Severe Hyperinflation According to IFRS 1

In 2010 the IASB was asked to clarify how an entity should resume presenting financial statements in accordance with IFRS after a period of severe hyperinflation, during which the entity had been unable to comply with IAS 29, Financial Reporting in Hyperinflationary Economies. It should be noted that an entity would be unable to comply with IAS 29 if a reliable general price index is not available to all entities with that same functional currency, and exchangeability between the currency and a relatively stable foreign currency does not exist. However, once the functional currency changes to a non-hyperinflationary currency, or the currency ceases to be severely hyperinflationary, an entity would be able to start applying IFRS to subsequent transactions.

IFRS 1 was amended to provide guidance on how an entity can present IFRS financial statements after its currency ceases to be severely hyperinflationary, by presenting an opening IFRS statement of financial position on or after the functional currency normalisation date.

It was believed that allowing an entity to apply the exemption when presenting an opening IFRS statement of financial position after, and not just on, the functional currency normalisation date would address practical concerns that may arise if the functional currency normalisation date and the entity's date of transition to IFRS are different. This amendment would also be available to entities that were emerging from a period of severe hyperinflation but had not applied IFRS in the past.

IFRS 1 permits an entity emerging from a period of severe hyperinflation to elect to measure its assets and liabilities at fair value. That fair value could then be used as the deemed cost in its opening IFRS statement of financial position. This approach expands the scope of the deemed cost exemptions in IFRS 1. However, because severe hyperinflation is a specific set of circumstances, the IASB wanted to ensure that the fair value measurement option was applied only to those assets and liabilities that were held before the functional currency normalisation date, and not to other assets and liabilities held by the entity at the time it made the transition to IFRS. Furthermore, where a parent entity's functional currency has been subject to severe hyperinflation, but its subsidiary company's functional currency has not been subject to severe hyperinflation, IFRS 1 does not require such a subsidiary company to apply this exemption.

Any adjustments arising on electing to measure assets and liabilities at fair value in the opening IFRS statement of financial position arise from events and transactions before the date of transition to IFRS. Thus, an entity should recognise those adjustments directly in retained earnings (or, if appropriate, in another category of equity) at the date of transition to IFRS.

Entities are required to prepare and present comparative information in accordance with IFRS. Furthermore, it should be noted that the preparation of information in accordance with IFRS for periods before the functional currency normalisation date may not be possible; hence, the exemption refers to a date of transition on or after the functional currency normalisation date. This may lead to a comparative period of less than 12 months. Entities should consider whether disclosure of non-IFRS comparative information and historical summaries would provide useful information to users of financial statements. In all such cases entities should explain the transition to IFRS.

Restating Historical Cost Financial Statements under Hyperinflation Conditions

The precise adjustments to be made depend on whether the financial reporting system is based on historical costs or on current costs. Although in both cases the goal is to restate the financial statements into the measuring unit that exists at the date of the statement of financial position, the mechanics will vary to some extent.

If the financial reporting system is based on historical costing, the process used to adjust the statement of financial position can be summarised as follows:

1. Monetary assets and liabilities are already presented in units of year-end purchasing power and receive no further adjustment. (See the appendix for a categorisation of different assets and liabilities as to their status as monetary or non-monetary.)
2. Monetary assets and liabilities that are linked to price changes, such as indexed debt securities, are adjusted according to the terms of the contractual arrangement. This does not change the characterisation of these items as monetary, but it does serve to reduce or even eliminate the purchasing power gain or loss that would have otherwise been experienced as a result of holding these items during periods of changing general prices.
3. Non-monetary items are adjusted by applying a ratio of indices, the numerator of which is the general price level index at the date of the statement of financial position and the denominator is of which is the index as of the acquisition or inception date of the item in question. For some items, such as plant assets, this is a straightforward process, while for others, such as work-in-process inventories, this can be more complex.
4. Certain assets cannot be adjusted as described above, because even in nominally historical cost financial statements these items have been revised to some other basis, such as fair value or net realisable amounts. For example, under the allowed alternative method of IAS 16, property, plant and equipment can be adjusted to fair value. In such a case, no further adjustment would be warranted, assuming that the adjustment to fair value was made as of the latest date of the statement of financial position. If the latest revaluation was as of an earlier date, the carrying amounts should be further adjusted to compensate for changes in the general price level from that date to the date of the statement of financial position, using the indexing technique noted above.
5. Consistent with the established principles of historical cost accounting, if the restated amounts of non-monetary assets exceed the recoverable amounts, these must be reduced appropriately. This can easily occur, since specific prices of goods will vary by differing amounts, even in a hyperinflationary environment, and in fact some may decline in terms of current cost even in such cases, particularly when technological change occurs rapidly. Since the application of price level accounting, whether for ordinary inflation or for hyperinflation, does not imply an abandonment of historical costing, being a mere translation into more timely and relevant purchasing power units, the rules of that mode of financial reporting still apply. Generally accepted accounting principles require that assets not be stated at amounts in excess of realisable amounts, and this constraint applies even when price level adjustments are reflected.
6. Equity accounts must also be restated to compensate for changing prices. Paid-in capital accounts are indexed by reference to the dates when the capital was contributed, which are usually a discrete number of identifiable transactions over the life of the entity. Revaluation accounts, if any, are eliminated entirely, as these will be subsumed in restated retained earnings. The retained earnings account itself is the most complex to analyse and in practice is often treated as a balancing figure after all other statement of financial position accounts have been restated. However, it is possible to compute the adjustment to this account directly, and that is the recommended course of action, lest other errors go undetected. To adjust retained earnings, each year's earnings should be adjusted by a ratio of indices, the numerator being the general price level as of the date of the statement of financial position, and the denominator being the price level as of the end of the year for which the earnings were reported. Reductions of retained earnings for dividends paid should be adjusted similarly.
7. IAS 29 addresses a few other special problem areas. For example, the standard notes that borrowing costs typically already reflect the impact of inflation (more accurately, interest rates reflect inflationary expectations), and thus it would represent a form of double counting to fully index capital asset costs for price level changes when part of the cost of the asset was capitalised interest, as required by IAS 23, Borrowing Costs. As a practical matter, interest costs are often not a material component of recorded asset amounts, and the inflation-related component would only be a fraction of interest costs capitalised. However, the general rule is to delete that fraction of the capitalised borrowing costs which represents inflationary compensation, since the entire cost of the asset will be indexed to current purchasing units.

