Tag Archives: Hyperinflation

Hyper inflation – International Accounting Standard 29

Basic idea –  In a hyperinflationary economy, financial statement should be adjusted in a way that the figures in them are shown in terms of the currency value as at the balance sheet date.

BACKGROUND

As distance is measured in meters, kilo meters, light years etc. money is measured in US dollars, GBP, Euro and other currencies.

We know a meter (unit of measurement) remains the same ie. a road measured in 1920 to be 100 kilo meters, if measured today will be again 100 kilo meters long
but this is not the case with money. £100 of 1920 is not equal to £100 of 2014, the value goes down due to a phenomenon with which we are all familiar named inflation.

Thus in accounting our scale of measurement itself is fluctuating.

Inflation is so much engrained in our lives that Accounting Standards do not even think about it.

This standard deals with a special situation called hyperinflation.

STANDARD

Hyperinflation is simply as the name suggests a situation where the value of currency is going down rapidly. This standard guides us in process to adjust figures in the
financial statements to remove the effects of hyperinflation.

Accounting standard does NOT give an exact percentage rate at which we can treat an economy to be hyper inflationary, this is in line

with the principles of accounting standards as being guiding principles rather than hard and fast rules.

But the standards have given us pointers to think when considering the question of hyperinflation:

(a) The general population prefers to keep wealth in assets like gold, silver , cig grates etc. or in a more stable currency like US Dollar , GBP , Euros etc. Also local currency earned by the entity is immediately converted in these assets / currencies to avoid loss of purchasing power.

Please note you will find many situations in developing economies, say India, in current time that companies especially those trading overseas may prefer to keep their overseas earnings in foreign currencies. For example, many outsourcing companies selling services to US clients get paid in USD. They may prefer to keep their earnings in USD maybe in a bank account in US with two motives. Firstly to escape the onerous foreign exchange regulations in the developing world and secondly to save the purchasing power of their earnings.

But we see that not many of them convert their local currency holdings to USD or in a similar stable currency.

Please also remember the words “general population” mentioned. So we are not limited to the accounting entity’s behaviour only.

(b) 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.

We can see such examples in the countries that have newly joined the EU and are on the path to convert their currencies to Euros in the near future eg. on the streets of Bucharest, Romania you will see many things priced in Euros  along with  the local currency, not only things like Houses , Cars , televisions, but things like monthly telephone contracts, home loans instalment . Here mostly vendor is a multinational company head quartered overseas and its main items of expenditure are in Euros (except in case of a house). They want to eliminate the currency risk by passing it to its consumers. Therefore a Romanian earns in RON (local currency) and pays his bills in Euros! The individual takes the currency risk rather than the multinational.
Why does such a thing happen? This comes down to bargaining power and we move in the field of economics like demand and supply. Where accounting ends, economics begins but there is a large overlap among them.

But even in the above Romanian example this standard will not trigger as the price quotations are not due to inflation but for reasons quoted above.

(c) 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.

(d) Interest rates, wages and prices are linked to a price index.

(e) The cumulative inflation rate over three years is approaching, or exceeds, 100 per cent i.e circa 26 percent annum.

Calculation:

Year1                    Year 2                    Year 3                    Year 4

£1                         £1.26                     £1.58                     £2

When we think of hyper inflation we think of extreme examples like Zimbabwe, Hungarian crisis and the Deutschmark after WW1 but there are a number of countries experiencing hyper inflation today.

CIA fact book is a good source of information and they have compiled a useful list of countries with their inflation rate , link :

https://www.cia.gov/library/publications/the-world-factbook/rankorder/2092rank.html

 

Measuring Unit –

We cannot just convert the currency values in financial statements to a more stable currency like if we are preparing financial statements in Venezuela for the year ended March 2014, simplest solution would have been to convert the trial balance figures of  Venezuelan currency to say USD at the reporting date and prepare the annual accounts but the Standard wants us to adjust the figures as per the General Price Index.

The standard (IFRS for SMEs not main IFRS ) states that ‘normally’ a recognised standard Index calculated and published by the Local government in our case the Venezuelan Government, but we all know Government’s usually try to push inflation figures down if they are not successful in reality.

As we are aware financials statements should show true and fair view , where using the Index produced by the local government may not be a satisfactory solution and an entity will need to look further afield for a satisfactory
Index like a stable foreign currency.

Please note prior year comparative figures will also need adjustment.

Process of conversion
Balance Sheet 

Monetary items like Cash in hand and at Bank, short term Debtors and Credtiors are NOT converted.

Assets and liabilities like loans etc which are Index linked (our Index or any other ) are converted as per the Index in the agreement.

All other items –

Items that are carried in the balance sheet at Net Realisable Value or Fair Value are NOT reinstated.

Fixed assets carried under historic cost will need adjusted from the date they were acquired both cost of acquisition and accumulated depreciation will need conversion.

All other asset/liabilities will be converted.

Equity – At the beginning of the first period of application of this Standard, the components of equity, except retained earnings, are restated by applying a general price index from the dates the components were contributed or otherwise arose.

This means suppose this Standard was adopted for the financial year 1st April 2013 to 31st March 2014. We will need to restate the balance sheet as at 31st March 2013 and any difference in the balance sheet due these conversions will be adjusted with Equity.

Restated retained earnings are derived from all the other amounts in the restated statement of financial position.

Profit and loss account

All Income and expenses will need to be converted from the date they were first entered in the books. Say we are making books for a company which has a year end at 31st December.

I have tried to convert the monthly wage bill of £100 as per the standard.

Monthly wage bill £100
Jan Feb Mar Apr May Jun Jul Aug Sep Oct Nov Dec
Price Index 100 120 140 140 150 155 160 160 160 160 180 180
Adjusted wages £180 £150 £129 £129 £120 £116 £113 £113 £113 £113 £100 £100
Total wages for P&L £1,473
Actual monies paid £1,200
£100 x 12 months

Example of May Conversion:

Expense               (Monthly wage bill ÷ the May index ) x  the December Index

100 x 180  =  £120
150

If general inflation is approximately even throughout the period, and the items of income and expense arose approximately evenly throughout the period, an average rate of inflation may be appropriate.

Any profit and loss occurring due to these adjustments will need to be shown separately.

 Points to ponder:

Please remember in an inflationary economy there is a gain of purchasing power by borrowers/debtors and loss of purchasing power by savers/creditors.

Example:

Suppose Mr A took a bank loan of £10000 , when his salary was £5000. There was a war or some other calamity in his country and rate of inflation shot up from say 1 % to 1000% per annum. Mr A is lucky he is part of a Workers Union and they collectively negotiate a salary increase in line with inflation of £100000 for him. Now you may notice that his salary is much larger in money terms but in reality he can only afford the same amount of goods and services that he use to last year with his £5000 salary. But he has gained in one respect. He notices that he can very easily pay off his bank loan of £10000 which has remained the same.

If we think in a different way the loan amount of£10k was almost worth 2 years of Mr A’s    wages but due to inflation , now his yearly salary is £100k ie. £8.33 k per month thus loan represent less than 2 months of wages of Mr A. I think Mr A will be very happy with his condition but the bank and ultimately the savers of the bank suffer.

Using this trick many governments in the developing world wipe off their huge debts on expense of their hard earned savings of their citizens but that is another topic.
Soon I will write to you why a country like India will not face a sovereign debt crisis like Greece.

When the economy ceases to be hyperinflationary – these adjustments stop as we take last year figures as our base to move forward.

Disclosures

(a) that financial statements have been adjusted;
(b) the identity and level of the price index
(c) amount of gain or loss

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