(In-depth analysis of IAS concepts concerning measurement of assets and other issues related to application of IAS 16, IAS 29, SIC 19, and IAS 21)
Michael Rodchenkov, Askold Birin, Vladimir Evseev
1. Asset Measurement
One of the major IAS concepts is to enable users of financial statements to arrive at economic decisions based on the evaluation of assets and liabilities of the company. It will allow them to measure the company’s assets’ ability to generate cash based on the historical data, expectations and results of the reporting period; and also to determine the potential to forecast future cash flows in terms of amount, inflow/outflow and reasonable assurance for cash inflow to the company.
There is a trend of supporting the concept of fair value measurement, which undoubtedly is viewed as the barest necessity; however, the exact method for determining fair value is yet to be found. In our opinion, the use of independent appraisers and regular asset valuations (2–3 times a year) may be misleading given the subjective nature of the appraisal process.
Therefore, we need to find a way for asset evaluation (especially in case when the value of an asset should be increased), which would arrive at the real fair values excluding short-term speculations and management effects (explained below).
This article is an attempt to prove that the assets of a company should be recorded at inflation-adjusted cost (since inflation significantly affects the value of assets), rather than at discounted future cash flows generated by a asset or a group of assets. The next logical step should be the application of impairment test for the inflation-adjusted value (if the impairment is caused by events, such as disposal or corruption of an asset).
Normally, the reduction of asset values is easily made, but increases in asset value may result in severe problems for those who audit and prepare the financial statements.
As we have said, one of the objectives of this article is to find an defined approach for asset measurement. We have chosen to base our research on the measurement of fixed assets. The valuation of long-term leases is excluded from this methodology as the discounted cash flow method produces the best possible approximation to fair value. The measurement approach given below may be applied in any other cases.
We support the idea that the inflation-adjusted cost approach is a way to arrive at the fair value of assets. In other words, there is no need for revaluation on regular basis, i.e. 2–3 times a year, as IAS recommends. On the contrary, company’s assets should be adjusted upwards to meet the inflation rates (based on consumer price index), bearing in mind movements in relative prices of certain assets1. Any misstatement of an asset value in the short-term is corrected in the long term and the examples in the next section illustrate this.
When there is no going concern and the fixed assets of the company are continuously growing, users of financial statements are interested in value of the assets purchased earlier to be comparable with the value of those acquired or sold in the reporting period. Users want to know the present value2 of the investments in assets in terms of current values rather than in terms of their values in the previous reporting periods. In the latter case, the capital invested in the company is misstated as well as the depreciation charges made in order to purchase a similar asset in the future.
In other words, assuming that inflation rate is about 3–4% over a 10-year period of time, total misstatement may consequently reach 50%, and depreciation deductions will be insufficient to cover the costs to replace such an asset. However, FASB (USA, Canada) that supports of the historic cost convention found a solution with accelerated depreciation. Unfortunately in terms of fair value measurement this raises as many questions as there are problems indicated in the present article.
Please note that generally there are no major problems with initial measurement the of a new asset except for certain cases that require recognition of expenses in the acquisition period or in long-term leasing arrangements. However, in the consequent periods the determination of the fair value is inevitable (which is inflation adjusted value of an asset from the date of acquisition; not related to the future economic benefits). The impairment test should be applied only to such figures, and consequently reflect the fair and impaired value and losses for the current period.
When purchasing a fixed asset it is assumed that:
- It is purchased with a purpose of obtaining additional income (a margin over the asset cost);
- Operations that utilize the asset will continue;
- To obtain maximum efficiency, the useful life should be long enough to permit the first assumption to occur, but at the same time as short as possible.
However, this does not mean that determination of the fair value of a fixed asset depends on the resultant cash flows from future periods.
To support the stated conclusions, the authors give the following examples:
For the simplicity of the example authors did not adjust the expenses at the average inflation rate.
The above tables illustrates that the residual value of 77,903 (inflation adjusted) is much closer to the fair value than the original figure of 70,000.
During the same period the market value of brewing equipment was:
Increase in value of the brewing equipment X1 at the market for the periods:
Average asset value is 105,925 USD (total amount for 4 years/4), and the average value denominated in inflation adjusted rubles amounts 105,708 USD.
