied from their quoted current values. In that period, the standards were not in use, and no law required adjustments, but different associations suggested different approaches due to the managerial purpose of presenting fair results of operations in annual reports. Some associations suggested that accountants should make inclusive adjustments to financial statements using an index of the general price level and adjust the inventories and fixed assets to correct the distortion of inflation (Corbin, 1956, p. 73).

In the '70s, Davidson and Weil (1975, p. 27) stated that at that time were two approaches to adjust the values due to inflation as s substitution of historical cost data of each of the items in financial statements to the current cost or as adjustment of the recorded historical cost data for a change in the value of monetary unit since each item was acquired. The changes are made using price indexes, but the first approach used the index of specific prices and the second used the general price level index (Davidson & Weil, 1975, p. 27).

In the '80s, inflation was a continuous issue, and hyperinflations were experienced in the late 1980s and early 1990s in many emerging markets. In the second half of the 1990s, most countries managed to lower their inflation rates; at the beginning of the 21st century, reduced inflation was sustained. However, since the mid-2000s, the inflation pressures have risen again, mostly because of food and energy prices but had been reduced to double-figure levels in the mid-1990s and by 2000 to single-figure levels (Asfuroğlu, 2021, p. 485). Due to the increase in the '80s, the IASC had adopted IAS 29 as of 1st January 1990.

When inflation occurs, the future cash flows will increase while at the same time, the purchasing power of the cash flows is decreased (Coulthurst, 1986, p. 33), and since the investors require real returns, higher monetary returns will be required to compensate inflation such as cost of capital. To reduce the cost of capital in money terms to the cost of capital in real terms, the following relationships apply (Coulthurst, 1986, p. 33):

Equation 1: Cost of capital in real terms

where:

m – money cost of capital rate

i – inflation rate

r – real cost of capital rate.

For example, if the money cost of capital is 18 per cent, the inflation rate is 10 per cent, and the cost of capital in real terms is 7,27 per cent.

Many historical figures in financial statements are economically irrelevant due to price changes, and holding gains and losses due to inflation should be eliminated from the income and assets and adjusted (Agustini, 2016, p. 49). The IAS 29 stipulated that the financial statements need to be restated or cleaned from inflation effects if, in the last three years, the cumulative inflation rate is approaching or exceeding one hundred per cent (Ilter, 2012, p. 2). In the years after 2000, the inflation was decreasing, but the petroleum or gas increase in prices affected the inflation rates.

OECD also had concerns about high inflations in Latin America due to the distortion of national accounts at current and constant prices unless special adjustment techniques are applied (Ilter, 2012, p. 4).

In times of higher inflation rates, over 25 per cent per year, in Burton's view, financial statements based on historical monetary units have little value, and actions to supersede such statements are necessary (Burton, 1975).

Conventional financial statements of a company are based on the assumption that the monetary unit is stable. Under inflationary conditions, however, the purchasing power of the money declines, causing some crucial figures of the conventional financial statements, especially net income and non-monetary assets' value, to be distorted (Goldschmidt, 1991, p. 4). In other words, the value of some assets is understated and should be revaluated.

The financial reporting regime under the US GAAP or IFRS is nominal and assumes no changes to the purchasing power due to inflation. When purchasing power is not constant, a nominal reporting system combines monetary amounts from different periods and decreases comparability across firms over time (Konchitchki, 2011, p. 1046).

Nominal financial statements, by their nature, do not account for gains and losses attributable to changes in purchasing power over time. For example, whereas the erosion of a firm's monetary assets (e.g., cash) attributable to inflation is a loss to the firm, the erosion of a firm's monetary liabilities (e.g., debt) is a gain. Further, whereas inflation-adjusted amounts of non-monetary items (e.g., land) accumulate inflationary effects over time to reflect changes in purchasing power, such effects are not recognised in nominal financial statements. The difference between inflation-adjusted and nominal earnings represents unrecognised gains and losses from inflation (Konchitchki, 2011, p. 1046).

3 Definition of inflation

Inflation is, by definition, a general increase in prices, not just an increase in the price of individual products and a consequent decrease in the value of a currency over time. Nowadays we can buy less than in the past. The definition in the Cambridge dictionary is:

»inflation noun [U] (INCREASE) - a general, continuous increase in prices;

Inflation noun [ U ] ECONOMICS, FINANCE - an increase in prices over time, causing a reduction in the value of money" (Cambridge University Press 2022, 2022).

