Impact of Inflation on Financial Statements
Fixed Assets under historical Cost accounting – Since the fixed assets are valued at historical cost (in most countries), the assets are stated at a much lower figure than their current replacement costs. This makes the company vulnerable to takeover bids and leads to lower valuations for the shareholders.
Depreciation – Since the assets are undervalued, consequently the depreciation on such assets are also undervalued. This leads to distortions in the make or buy decisions of the assets. This consequently overstates the profit of the enterprise.
In case of inflation, the cost of raw materials and goods purchased for re-sale are rising. Under the cost concept only cost of purchase is taken to the Income Statement. Generally, in case of Inflation, the fair value is greater than the cost and this difference between the cost and the fair value of such goods is also taken to the Income Statement as Holding Gains. Consequently the profit is again inflated as actually the company would be required to replace the inputs at higher costs.
Cash, Cash equivalents and Receivables lose their value in terms of Purchasing Power and the real values of liabilities do not get reflected. The increase in interest rate of loans do not get reflected in the financial statements.
Profits and Return on Investments are overstated as Revenues are recorded at increased price levels while costs are not.
The financial statements reflect a very high growth in sales value, profits, capital additions etc. The actual growth rates of these items can be assessed only after necessary monetary adjustments.
The Regulatory Aspect under IFRS – IAS 29 – FINANCIAL REPORTING IN HYPERINFLATIONARY ECONOMIES
To cater to the needs of an Inflation Accounting, the IASB came out with an Accounting Standard. Entities operating in hyperinflationary economies, and those preparing IFRS consolidated financial statements that include a foreign entity operating in a hyperinflationary economy, must take full account of the effects of inflation using a ‘current purchasing power’ approach under IAS 29. This requires an understanding of the economic concepts underlying the standard and a complex series of procedures and reconciliations to ensure accurate results.
Objective of IAS 29
The objective of IAS 29 is to establish specific standards for enterprises 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; 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 enterprise 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]
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]
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