Conclusions:
Valuation of assets based on the historical basis even given an insignificant inflation rate, in the long term, may result in a significant misstatement of asset value. This corresponds to the 11,2913 USD in our example;
Inflated value and realizable value of the same asset may vary within different periods. However, in a long term asset value corresponds to the market value or replacement cost (105,925 and 105,708 USD).
Other influences may result in an increase in realizable cost (for instance, growing demand for beer or increasing value of aluminum (prime component of the equipment)). However, when valuing assets these are irrelevant and should be disregarded. Besides, it has been historically proven that aluminum price tends to increase or decrease , whereas demand for beer may be satisfied within a short period of time.
The impairment test may be applied to obsolete assets (in our example brewing equipment) and the discounted cash flow reflected in the asset value.
Assessing management effects
The following example help us understand management’s effects on the proper determination of the fair value of assets.
Example.
Two 30-year old farmers own a combine which they intend to work it in two 12-hour shifts. Therefore, they work the combine to 100% of its capacity. The estimated cash flow generated by the combine operation is 200,000 USD a year.
In a different scenario, when an elderly farmer operates an identical combine for less than 6 hours a day, the estimated cash flows would be 60,000 USD. In this scenario the farmer also believes that he works the combine to 100% of its capacity.
Apparently the discounted cash flow method will distort the measurement in this example, and the current inflation-adjusted approach balances the values of the combine in the examples above.
It seems difficult to assess management effect on the proper measurement of an asset when applying the conclusions of the example to larger businesses with larger assets.
Undoubtedly management may have a significant impact on asset value using present value approach. Therefore, we may conclude the following:
- Since the potential cash flows generated by certain assets may be effected by various factors (such as management quality, management judgment, market conjuncture and other factors), measurement based on discounted cash flows provides a variable value. Therefore, it may not be treated as a fair value of an asset, as it is always a subjective opinion.
- A user of accounting information should wherever possible disregard the value placed on an asset by management. This will enable him to gain a fair and objective information from financial statements unaffected by the short-term factors and oriented towards long-term term results.
2. How the Reporting Currency Affects Asset and Performance Measurement
- How macroeconomic factors affect asset value and performance measurement
- Application of consumer price index to ruble measurement to at the reporting date
- Application of stable measurement currency
A financial performance analysis requires assessment of the impact of macroeconomic factors such as devaluation of the national currency and inflation. Failure to consider the effect of these factors on fair value measurement may result in critical misinterpretation of the information provided in the reports.
In accounting for inflation there are two basic approaches to reporting:
1) A «hard» currency least exposed to the devaluation is used as the reporting currency.
2) The national currency adjusted for inflation or deflation is used as the reporting currency. However, the statements may be later presented in any currency: inflation-adjusted figures are divided by the exchange rate at the reporting date.
The first of the following examples illustrates the effect on asset values that results from devaluation of the national currency, i.e. purchasing power of the national currency changes in a market where other currencies prevail. Conversion of the national currency into a «hard» currency using the exchange rate at the transaction date may solve this problem.
The second of the following examples illustrates declining purchasing power of a certain amount of money expressed in the national currency against the same amount reported at an earlier date. Expressing the figures based on the movements in the value of the national currency can help resolve this problem.
These approaches have both advantages and disadvantages and we need to determine the prerequisites for the application each. International Accounting Standards require adjustment for inflation in hyperinflationary economies (according to IAS 29).
Standing Interpretation Committee Document SIC-19 requires the reporting company to use either «hard» currency or national currency adjusted for movements of the purchasing power of the national currency as of the reporting date. It is recommends to use the national currency units for the purpose of financial statements. In addition, the reporting company must consistently apply the same currency through the financial statements irrespective of the currency of origin.
When a company operates in an economy undergoing significant national currency devaluation and increasing inflation, this may result in serious structural problems in the financial statements such as the overstatement of profit, undervaluation of assets and payment of dividends out of capital.
This statement sounds very reasonable with regard to the entities (or their subsidiaries) that operate in developing countries and economies in transition.
The examples that follow are based on certain assets of a hypothetical company operating in a hyperinflationary environment.
In the period from 1995 to 2001 in the Russian Federation, the economy was subject to high volatility, inflation rate jumps and exchange rate fluctuations. This period is used as the basis for our examples.