The price change, the overall increase (or decrease) in prices, is measured in the goods and services consumers buy over the year and are represented by a "shopping basket" or market-based "basket" of goods and services. The year-on-year inflation rate is calculated as the ratio of the total basket price in a given month compared to the same month one year ago. In the basket, different products and services have certain weights depending on consumption. Products and services bought more often, such as electricity, have a higher weight.

In the EU, inflation is measured by the Harmonised Index of Consumer Prices, HICP (a common methodology for calculating inflation). The HICP is produced by each European Union Member State using a harmonised methodology, as defined in Regulation (EU) 2016/792 (The European Parliament and the Council, 2016) and connected to implementing regulation. The HICP measure the changes over time in the prices of consumer goods and services acquired by households and give a comparable measure of inflation as they are calculated according to harmonised definitions (Eurostat, 2022a). Data is available monthly and annually, broken down by detailed consumption categories with country and item weights. The HICP is calculated by collecting the prices of products and services from a basket (295 product categories) monthly, by setting weights for each product or service, and by setting country-specific weights (the impact of aggregate consumption expenditure in the Euro area). The impact of consumption on the average household budget and aggregate consumption expenditure in the Euro area is monitored regularly.

Figure 1 : Comparison of annual inflation growth rates in the European Union, the Euro area and Slovenia from 2008 to November 2022

Source: European Commission, 2022

The inflation in the EU and Euro area has been increasing since January 2021. The average rates are around 10 % yearly. Figure 2 shows the weight for different goods and services and the annual percentage increase.

Figure 2: Annual inflation rates in the Euro area

Source: (Eurostat, 2022b)

Considering the main components of euro area inflation, we can conclude that energy has the highest annual rate last year, followed by food, alcohol & tobacco, and non-energy industrial goods and services (Eurostat, 2022b).

4 Inflation and financial statements

Inflation is also important when dealing with accounting data. Many accountants do not think of financial reporting under International Financial Reporting Standards in an inflationary economy. External financial reporting could not change significantly due to increased inflation unless the inflation rates reach a hundred per cent in three years. The managerial financial reporting could and should be adjusted to accurate and up-to-date prices and values for internal reporting. However, internal reporting for decision-making might change, as higher input prices such as energy, raw material and services significantly alter the cost and the determination of the selling price. Furthermore, the higher prices should affect management accounting and the calculation of sales prices.

International Financial Reporting Standards are used for financial reporting to external stakeholders and do not specifically address inflation accounting or define rules for measuring items in financial statements. International Accounting Standard 29 addresses only financial reporting in a hyperinflationary economy for both corporate and consolidated financial statements. US GAAPs are also addressing hyperinflation. The following table presents the differences between IFRS and US GAAP addressing inflation.

Table 1: Comparison between IFRS and US GAAP accounting for hyperinflation

Source: KPMG, 2022

Inflation accounting has benefits such as adjusted values for internal, external users and management that show more realistic and comparable figures relative to historical financial statements and competitors. The current revenues are accurate when the values are updated for the inflation index. Nevertheless, the disadvantages are in the complicated preparation of financial statements, which could lead to multiple restatements and constant changes in the financial statements.

Inflation is unlikely to have a material impact on the items in the financial statements and their measurement, but it may change the discount rates we use to measure leases and affect the provisioning for loss-making contracts and the carrying amount of property, plant and equipment if we have chosen the revaluation or fair value model. The impacts on each category are described below.

The impact could be expected for discount rates when discounting future cash flows, such as for leases or financial instruments where we estimate future payments. As inflation rises, the interest rates rise, which means higher discount rates and a reduction in the present value of future payments.

In the case of leases, there is a possibility that the lease terms may be renegotiated, which may result in a change in the lease agreements. A modification in leases should be accounted for under IFRS 16 Leases if the leases do not contain a variable rent that changes with the increased cost of living (inflation).

The impact of higher prices of inputs is also reflected in higher operating costs. Where there is no possibility of passing the higher costs to raised prices for consumers, companies may operate at a loss on certain contracts (onerous contracts), which implies provisioning and measurement under International Accounting Standard 37 - Provisions Contingent Liabilities and Contingent Assets (IASB, 2020). The standard defines a provision as a liability of uncertain timing or amount that is a present obligation of an entity and arises from past events (IASB, 2020). When settled, the obligation is expected to result in an outflow of resources embodying economic benefits. The entity also does not have a realistic prospect of settling the obligation that can be estimated reliably.

