Inflation Accounting: Practices in Different Countries

Larissa Gorbatova

On 10 December 2000, Mr. David Damant, member of the Board of the International Accounting Standards Committee (IASC), initiated a seminar on accounting in hyperinflationary economies with participation of Board members, IASC Steering Committee observers and members from Brazil, Zimbabwe, Mexico, Russia, Switzerland, UK and the USA. The seminar discussed issues arising from the implementation of IAS 29, Financial Reporting in Hyperinflationary Economies, in different countries as well as their approaches to the recognition of the effects of high inflation in financial statements, including consolidated accounts. These problems are especially relevant to Russia that has been in a period of hyperinflation since 1991.

The discussion revealed major issues of IAS 29 implementation that can be broken down into two categories:

• issues of inflation measurement (i.e. doubts about validity of indices, lack of a case-by-case approach to different economic sectors in measuring the effects of inflation, indices for short time periods are not always available, the hyperinflation threshold of 100% over three years is quite arbitrary);
• issues of inflation accounting (the accounting treatment results in a disadvantage of financial institutions and other companies holding an excess of monetary assets over monetary liabilities as well as in inadequate measurement of deferred taxes).

Accounting and reporting issues in hyperinflationary economies are extremely important. Despite the fact that the seminar proposed no alternative to IAS 29 other than the use of a hard currency, this issue is yet to be solved. The discussion resulted in a proposal that the incoming new IASC Board should come back to this topic given practical issues raised in order to develop acceptable solutions either on existing or revised IAS 29 basis.

An overview of accounting practices in some countries and companies is given below with respect to the recognition of the effects of high inflation.

Zimbabwe. The Zimbabwe Stock Exchange (ZSE) requires listed companies to prepare IAS financial statements. The Institute of Chartered Accountants of Zimbabwe (ICAZ) examines IASs, IASC Exposure Drafts and Interpretations and recommends that Zimbabwe Accounting Practices Board, «a supreme accounting body», should adopt (or not adopt) them. All existing IASs are currently subject to application in Zimbabwe.

The inflation rate in Zimbabwe which approached 120% for three years during 1992-1996 is now much lower. Nevertheless, in November 1999 the ICAZ concluded that the country met other criteria of hyperinflation listed in IAS 29 (except the inflation rate) and, accordingly, suggested applying IAS 29 in Zimbabwean enterprises. The ICAZ held a number of discussions with the Zimbabwe Stock Exchange and Zimbabwe Accounting Practices Board as well as with enterprise managers.

The meetings identified major practical problems of IAS 29 application arising from the following requirements of the standard:

• IAS 29 should be applied from the beginning of the period in which the existence of hyperinflation is identified;
• items in financial statements must be restated by applying a general price index if data cannot be presented in these financials on the historical cost basis of accounting.

The first of the above problems arises from insufficient data on inflation rates for short periods of time, which causes difficulties in the application of IAS 29 in the short run. The second problem follows from the need for a certain «period of transition» during which, in addition to data restated for an inflation index, the presentation of figures based on historical or other unrestated cost is also allowed.

Eventually, the proposed approach to IAS 29 application in Zimbabwean enterprises can be considered a compromise because, while enterprises are required to apply IAS 29 starting from 2000 financial statements:

• separate presentation of data based on the previous basis of accounting is permitted in addition to figures based on IAS 29 application;
• the auditor’s report on financial statements covering periods beginning before 1 January 2000 must include a special paragraph explaining that IAS 29 requirements have not been applied to the financial statements.

Mexico. Mexico has more than a twenty-year history of high inflation accounting. IASs are not currently applied in Mexico but national requirements for recognition of the effects of inflation in financial information are quite similar to those of IAS 29.

At first, under a 1979 Mexican Act disclosures we required of the effects of inflation in the notes to financial statements. The major problem was a lack of commitment of enterprises to implementing these requirements, which resulted in inaccurate disclosures. A new Act was adopted in 1984 that required enterprises to recognize the effects of inflation in financial statements. The Act was revised several times in line with changes in inflation accounting methodology. Initially, the 1984 Act permitted enterprises to measure assets at their replacement cost. This accounting treatment was later prohibited for all assets other than inventories.