During 1995–1997 the trend of ruble devaluation in relation to the currency of developed countries had a high degree of correlation with the inflation rate trend.
Crisis of 1998 resulted in a significant devaluation of the Russian ruble against «hard» currencies (primarily USD), whereas prices for the domestic Russian goods stayed reasonably unchanged. Russia adopted an import substitution policy, i.e. selling domestic goods instead of imported goods, which to an extent helped to maintain the inflation tension.
During the period 1999–2001 the inflation growth rate significantly outpaced the devaluation of the ruble mainly as a result of the abrupt structural changes of 1998.
As shown in Table 1, trends in ruble devaluation and inflation were different during the review period. This significantly affects the valuation of assets purchased during the period using either the inflation adjusted rubles approach or the hard currency approach.
There are also major differential effects in the domestic prices. For example, there were significant increases in house prices at the same time as relatively little change in the securities prices in the same time frame.
The examples in Tables 2–5 below illustrate this problem.
The price growth rates shown in the examples were based on the consumer price indices published by State Statistics Committee of the Russian Federation.
Devaluation (RUR/USD) is measured by the Central Bank’s official rate.
Example.
A company purchased a new Lada automobile on December 31, 1999 for RUR 118,192.4
On January 1, 2000 the RUR/USD rate was 28.48 rubles.
At December 31, 2000 the RUR/USD rate was 29.22. The exchange rate grew by 2.53%.
In the same period the inflation rate was 22.83%
At December 31, 2000 an identical but new Lada automobile cost RUR 151,944.5
Table 2 sets out the value of the asset in both currencies, either inflated Russian rubles or US dollars.
In rubles, the difference between actual and expected values in rubles at the end of year 2000 (151,944-145,175=6,749 RUR) result from a combination of speculative demand and the use of an annual average index.
However, when reporting in USD the estimated value of the automobile Lada was expected at 4,255, which is 945 USD (or 945x29.22 = 27,613 RUR) less than a real value of an automobile.
In accordance with the concept of the historical value of the car, the replacement cost of the automobile at the end of the reporting period must be equal to the value of a similar automobile provided that the value is only effected by the macroeconomic factors.
When an automobile is bought by rubles, the best way to record it is in RUR expressed in the current purchasing power as at the reporting date (second approach).
As Table 3 shows the expected value of metal ties based on inflated rubles is 2,947.92. This is extremely close to the market price of 2,920 RUR whereas the dollar valuation is significantly different at 2,432 RUR (86.38x28.16).
The calculation is similar to previous tables. Again the expected value is very close to the market price.
(See Table 5.)
Bread was among the products, the price of which was state controlled / subsidized.
This explains why bread price prices do not follow the pattern established in the other examples.
Bread prices expressed in USD are significantly different from expectations (0.27– 0.22) x 28.16 = 1.4 RUR per loaf.
To prove the ideas expressed above we have tried to forecast the values of several items based on the USD/RUR exchanged rate determined in the State budget for the year 2002.
Inflation for 2001 was 18.6% and expected inflation rate for 2002 is 16%. Dollar rate at the end of 2001 was 30.14 RUR, and the forecasted USD/RUR rate for the end of 2002 is 32 (Dollar is expected to grow by 6.67%). (See Table 6.)
Conclusion:
From the examples above we may conclude that reporting in USD or any other «hard» currency may significantly affect asset values.
This is true for companies (or their subsidiaries) operating in the transition economies and developing countries. It is also true for countries with a fixed foreign exchange rate or significant foreign currency restrictions e.g. currency corridor.
The following example examines the macroeconomic factors and their effect on the valuation of an asset bought for foreign currency (USD in the example).
The move to fair value accounting shows that replacement cost accounting is of interest to the users of financial information.
The examples below show the effect of reporting currency on reported figures at book value and current value.
Example 1.
At the beginning of 1999, a company purchased 8 automobile Lada at the average price of 75,000 RUR. The total cost was 600,000 RUR (or, converted in USD 3,320 each).
Assuming the useful life of an automobile is 2 years the vehicle will be depreciated straight-line over this period.
Inflation during 1999 and 2000 was 36.5% and 20.3% respectively.
RUR/USD exchange rate was 22.6 at the beginning of 1999 and 27 at the end. At 31 December 2000 the rate was 28.2. (See Table 7.)