Higher input prices will have the most significant impact on the company's business. If companies measure inventories using the FIFO method, they will measure inventories at a lower historical cost, which means that pre-tax profits will be higher. However, owners can also expect higher labour and service costs due to general price increases.

The impact of inflation may also be seen in the valuation of fixed assets if the entity has chosen to use the revaluation or fair value model instead of the cost model. In this case, the fair value of the fixed assets should be reviewed at each reporting date, and the revaluation adjustment should be disclosed separately. If the carrying amount increases, the increase is shown as a revaluation reserve in equity and other comprehensive income, and if it decreases, the revaluation reserve is first reduced, and the difference is recognised in profit or loss as an operating expense. It is also important to note that depreciation is charged on the new revalued amount, which means that depreciation is higher if the carrying amount increases and the impact on profit or loss are negative due to higher depreciation expense.

5 Hyperinflation and the financial statements

As mentioned earlier, IAS 29 deals with accounting in hyperinflationary economies. The standard is applied in preparing both entity and consolidated financial statements where the functional currency of the entity is the currency of the hyperinflationary economy. A hyperinflationary economy is defined as an economy in which, because of a decline in purchasing power, comparisons of amounts arising from transactions and other events that occurred at different times or even within the same accounting period are misleading. The restatement of amounts in the financial statements is a matter of judgement, as the standard does not specify an absolute rate that determines hyperinflation, but the characteristics of a country's economic environment, which include, but are not limited to:

• the general population prefers to keep its wealth in non-monetary assets or a relatively stable foreign currency. Amounts of local currency held are immediately invested in maintaining 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 per cent (IASB, 2022b).

US GAAP assesses hyperinflationary economies as a two-step methodology (KPMG, 2022):

Step 1: Perform quantitative analysis of the cumulative inflation rate – any economy that has a cumulative inflation rate for the three years preceding the beginning of the reporting period in excess of a hundred per cent is considered to be hyperinflationary;

Step 2: If step 1 results in the cumulative rate being less than a hundred per cent, judgment is applied in analysing historical inflation rate trends and other pertinent economic factors.

IFRS specifies that the information in the financial statements should be presented in the current measuring unit at the end of the reporting period and restated retrospectively. The method to restate items can be based on a historical or current cost approach. The current purchasing power method (CCP) involves adjusting the financial statements and associated numbers to the current price. For non-monetary items, this is done by taking historical figures and applying a specific conversion rate based on a price index. The conversion rate is calculated by dividing the index price at the end of the period by the index price at the beginning of the period. Monetary items are subject to a net gain or loss during adjustment. The current cost accounting method (CCA) takes the fair market value instead of the historical cost. This method must adjust all monetary and non-monetary assets to their current values. IAS 29 specifies procedures and judgement and prompts consistency of application from period to period (IASB, 2022b).

Statement of financial position at historical cost

The amounts in the statement of financial position should be presented in the current measuring unit at the end of the reporting period and restated using the general price index. This method is also referred to as current purchasing power. The index is calculated as the quotient between the index at the end and the beginning of the period. Non-monetary asset items are multiplied by the coefficient. The adjustment affects net profit or loss and is disclosed separately. The monetary asset items are already daily valued at the statement of financial position date. The monetary items are cash, cash equivalents, loans, receivables, debt securities, payables, borrowings, and taxes payable, and the non-monetary items are property, plant and equipment, intangible assets, biological assets, investment property, equity investments (e.g. ordinary shares), inventories, deferred income, some provisions, and so forth.

Table 2: Example of restatement of an item in the statement of financial position

Source: own calculation

If non-monetary items are carried out at the current cost, we do not restate them because the current cost means the value reflecting the current purchasing power at the end of the period.

Non-monetary items are recognised at cost or cost less valuation allowance, which means that the items are at the amounts at the date of acquisition or historical costs. The cost or cost less allowance of each item must be recalculated. The restatement is made by applying the change in the general price index from the date of acquisition to the statement of financial position date. Property, plant and equipment, investments, inventories of raw materials and supplies, goodwill, patents, trademarks and similar assets should be restated from the date of acquisition. The value of intermediate and finished goods inventories is recalculated from the dates on which acquisition and conversion costs are incurred.

Income statement and Statement of comprehensive income

All items of profit and loss and comprehensive income are presented in terms of the measuring current measuring unit at the end of the reporting period, which means that all amounts must be restated using changes in the general index of price inflation since the date on which the entity initially recorded the income and expense in the financial statements.