The underlying principle of the 1984 Act is the recognition of income based on the concept of capital maintenance similar to IASs. The difference between the [Mexican] methodology of asset restatements and IAS rules is as follows: the National Consumer Price Index (NCPI) is applied to all non-monetary assets other than inventories whose value, as stated above, is adjusted to replacement cost. In addition, the so-called «combined» index that includes inflation index and exchange rate is applied for imported equipment. The financial statements are prepared using solely a national currency.

Problems of Consolidated Reporting in Hyperinflationary Economies

The Nestle and Novartis Swiss corporations that have branches in many countries provided their own vision of accounting and reporting in hyperinflationary economies. While Nestle applies a model suggested in IAS 29 for consolidated reporting purposes, Novartis finds this model rather controversial and is inclined to use US dollar equivalents in measuring transactions. It is not the first time that a hard currency is proposed as a reporting one in countries with high inflation and an unstable national currency. These proposals have not been approved by the International Accounting Standards Committee which allows the use of a stable foreign currency in place of the national currency only when it is a functional currency, (i.e. used for settlements with counterparties).

The case for the use of a hard currency in place of the national currency as a method of inflation accounting is its simplicity, objectivity and availability. Data on exchange rates are available even for short time periods. Unlike indices whose values depend on their computation techniques, exchange rates are market driven. In addition, according to Novartis, when enterprises «speak» in a US dollar language, the use of a dollar as a primary reporting currency seems quite reasonable. Moreover, in the view of investors willing to obtain information about the real return on invested capital, «dollar-based» accounts are much more meaningful that those restated by applying an inflation index. Similarly, when consolidating branches from different countries, finding a common «dollar» denominator is much easier and more consistent than a two-stage model suggested in IAS. Under IAS, the financial statements need to be first restated by applying an inflation index and then translated at closing rates. However, it should be noted that, like an inflation index, an exchange rate is very often driven by political reasons. So it is subject to manipulation by authorities.

Reflecting the Effects of Changing Prices in the Preparation of Financial Statements by Russian Enterprises

Inflationary changes in prices are one of the most substantive reasons why information is misrepresented in financial statements of [Russian] enterprises. Purchasing power of the reporting currency [unit of account] that varies in different accounting periods and even within the same accounting period requires relevant restatements of financial statements. The methodology of inflation accounting in bookkeeping and preparing financial statements is based on the concept of capital maintenance under which a profit represents the increase in either financial capital or physical capital (such as operating capability).

There are two major approaches in accounting practices of different countries. The first approach is based on the concept of financial capital maintenance and applies a general price index (usually consumer price index) to non-monetary balance-sheet items. The second approach is based on the concept of physical capital maintenance and involves the restatement of financial statements to reflect the effects of changes in the specific prices of assets held. Similarly, the comparability of data under changing prices is achieved under International Accounting Standards IAS 15, Information Reflecting the Effects of Changing Prices, and IAS 29, Financial Reporting in Hyperinflationary Economies.

Specific Features of Russian Inflation

Specific features and major problems of applying the above approaches to the restatement of Russian financial statements are directly related to specific features of Russian economic development for the past decade, primarily, specific features of Russian inflation.

Unlike classical hyperinflation, Russian inflation in 90s was characterized not only by sky-rocketing prices but also by a significant change in price ratios. Prices for some products were rising at a rate that is several times higher than that for other products (see Attachments 2, 3). «It should be noted that increases in prices were not merely progressive in relation to all commodities and services in Russia but also accompanied by substantive shifts in the structure of consumer prices and expenses…» [1].

The change in price ratios was primarily due to the integration of the «closed» Russian economy in the world market, which resulted in the emergence of new consumer goods and prices for some (primarily, export-oriented) goods approaching world market prices. The most substantial discrepancies between rates of increases in prices for different products were during the so-called «price liberalization» period and right after the August 1998 financial crisis, i.e. when Ruble was devaluing at the fastest rate (Attachment 1).