To restate the current period's statement of comprehensive income, a reasonably accurate result can be obtained if revenue and expense accounts are multiplied by the ratio of end-of-period prices to average prices for the period. Where price changes were not relatively constant throughout the period, or when transactions did not occur ratably, as when there was a distinct seasonal pattern to sales activity, a more precise measurement effort might be needed. This can be particularly important when a devaluation of the currency took place during the year.

While IAS 29 addresses the statement of cash flows only perfunctorily (its issuance was prior to the revision of IAS 7), this financial statement must also be modified to report all items in terms of year-end purchasing power units. For example, changes in working capital accounts, used to convert net income into cash flow from operating activities, will be altered to reflect the real (i.e., inflation-adjusted) changes.

To illustrate, if beginning accounts receivable were €500,000 and ending receivables were €650,000, but prices rose by 40% during the year, the apparent €150,000 increase in receivables (which would be a use of cash) is really a €50,000 decrease [(€500,000 × 1.4 = €700,000) – €650,000], which in cash flow terms is a source of cash. Other items must be handled similarly. Investing and financing activities should be adjusted on an item-by-item basis, since these are normally discrete events that do not occur ratably throughout the year.

Additionally, the adjusted statement of comprehensive income will report a gain or loss on net monetary items held. As an approximation, this will be computed by applying the change in general prices for the year to the average net monetary assets (or liabilities) outstanding during the year. If net monetary items changed materially at one or more times during the year, a more detailed computation would be warranted. In the statement of comprehensive income, the gain or loss on net monetary items should be associated with the adjustment relating to items that are linked to price level changes (indexed debt, etc.) as well as with interest income and expense and foreign exchange adjustments, since theoretically at least, all these items contain a component that reflects inflationary behaviour.

Restating Current Cost Financial Statements under Hyperinflation Conditions

If the financial reporting system is based on current costing (as described earlier in the chapter), the process used to adjust the statement of financial position can be summarised as follows:

1. Monetary assets and liabilities are already presented in units of year-end purchasing power and receive no further adjustment. (See the appendix for a categorisation of different assets and liabilities as to their status as monetary or non-monetary.)
2. Monetary assets and liabilities that are linked to price changes, such as indexed debt securities, are adjusted according to the terms of the contractual arrangement. This does not change the characterisation of these items as monetary, but it does serve to reduce or even eliminate the purchasing power gain or loss that would have otherwise been experienced as a result of holding these items during periods of changing general prices.
3. Non-monetary items are already stated at year-end current values or replacement costs and need no further adjustments. Issues related to recoverable amounts and other complications associated with price level adjusted historical costs should not normally arise.
4. Equity accounts must also be restated to compensate for changing prices. Paid-in capital accounts are indexed by reference to the dates when the capital was contributed, which are usually a discrete number of identifiable transactions over the life of the entity. Revaluation accounts are eliminated entirely, as these will be subsumed in restated retained earnings. The retained earnings account itself will typically be a “balancing account” under this scenario, since detailed analysis would be very difficult, although certainly not impossible, to accomplish.

The current cost statement of comprehensive income, excluding the price level component, will reflect transactions at current costs as of the transaction dates. For example, cost of sales will be comprised of the costs as of each transaction date (usually approximated on an average basis). To report these as of the date of the statement of financial position, these costs will have to be further inflated to year-end purchasing power units, by means of the ratio of general price level indices, as suggested above.