Cash flow statement

The statement of cash flows is also presented in the current measuring unit at the end of the reporting period.

Taxes

Restatement of financial statement amounts may result in differences between the carrying amounts of individual assets or liabilities and their tax bases. Differences are accounted for under IAS 12 Income Taxes.

Consolidated financial statements

A parent that reports in the currency of a hyperinflationary economy may have subsidiaries that also report in the currencies of hyperinflationary economies. The financial statements of the subsidiaries shall be restated using the country's general price index in the country's currency in which the entity reports. Only after restatement, the information is included in the consolidated financial statements. The restated financial statements should be translated at closing rates if the subsidiary operates abroad. When consolidating financial statements, reporting dates may differ, and all items, monetary and non-monetary, should be restated into the current measuring unit at the date of the consolidated financial statements.

6 Conclusion

This article aims to highlight the potential impact of inflation on items in financial statements. Management needs to address and detect inflation risks and assess the impact on operations and performance.

After considering and adjusting inflation values, the financial statements present an unbiased view of the financial position. Depreciation to the true value is represented when it is calculated on a real (fair) and not historical value. Comparing two financial years becomes reliable when the items in financial statements are adjusted for inflation. Inflation accounting shows the current profit based on current prices and reflects corrected and updated value, so financial statements state updated figures as per the current prices, factoring in inflation and the profit and loss account, the business income is not overstated. With the adjusted values, the dividends to shareholders are lower compared to the nominal figures without the adjustments.

The restatement of the amounts in the financial statements is unnecessary as inflation in the Euro area has not yet reached 100% over the last three years, and we do not qualify Euro Area as a hyperinflationary economy.

7 Literature

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Asfuroğlu, D. (2021). The Determinants of Inflation in Emerging Markets and Developing Countries: A Literature Review. Anadolu Üniversitesi Sosyal Bilimler Dergisi, 21(2), 483–504. https://doi.org/10.18037/ausbd.959251

Bermingham, C., Coates, D., Larkin, J., Brien, D. O., & O'Reilly, G. (2012). Explaining Irish Inflation During the Financial Crisis. Central Bank of Irland, 09/RT/12, 36.

Burton, J. C. (1975). Financial reporting in an age of inflation. Institute of Business and Economic Research, University of California, for the Professional Accounting Program. https://www.sechistorical.org/collection/papers/1970/053074_Burton.pdf

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Davidson, S., & Weil, R. L. (1975). Inflation Accounting: What Will General Price Level Adjusted Income Statements Show? Financial Analysts Journal, 31(1), 27–31. https://doi.org/10.2469/faj.v31.n1.27

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Goldschmidt, Y. (1991). Inflation Adjustments of Financial Statements (Agriculture and Rural Development Department, p. 38) [Working Paper]. https://documents1.worldbank.org/curated/en/551701468739252370/pdf/multi-page.pdf

IASB. (2020, May). IAS 37 Provisions, Contingent Liabilities and Contingent Assets. https://www.ifrs.org/content/dam/ifrs/publications/pdf-standards/english/2022/issued/part-a/ias-37-provisions-contingent-liabilities-and-contingent-assets.pdf

IASB. (2022a, 6th October). IFRS - High Inflation. https://www.ifrs.org/projects/completed-projects/2016/high-inflation/

IASB. (2022b, 10th October). IAS 29 Financial Reporting in Hyperinflationary Economies. https://www.ifrs.org/issued-standards/list-of-standards/ias-29-financial-reporting-in-hyperinflationary-economies/#standard

Ilter, C. (2012). Exploring the Effects of Inflation on Financial Statements Through Ratio Analysis. SSRN Electronic Journal. https://doi.org/10.2139/ssrn.2186707

Konchitchki, Y. (2011). Inflation and Nominal Financial Reporting: Implications for Performance and Stock Prices. The Accounting Review, 86(3), 1045–1085. https://doi.org/10.2308/accr.00000044

KPMG. (2022, 10th October). Hyperinflationary economies. https://advisory.kpmg.us/articles/2017/hyperinflationary-economies.html

The European parliment and the Council. (2016). Regulation (EU) 2016/792 of the European Parliament and of the Council of 11th May 2016 on harmonised indices of consumer prices and the house price index, and repealing Council Regulation (EC) No 2494/95 (Text with EEA relevance) (Regulation (EU) 2016/792). https://eur-lex.europa.eu/eli/reg/2016/792/oj