Hyperinflation
What you'll learn
- LOS 9.gAnalyze how alternative translation methods for subsidiaries operating in hyperinflationary economies affect financial statements and ratios.
In a hyperinflationary environment, the local currency will rapidly depreciate relative to the parent’s presentation currency because of a deterioration of purchasing power. In this case, using the current rate to translate all of the balance sheet accounts will result in much lower assets and liabilities after translation. Using the lower values, the subsidiary seems to disappear in the parent’s consolidated financial statements.
In reality, the real value of the nonmonetary assets and liabilities is typically not affected by hyperinflation because the local currency denominated values increase to offset the impact of inflation (e.g., real estate values rise with inflation). Unfortunately, adjusting the nonmonetary asset and liabilities for inflation is not allowed under U.S. GAAP; although, adjusting for inflation is permitted under IFRS. As a result, IFRS and U.S. GAAP differ significantly when dealing with a subsidiary operating in a hyperinflationary environment.
Under U.S. GAAP, a hyperinflationary environment is one where cumulative inflation exceeds 100% over a 3 year period. Assuming compounding, an annual inflation rate of more than 26% over three years will result in cumulative inflation over 100% (1.263 − 1 is approximately equal to 100%). When hyperinflation is present, the functional currency is considered to be the parent’s presentation currency; thus, the temporal method is used to remeasure the financial statements.
The IASB does not specifically define hyperinflation; however, cumulative inflation of over 100% in a 3 year period is one indication that hyperinflation exists.
IFRS does not use the temporal method for subsidiaries operating in a hyperinflationary environment. Instead, the foreign currency financial statements are restated for inflation and then translated using the current exchange rate. Restating for inflation involves the following procedures:
Nonmonetary assets and nonmonetary liabilities are restated for inflation using a price index. Since most nonmonetary items are reported at historical cost, simply multiply the original cost by the change in the price index for the period between the acquisition date and the balance sheet date.
It is not necessary to restate monetary assets and monetary liabilities. The components of shareholders’ equity (other than retained earnings) are restated by applying the change in the price index from the beginning of the period or the date of contribution if later. Retained earnings is the plug figure that balances the balance sheet.
In the statement of retained earnings, net income is the plug figure. The income statement items are restated by multiplying by the change in the price index from the date the transactions occur. The net purchasing power gain or loss is recognized in the income statement based on the net monetary asset or liability exposure.
Holding monetary assets during inflation results in a purchasing power loss. Conversely, holding monetary liabilities during inflation results in a purchasing power gain. This figure forces the net income to be same as the net income figure that was the plug figure in the statement of retained earnings.
Let’s look at an example.
Imagine that a foreign subsidiary was created on December 31, 2021.
The LC is the currency of the country where the foreign subsidiary is located. The subsidiary’s balance sheets for 2021 and 2022, and income statement for the year ended 2022, are shown in the following:
Also, use the following price indices:
| Date | Index |
|---|---|
| December 31, 2021 | 100 |
| December 31, 2022 | 150 |
| Average for 2022 | 125 |
Prepare an inflation adjusted balance sheet and income statement for 2022.
Solution
The nonmonetary assets (supplies) and the common stock are inflation adjusted based on the change in the beginning and ending price index because the amounts were outstanding for the entire year. The revenues and expenses occurred throughout the year and are inflation adjusted using the change in the average and ending price index. Notice the monetary assets (cash) and monetary liabilities (accounts payable) are not inflation adjusted.
Instead, the purchasing power gains and losses are calculated.
In this example, 2022 was the first year, hence, there were no beginning retained earnings. Therefore, the plug figure of LC10,500 has to be net income minus dividends for the current year. Given that dividends = 0, net income has to be LC10,500.
But it is not; hence, again, a plug figure (this time, in income statement) is needed to make sure that net income is equal to LC10,500. This plug (in income statement) is the net purchasing power gain or loss. Here, the gain is LC6,900.
Alternatively, inflation results in a purchasing power loss of LC2,500 on the beginning cash balance [−LC5,000 × (150 − 100) / 100] and a loss of LC600 on the increase in cash [−LC3,000 × (150 − 125) / 125]. Additionally, inflation results in a purchasing power gain of LC10,000 on the accounts payable [LC20,000 × (150 − 100) / 100]. Thus, adjusting for inflation will result in a net purchasing power gain of LC6,900 (−LC2,500 loss on beginning cash − LC600 loss on increase in cash + LC10,000 gain on accounts payable).
Notice the similarities of adjusting the financial statements for inflation and remeasuring the financial statements using the temporal method.
Under the temporal method, the monetary assets and liabilities are exposed to changing exchange rates. Similarly, it is the monetary assets and liabilities that are exposed to the risk of inflation. Purchasing power gains and losses are analogous to exchange rate gains and losses when the foreign currency is depreciating.
For example, if a subsidiary has net monetary liability exposure in a depreciating environment, a gain is recognized under the temporal method. Likewise, a purchasing power gain is recognized when a net monetary liability exposure is adjusted for the effects of inflation. The gain or loss from remeasurement is recognized in the income statement as is the net purchasing power gain or loss that results from inflation.
Under IFRS, once the subsidiary’s financial statements are adjusted for inflation, the restated financial statements are translated into the parent’s reporting currency using the current exchange rate.
Analyzing Foreign Currency Disclosure
Up to this point, we have examined a multinational parent with only one subsidiary. This made the analysis easier (although it sure doesn’t seem that way) because we were able to link the effect of the choice of translation method to the consolidated financial statements for the specific subsidiary.
However, in practice, multinational firms may have many foreign subsidiaries, which means that the CTA on the balance sheet, the remeasurement gain or loss in the income statement, and the parent company’s ratios include the effects of all of the subsidiaries. Unfortunately, disclosure requirements are limited, so it is difficult for the analyst to get information about the firm’s currencies and the specific exposure to the currencies. In some cases, it is even difficult to determine what accounting method (temporal or current rate) the firm uses for its various foreign operations.
What little information that is available is found in the financial statement footnotes and the management discussion and analysis section of the annual report.
As previously discussed, management judgment is involved in deciding on the functional currency of a foreign subsidiary. Firms operating in the same industry may use different methods for translation purposes thereby making comparisons more difficult. One solution involves adding the change in the CTA to the firm’s net income.
Recall the change in the CTA is equal to the translation gain or loss for the period. By bringing the translation gain or loss into the income statement, comparisons with a temporal method firm are improved. The solution does not totally resolve the problem but it is a good start.
The same solution can be applied to all non owner changes in shareholders’ equity. For example, adding the unrealized gains and losses from fair value through OCI securities to net income would allow an analyst to compare the company to a firm that owns fair value through profit or loss securities.
Including the gains and losses (that are reported in shareholders’ equity) in net income is known as clean surplus accounting in the analytical community. The term dirty surplus is used to describe gains and losses that are reported in shareholders’ equity.