In addition, the adjusted statement of comprehensive income will report a gain or loss on net monetary items held. This will be similar to that discussed under the historical cost reporting above. However, current cost statements of comprehensive income, if prepared, already will include the net gain or loss on monetary items held, which need not be computed again.

To the extent that restated earnings differ from earnings on which income taxes are computed, there will be a need to provide more or less tax accrual, which will be a deferred tax obligation or asset, depending on the circumstances.

Comparative Financial Statements

Consistent with the underlying concept of reporting in hyperinflationary economies, all prior-year financial statement amounts must be updated to purchasing power units as of the most recent date of the statement of financial position. This will be a relatively simple process of applying a ratio of indices of the current year-end price level to the year earlier price level.

Consolidated Financial Statements

A parent reporting in the currency of a hyperinflationary economy may have subsidiaries that also report in the currencies of hyperinflationary economies. The financial statements of any such subsidiary need first to be restated before they are included in the consolidated financial statements by applying a general price index of the country in whose currency it reports. Where such a subsidiary is a foreign subsidiary, its restated financial statements are translated at closing rates. The financial statements of subsidiaries that do not report in the currencies of hyperinflationary economies are dealt with in accordance with the normal translation principles in IAS 21.

If financial statements with different reporting period ends are consolidated, all items, whether non-monetary or monetary, need to be restated into the measuring unit current at the date of the consolidated financial statements.

Other Disclosure Issues

IAS 29 requires that when the standard is applied, the fact that hyperinflation adjustments have been made must be noted. The underlying basis of accounting, historical cost or current cost should be stipulated, as should the price level index that was utilised in making the adjustments.

Economies which Cease Being Hyperinflationary

When application of IAS 29 is discontinued, the amounts reported in the last statement of financial position that had been adjusted become, effectively, the new cost basis. The previously applied adjustments are not reversed, since an end to a period of hyperinflation generally means only that prices have reached a plateau, not that they have deflated to earlier levels.

Guidance on Applying the Restatement Approach

IFRIC issued an Interpretation of IAS 29 (IFRIC 7, Applying the Restatement Approach) that addresses the matter of differentiating between monetary and non-monetary items. IAS 29 requires that when the reporting entity identifies the existence of hyperinflation in the economy of its functional currency, it must restate its financial statements for the effects of inflation. The restatement approach distinguishes between monetary and non-monetary items, but in practice it has been noted that there is uncertainty about how to restate the financial statements for the first time, particularly with regard to deferred tax balances, and concerning comparative information for prior periods. IFRIC 7 addresses these matters.

Under IFRIC 7, in the first year that an entity identifies the existence of hyperinflation, it would start applying IAS 29 as if it had always applied that standard—that is, as if the economy had always been hyperinflationary. It must recreate an opening statement of financial position at the beginning of the earliest annual accounting period presented in the restated financial statements for the first year it applies IAS 29.

The implication of this Interpretation is that restatements of non-monetary items that are carried at historical cost are effected as of the dates of first recognition (e.g., acquisition). The restatements cannot be effected merely from the opening date of the statement of financial position (which would commonly be at the beginning of the comparative financial statement year). For example, if the year-end 2013 statement of financial position is the first one under IAS 29, with two-year comparative reporting employed, but various plant assets acquired, say, in 2005, the application of IFRIC 7 would require restatements for price level changes from 2005 to year-end 2012.

Non-monetary assets that are not reported at historical costs (e.g., plant assets revalued for IFRS-basis financial reporting, per IAS 16) require a different mode of adjustment. In this situation, the restatements are applied only for the period of time elapsed since the latest revaluation dates (which should, per IAS 16, be recent dates in most instances). For example, if revaluation was performed at year-end 2010, then only the period from year-end 2010 to year-end 2012 would be subject to adjustment, as the year-end 2010 revaluation already served to address hyperinflation occurring to that date.

IFRIC 7 provides that if detailed records of the acquisition dates for items of property, plant and equipment are not available or are not capable of estimation, the reporting entity should use an independent professional assessment of the fair value of the items as the basis for restatement. Likewise, if a general price index is not available, it may be necessary to use an estimate based on the changes in the exchange rate between the functional currency and a relatively stable foreign currency, for example when the entity restates its financial statements.

IFRIC 7 also provides specific guidance on the difficult topic of deferred tax balances in the opening statement of financial position of the entity subject to IAS 29 restatement. A two-step computational procedure is required to effect the restatement of deferred tax assets and liabilities. First, deferred tax items are remeasured in accordance with IAS 12 after having restated the nominal carrying amounts of all other non-monetary items in the opening statement of financial position as of that date. Secondly, the remeasured deferred tax assets and/or liabilities are restated for hyperinflation's effects from the opening date of the statement of financial position to the reporting date (the most recent date of the statement of financial position).