The average realizable value is (3,320 + 4,378 + 5,396)/3 = 4.365 USD.
For 8 automobiles, the total difference between International Financial Reporting Standards valuation and current cost at the end of the 2000 is 34,938 USD for 8 automobile (4,367 USD each). The computations show that inflated cost under IFRS is the same as the current value of fixed assets. The dollar denominated value is significantly understated and equals 26,549/8 = 3,320 USD.
Example 2.
A Ford Mondeo was purchased for 26.549 USD (600.000 RUR) on 31 December 1998.
The useful life of a automobile is assumed to be 2 years and straight line depreciation is written off over this period.
Inflation in 1999 and 2000 was 36.5% and 20.3% respectively.
RUR/USD rate at the beginning of 1999 was 22.6, as the end of 1999 it was 27, and at 31 December 2000 was 28.2. (See Table 8.)
Table 8 shows that over 2 years, the difference between the inflated value of an automobile and its historical cost is 34,938 – 26,549 = 8,389 USD or 31%.
Obviously, cost of an acquisition of a automobile expressed in USD is more closely related to the actual cost of a automobile, since the company paid dollars for it, and its price is denominated in USD and this is unchanged (if everything else stays the same).
So the value of items purchased for USD are closer to the fair values if they are accounted for in USD.
This section confirms the principles set out in the examples
On 31 December 1999 a foreign investor made a 1m. USD equity investment in a Russian company.
The RUR/USD exchange rate at 31 December 1999 was 27, and at 31/12/01 was 28.16.
Inflation rate over 2000 was 20.13%.
Table 9
As Table 9 show, the application of an inflation index at the balance sheet date may misstate the initial investment by 151,815 USD.
If acquisition value was denominated in rubles and then converted into dollars at a rate given at the balance sheet date, this results in a misstatement.
The company’s assets reflect the investment and any apparent changes in them are part of equity. They are the nature of a capital reserve and should be included in retained earnings rather than initial capital.
Therefore, when equity contributed in dollars and reflected in rubles is indexed by the inflation rate, the indexing period is from the moment investment was made (or previous revaluation) until the balance sheet date.
The example above uses the index of 28.16/27x100% = 104.29%
Thus, reflection of assets purchased for foreign currency against the inflated cost in Russian rubles will eventually result in misstatement of reporting data.
The size of misstatement will increase over time and is determined by the currency exchange rate and inflation rate in the country of business operations.
Conclusions:
- Companies should report in rubles including an inflation component for assets (liabilities) purchased for Russian rubles, and excluding inflation component for assets (liabilities) purchased for hard currency in developed countries.
- Reporting adjustments for an inflation component is appropriate even in the countries where the inflation rate noted to be insignificant (3–4% annual rate), since after lengthy periods of time (8–10 years) misstatement of assets with long useful life will be significant (about 40–50% within 10 years).
Independent appraisers are engaged to facilitate an adjustment of the carrying value of assets in the financial statements to the value of a replacement asset.
A simple inflation adjustment of the assets value can also produce a similar approximation to fair value.
- Presently, developed countries get involved in purchases of inventory in developing countries and countries in transition, for example, People Republic of China or India and in such circumstances the inflated component of the assets value should be considered.
- When analyzing performance of the company it is necessary to re-calculate the figures using an inflation rate based on the a consumer price basket.
- When the inflation growth rate exceeds the ruble devaluation rate it is necessary to consider the effect of the interest generated by savings.
When making a bank deposit it is essential that the ruble deposit interest rate is higher than foreign currency deposit rate or loss will result.
For example during a period of 20% ruble inflation banks offered 16% for ruble deposit and 8% for foreign currency deposit (USD). In such a case interest on the funds deposited in rubles is smaller than the inflation rate but still will have a significant positive net effect when converting interest amount into dollars. USD growth is only 2,4% per annum. This explains the existing policy when the ruble annual deposit rate is below the inflation rate.
- A comparative analysis of the prices of goods both at domestic and foreign markets is necessary in order to identify goods with artificially low value. This will prevent misstatement of values as a result of hidden government subsidies such as existed during soviet times.
- For the purpose of planning of ruble reported operations, the following formula should be used: estimated earnings of the company + inflated component (10% of expected increase in the proceeds + 20% inflation rate + [10% * 20%] expected inflation effect on the estimated earnings)
Therefore, when planning company performance compound interests should be applied.