A high percentage of non-cash transactions between Russian enterprises is another important factor of price ratios. The percentage of non-cash transactions in some enterprises amounted to about 90% of total sales. According to the survey of manufacturing enterprise managers, the average percentage of barter transactions accounted for 42% of total sales in 1997, 51% – in 1998 and 42% – in 1999. [2]. Despite the fact that the percentage of barter transactions has been diminishing for the past two years, the percentage of set-offs, veksels [promissory notes and bills of exchange], barter, etc. in total transactions is still rather high. So, in addition to cash prices, enterprises have also been using «barter», «set-off», «veksel» and other prices. The gaps between these prices can amount to as much as dozens of percent. This resulted in the blur of the «shipment value» concept and incomparability of shipment values of different enterprises where non-cash transactions account for different percentages of the total turnover. Besides, even prices used in cash transactions cannot be regarded as truly market ones if the percentage of cash transactions amounts to less than half of total sales.

Rapid shifts in price ratios, changing structure of consumer basket as well as a high percentage of non-cash transactions between enterprises affect adversely the precision of estimates of price indices. Some economists indicate significant errors in the calculation of price indices, including consumer price index (CPI), which has been a traditional benchmark of the inflation rate. They do not recommend relying on the CPI and other price indices in performing special calculations: «…for objective reasons, the increase in Russian consumer prices during economic reforms cannot be estimated with precision, which needs to be taken into account when using Goscomstat CPI.»[3]. It should be noted that errors in calculating price indices do occur in developed economies. However, in transition economies, this problem represents a real obstacle to obtaining comparable financial information. «The economy in transition is evolving more rapidly than a stable economy. The current national statistics system is more suitable for the latter. So economic indicators are measured with much lower precision in transition economies…» [4].

Applying IAS 29 in Russian Environment: What Should be Restated?

Under IAS 29, current period accounting data and financial statements as well as corresponding figures for the previous periods are restated by applying a general price index. The CPI has been traditionally used in Russia for this purpose. In addition, the Producer Price Index for Manufacturing Industries (PPI) can also be applied. However, in the view of experts in [5], errors in calculating the PPI are even greater than those in calculating the CPI. Due to significant errors in calculating price indices, there are doubts that their application will enhance the quality of financial disclosures. Besides, under the rapidly changing structure of prices, the consumer price index is similar to «the average temperature in a hospital» and can no longer provide a fair view of enterprises in specific industries and their «consumer baskets».

Under IAS 29 (p.19), the amount of assets restated by applying a general price index shall be reduced to recoverable amount of property, plant and equipment, net realizable value of inventories or current market value of investments in cases when the restated amount exceeds a relevant price «param»eter. However, Attachment 3 proves that prices for some commodities can be not only several times lower but also several times higher than the CPI. So financial statement items restated for a general price index can be significantly lower than the market value of assets, which would result in the understatement of the enterprise’s assets and equity and, eventually, can affect adversely its capitalization.

[Attachment 3 shows rates of increase in producer prices for selected groups of Property, Plant and Equipment. CPIs for similar periods are given in Attachment 3 for comparability purposes. As is shown in Attachment 3, the greatest discrepancies between the CPI and individual commodity indices arise in the case of pulp and paper industry equipment (CPI in 1994 is 1.75 times lower and in 1996 it is 1.36 times lower than the PPI for pulp and paper) and in the case of computers (CPI in 1994 is 1,97 lower and in 1996 it is 1,22 times lower than the PPI for computers). So those enterprises which either produce or have such equipment as part of their Property, Plant and Equipment ended up having a misrepresented picture of their financial position and operating results for 1994 and 1996. Besides, this misrepresented information affects adversely the quality of financial disclosures in financial statements for future periods.]

Enterprises whose consumer basket is rising in price at a faster rate than the general rate of price increases find themselves at a disadvantage when a uniform price index is used to restate financial statements under IAS 29 for all enterprises irrespective of their industry and specific features of consumer basket. Appeals to the prudence principle cannot be considered valid because the difference between indices (see Attachments 2 and 3) can reach as much as dozens of percent. So financial statement items can become even less comparable not only with the corresponding figures of the enterprise’s own financial statements of different reporting periods but also with the financial statements of different enterprises of the same period. This also goes for the financial statements of companies from different countries that raise investments in international capital markets.

