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Cover Story: Accounting for hyperinflation

TURKEY is experiencing hyperinflation first-hand, following its unconventional method of combating inflation by lowering the interest rate.

With inflation at above 80% year on year in September, the lira has weakened (150% since 2021) to the point where historical benchmarks no longer reflect a company’s true financial position.

To illustrate: A business sold a product for TRY100,000 (RM25,330) in 1Q2022. In 2Q2022, it sold a similar product for TRY150,000. While its revenue has risen 50%, that TRY150,000 does not have the same purchasing power from a quarter ago.

This is where hyperinflation accounting under IAS 29 comes in. Introduced in 1987, it is a reporting standard used by companies and auditors in this once-in-a-blue-moon scenario.

There are several indicators qualifying an economy as hyperinflationary, according to the International Financial Reporting Standards (IFRS). They include the three-year cumulative inflation rate approaching or exceeding 100%.

Turkey has joined countries such as Argentina, Venezuela, Sudan, South Sudan, Iran, Lebanon, Zimbabwe, Suriname and Yemen, according to the list of hyperinflationary economies provided by the International Practices Task Force (IPTF) of the Centre for Audit Quality (CAQ).

How the accounting shows in financial position

Interestingly, whether a company’s financial position improves or deteriorates after an adjustment depends on the type of assets and liabilities held — either monetary or non-monetary.

IHH Healthcare Bhd, which has 17 hospitals in Turkey, booked net positive hyperinflationary adjustments of RM45.9 million in 2QFY2022 ended June 30.

While it booked higher depreciation and staff costs, its position was helped by a net monetary gain of RM295.54 million. Having said that, there will be future adjustments when the hyperinflation situation changes further.

Separately, Tenaga Nasional Bhd, which owns a 30% stake in Turkey power unit GAMA Enerji AS, says it is still too early to assess the impact of IAS 29, as the associate is still preparing its application.

With the accounting standard, the balance sheet, non-monetary historical assets (such as property) and liabilities (such as manufactured products owed to a client, or services) are adjusted to current prices, while monetary assets (such as cash in lira) and liabilities (loans in lira) are not restated.

Equity components are also restated, as with cash flows, and profit and loss statements.

When one holds cash or has an outstanding loan principal, it does not change in lira terms compared with a year ago, but weakens in ringgit terms.

“Whenever there’s inflation, the story would be, you don’t hold cash. You’d better buy as many assets as possible to secure the current purchasing power before it buys fewer things later,” an auditor says.

It also means a lira borrower benefits from hyperinflation, as it now takes less ringgit to pay off the debt — at least until the interest rate adjustment hits.

“In theory, those holding liabilities previously may benefit,” he suggests. “If you borrowed TRY100,000 to buy a property three years ago, that same property may be sold at a much higher price to fully repay the debt with some profit left — although there are many other moving parts to consider.”

Meanwhile, non-monetary liabilities such as products or services owed to a client are adjusted, as it now costs more to manufacture that product.

Similarly, non-monetary assets (such as property) may skyrocket in lira terms. There is a catch — the higher asset price is now matched with higher depreciation.

“On the one hand, [holding non-monetary assets allows a company to] benefit from holding gains, but the drawback is that holding gains on items such as inventories are taxed upon sale,” Ernst & Young Accountants LP professional practice group partner Pieter Dekker tells The Edge.

“For example, if a company buys inventory in January and sells it in July at 40% mark-up, but in that same period there was 40% inflation, then economically the company has not really made a profit.

“However, as tax generally is levied on an unadjusted cost basis, the 40% mark-up will be taxed and the company ends up worse off than before it bought the inventory.

“So, it is crucial to be mindful of the tax on holding gains that do not represent real economic profits and try to minimise the holding period of inventories.”

Ultimately, assets such as land and property are attractive — if the company can hold them indefinitely, and avoid or postpone triggering taxes by not selling them.

“In short, it is important to reduce the net monetary position by keeping non-interest-bearing cash balances to a minimum and financing the operations with borrowings as long as the interest rate on them is lower than the rate of inflation,” Dekker says.

What about companies that do not apply hyperinflationary accounting?

Having said that, not all companies operating in Turkey adopt hyperinflation accounting. Malaysia Airports Holdings Bhd (MAHB), which operates the Istanbul Sabiha Gökçen International Airport, does not adopt lira as its functional currency.

While that implies a company is less exposed to currency risk, one should be reminded that it is still operating in a hyperinflationary economy.

“As such, it is still exposed to many of the risks that result from the actions that local authorities take to address the balance of payments problems and adverse impacts on its business model,” Dekker points out.

This includes higher interest rates, currency or capital controls, import restrictions, price controls, inability of customers to pay, increased costs of doing business and higher taxes. One example is Sri Lanka, which has already imposed higher corporate taxes of 30%, from 24%, as a measure to cushion the impact of the economic crisis there.

However, the country is not yet on the list of hyperinflationary economies despite inflation being near 70% and the 80% decline in the rupee against the US dollar this year.

“Not applying hyperinflation accounting has many counterintuitive consequences, such as the revenue of companies may appear to show healthy growth in local currency terms, but most of that growth will be the result of inflation.

“Foreign investors in such companies should realise that these ostensibly rosy developments disappear once the local currency numbers are translated into the currency of a foreign parent,” Dekker says.

“In the parent’s currency, the devaluation of the hyperinflationary currency will probably more than offset the revenue growth in local currency. The parent will need to recognise currency translation losses in other comprehensive income, and the value of the net investment shrinks from the parent’s point of view.

“Also, when the subsidiary starts applying hyperinflation accounting in a future period, this will have significant adverse effects on cost of sales, depreciation and impairment testing in the local financial statements.”

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