- When budgeting an average inflation rate applies. For example, for purchased items or other short-term assets:
This approach may help determining an approximate amount of the inflation component. A more precise figure may be calculated using the formula:
Average inflation rate =
1.2 / ((1.2 + 1)/2) = 1.09 or 9%.
- Foreign contracts should take into account the movements in the RUR/USD rate, for example, in 2001 the average rate was 31.49 rubles for 1 dollar.
- Financial statements should include supplements based on IAS 29 and IAS 16 with regard to asset measurement in the transition economies.
The accounting treatment should provide a breakdown of fixed assets that are manufactured and purchased in:
- transition economies
- stable economies (western countries, that do not suffer significant fluctuations in costs)
- other countries, although classified as transition economies, but that apply different inflation rates and other factors affecting the measurement.
The value of assets purchased in transition economies by the companies operating in the developed economies must be also be adjusted against the inflation rate that exists in the country of origin. This will help to measure the real asset value, which is essential given the increase in globalization.
- The value of fixed assets purchased in stable economies will be similar to that for receivables denominated in the hard currency of the country.
- The authors have found out that many readers of this article considered treatments described above as alternative techniques of independent appraisal. It is entirely wrong. These treatments should be used for accounting purpose only. Inflation-adjustment treatments are not meant to replace appraisers’ services. Their work will remain in detection of any discrepancies between accounting figures and fair values. However, in the authors’ opinion, the gap between accounting and appraisers’ values will be less significant once these inflation-adjustment treatments are applied.
Michael Rodchenkov is Director of International Financial Reporting Group, FBK PKF-Moscow, Askold Birin is IFRS Group Assistant Manager, Vladimir Evseev is IFRS Group Assistant.
They can be contacted by telephone +7 (095) 737 5353.
International Background
David Damant comments on inflation accounting adjustments
This very useful article demonstrates a number of effects of inflation on the situation in the Russian Federation. It should be added, however, that the trend world-wide is towards the fair value of assets (and indeed liabilities). Fair value – the value of the individual asset itself – reflects reality. In calculating the fair value of an asset, the use of the movement in the consumer price index or a foreign currency is no more than a substitute figure, in cases where the value of the individual asset price movement cannot be calculated. Real estate prices for example may move independently of the general level of inflation, as can the price of oil. The article’s references to relative price movements are therefore very relevant.
The thinking on the measurement of assets within the new as well as the old Board of the International Accounting Standards Committee has been and is as follows. Partly because of the enormous controversy about fair value accounting in the 1970s, and partly because individual categories of assets deserve individual attention, the matter has been dealt with category by category.
Already, fair value is required (significantly but not completely) for financial instruments in IAS 39 which is coming into force, and (completely) according to the proposals of the Joint Working Group of Standard Setters. These proposals will probably take some time before adoption, but the trend is very much in their favour.
Support is given to this last statement by the fact that a likely outcome of the current «review» of IAS 39 and the required disclosures concerning financial instruments is to permit companies to adopt full fair valuing for all financial assets and liabilities (as recommended by the Joint Working Group) if the enterprise so desires. This is significant in pointing the way to future decisions by the International Accounting Standards Board (IASB).
In addition, the IASB already has fair value requirements for investment properties and agriculture. This leaves only fixed assets (where there is currently something of an option). The question of the measurement of fixed assets is on the agenda of IASB.
The other aspect of the matter is the effect of all these changes on the income statement. When inflation accounting was first discussed in the 1970s, the income statement was not under review as it now is. If (as is virtually certain) we soon move towards a comprehensive income statement (containing all changes in the shareholders funds except transactions with owners as owners), then the handling of plusses and minuses from revaluations as we move to fair value for assets (and liabilities) will be part of the overall discussion of the make-up of the new income statement, and of the definition, or definitions, of «profit».
There is also the question of the definition of «fair value» – is it exit value, value in use, value to the business, etc? Even though this is a contentious subject which will take some time to resolve, no one should imagine that contention over this definition will stop the drive to a fair value system and the eventual end of historic cost.
David Damant is a member of the Standards Advisory Council at the IASB and a former senior IASC Board member. He can be contacted at e-mail damantd@swordgroup.co.uk.