Russian Experience in Reflecting the Effects of Changing Prices

Obviously, the effects of changing prices, including inflation, need to be reflected. The Russian Government made certain attempts in this direction and in 1993-1998 issued special rulings whereby enterprises were required to revalue their fixed assets. In the earlier periods (1993-1994), enterprises had to use Goscomstat producer price indices. Later on, in addition to Goscomstat indices, enterprises were allowed to remeasure Property, Plant and Equipment directly to current market values (some of Goscomstat indices are given in Attachment 3).

The drawbacks of these remeasurement procedures are as follows:

• inaccuracy of indices (PPI);
• one-sided approach (property, plant and equipment were subject to restatement while other assets were carried at cost);
• restatement of comparative information for previous periods was not required;
• in 1994-1995, enterprises were not permitted to use market values when indices did not represent fairly changing prices;
• incomplete accounting for physical wear and tear of equipment, which is quite crucial for Russian enterprises because many companies hold property, plant and equipment whose wear and tear exceeds 50%;
• enterprises are not required to disclose all necessary information in their financial statements;
• the government controlled the restatement of property, plant and equipment in order to address the needs of tax authorities that feared the overstatement of costs arising from the remeasurement of property, plant and equipment and restatement of depreciation charges.

However, the advantage of this methodology is a case-by-case approach to restating different categories of property, plant and equipment, which would make it possible to partially reflect changes in price ratios.

Current Economic Environment

Despite a significant decrease in consumer price indices in Russia from the beginning of 2000 (up to 1.3 – 2.1% per month in the autumn of 2000 and 16.5% for the first 10 months of 2000), the cumulative inflation rate is still pretty high, i.e. 187.7% from the beginning of 1998 to October 2000 [6]. Even without taking into account 1998 data, the total increase in consumer prices amounted to 58.3% from the beginning of 1999 to October 2000 [6]. So the economic environment of the Russian Federation still meets characteristics of hyperinflation as specified by IAS 29: the cumulative inflation rate over three years exceeds 100%, payments for certain commodities such as exported or consumer goods are pegged to the exchange rate and the population prefers to keep its wealth in a stable foreign currency rather than in bank accounts or similar assets.

At the same time, due to continued structural economic reforms, prices for different products keep changing irregularly, which leads to shifts in price ratios. Despite a significant decrease in the percentage of non-cash transactions between enterprises, the percentage of barter in total sales is still high – 34-38% of total sales in manufacturing industries in the second half of 1999 [2]. These factors lead to errors in the calculations of price indices, primarily, composite indices such as CPI and PPI, which reduces the efficiency of the restatement of accounting data and financial statements by applying general price indices in accordance with IAS 29.

Possible Solutions

The Russian situation with prices might be a unique consequence of the transition from the «closed» communist economy to an open free market economy. Nevertheless, any country that undergoes structural shifts in its economy can find itself in a similar situation, which requires accounting for not only a change in the general purchasing power of Ruble (which is not always practicable given errors in the calculation of price indices) but also for a change in the consumer basket of specific enterprises or, at least, industries.

Some experts, including those from Russian audit firms and users of financial statements, suggest the following ways of reflecting changing prices in the financial statements of Russian enterprises:

1. Using US dollar for bookkeeping purposes. However, as is shown in Attachment 4, movements in the exchange rate were consistent with Ruble inflation rates during very short periods of time. In addition, movements in the exchange rate depend directly on political decisions. Nevertheless, in the view of investors (and not only foreign ones), the use of a hard currency in measuring all transactions of the enterprise is the most understandable and useful approach in hyperinflationary economies because it enables one to measure the return on investments in the measuring units which investors use in their practices. However, the translation of IAS 29-based financial statements into US dollars reduces the meaningfulness of accounts and leads to additional difficulties in their analysis because the translation involves an additional accounting estimate, i.e. a general price index.
2. Using different approaches of IAS 15 to the restatement of non-monetary assets, including:

• price «param»eters current at the balance sheet date, i.e. recoverable amount in the case of property, plant and equipment, net realizable value in the case of inventories and current market value in the case of investments. The advantage of this approach is the fact that it enables enterprises to use their own judgment in measuring assets on the basis of comprehensive information about prices with relevant adjustments for non-cash market prices. However, this option is cost-intensive for both enterprises and audit firms because it implies physical inventory taking of assets and obtaining a lot of additional information about prices which is not always publicly available. Given that IASs are generally used by very large enterprises with lots of subsidiaries, restatements of assets to current costs do not seem feasible. In addition, these calculations imply lots of subjective judgments in the overall reporting process. No wonder, some countries gave up this approach after several years of its application (see Mexican experience). However, under IAS 29 (p.19) this method of restatement has already been implicitly introduced for those assets that are rising in price at a lower rate than the general level of consumer prices. However, this treatment is not effective for those assets that are rising in price at a faster rate than the general price index. When using this approach, it is necessary to disclose the sources of data on prices (publicly available information, prices of specific transactions, etc.).
• price indices for aggregate commodity groupings. One should not necessarily apply national statistics data. It is also possible to use data of private-sector information agencies that, in the view of experts, are sometimes more accurate and reliable. The advantage of this approach is the fact that it is possible to reflect shifts in price ratios on the basis of less subjective information from publicly available sources. The major drawback of this approach is the use of price indices the calculations of which are not always reliable and known. However, this drawback is inherent in any method that involves the application of price indices. If this approach is used, a special focus should be made on the disclosure of sources of information about price indices, groups of assets and values of indices.
• an approach combining features of both the current cost approach to be applied to some items (such as inventories and investments) and price indices to be applied to other items (e.g. property, plant and equipment).

1. Bessonov V.A. Errors in estimates of the increase in Russian consumer prices. // Economic magazine of the Higher School of Economics, 1998, #1, p.36.
2. REB indexes. – Russian Economic Barometer, #4, 1999, p.65.
3. Bessonov V.A. Errors in estimates of the increase in Russian consumer prices. // Economic magazine of the Higher School of Economics, 1998, #1, p.31.
4. the same edition, p.62.
5. the same edition, p. 61.
6. data of the Russian Goscomstat.

Attachment 1

The Ratio of Consumer Price Indices to Producer Price Indices for Manufacturing Industries in 1992-1999. *

* computed on the basis of data from the Review of Economic Policy in Russia for 1999. – Bureau of Economic Analysis, ТЕИС, Moscow 2000.
** consumer price index (percent change in relation to the previous year)
*** producer price index for manufacturing industries (percent change in relation to the previous year)
**** total price increases for 1991-1999 (percent change).

Periods that have been set in bold type are characterized by the most vehement (structural) shifts in price changes over time.

Since 1 January 1992, the Russian Government has stopped controlling prices other than those for products such as electricity. The abrupt move to a free market environment led to sharp increases in prices for virtually all products and services. This measure of the Russian Government was called «shock therapy» and «price liberalization». It gave rise to hyperinflation which had been unknown in Russia before 1992.

In August 1998, the financial crisis broke out in Russia. The national currency devalued almost three times in relation to the US dollar within the next four months (see Attachment 4). CPI for this period amounted to 1,71.

Attachment 2

Attachment 3

* – data of the Russian National Statistics Committee (Goscomstat): Goscomstat Letter #17-1-17/1501, dated 30 November 1994, Goscomstat Letter #24-1-20/2861, dated 15 December 1996.
** – Consumer price index

Attachment 4

Movements in the Exchange Rate (between the Russian Ruble and US dollar) and the decrease in US dollar purchasing power in the Russian market during 1992-1999.*

* – computed on the basis of data from the Review of Economic Policy in Russia for 1999. – Bureau of Economic Analysis, ТЕИС, Moscow 2000.
** – denominated rubles.
*** – percent change in relation to 1991.

Larissa Gorbatova is a Deputy Head of MinFin Accounting Methodology Department. She can be contacted by e-mail lgorbatova@hse.ru.