Inflation

1. Inflation  Accounting for changing prices is especially germane to managers of MNEs as rates of inflation vary substantially from country to country. Late 1980s--Brazil topped 600% inflation Bolivia�24,000% annual inflation in 80s, as high as 30,000% during part of 1990 Argentina..20,000 % in 1990

2. Most dramatic hyperinflation in German, 1922-1923: over 1 billion percent annually!

3. Accounting for Price Changes and Inflation Internationally Rates of inflation vary substantially from country to country... Thereby increasing the potentially distortive effects of inflation on reported results of operations. Local inflation, in turn, impacts exchange rates used to translate foreign currency balances to their domestic currency equivalents. Thus, it is difficult to separate the issue of foreign currency translation from the issue of inflation when accounting for foreign operations.

4. Accounting for Price Changes and Inflation Internationally Effective inflation management techniques are, in turn, largely dependent on an information system that enables managers to gauge the distorting effects of inflation on enterprise performance and elements of financial position. Even if price stability is achieved in one country, it is unlikely to be accompanied by price stability throughout the rest of the world.

5. The effects of changing prices depend partially on the transactions and circumstances of an enterprise, and users do not have detailed information about those factors. Statements by managers about the problems caused by changing prices will have greater credibility when enterprises publish financial information that addresses those problems.

6. Even when inflation rates have slowed, accounting for changing prices is useful as: (1) The cumulative effect of low rates of inflation over time can be significant. (2) The distorting effects of previous inflation can persist for many years . (3) Specific price changes may be significant even though changes in the general price level may not.

7. Example Acquire two identical assets, One year apart. Assume 10% inflation, and that the first asset purchased was not put into service until the second is purchased. Cost of A = X Cost of B = 1.10X B has a 10% higher Book Value and 10% more depreciation expense to match against revenues. Identical revenues produced by asset A will APPEAR to be more profitable than revenues produced by asset B.

8. Balance Sheet Impaired comparability, since its components are stated in dollars having different purchasing power. Thus, assets acquired at equal purchasing power costs are stated at different dollar amounts.

9. During a period of rising prices, asset values based on historical cost seldom reflect current worth. Understated asset values, in turn, worsen solvency ratios and invite hostile takeovers.

10. Income Statement Primary criticism is that historical cost accounting reports understate expenses and overstate income.

11. Should a firm actually distribute all of its overstated earnings in the form of higher dividends, wages, etc., it may not preserve adequate resources internally with which to replace specific assets whose prices have risen. (Inventories, plant and equipment)

12. Overstatements in Income Overstatements in income may lead to: 1. Increases in proportionate taxation 2. Requests by shareholders for more dividends 3. Demands for higher wages by labor or their representatives 4. Actions by host governments not in the best interests of multinational operations (e.g., taxes) 5. Reduced confidence in the credibility of enterprise accounting reports.

13. Tax & Dividend Implications The distortions introduced by inflation on the Financial Statements capacity to impartially convey economic information are serious enough. Worse, the consequences derived from basing tax and dividend payment decisions on inflation. Distorted accounting information is very serious indeed.

14. As the purchasing power of money deteriorates because of inflation, the assets of a business�and debt and stockholders� equity�come to be stated in terms of the depreciated currency.

15. Without the intervention of the income tax, and assuming none of the phantom profits were used to increase dividends, the relationships among these elements of the corporate balance sheet would undergo only minor change.

16. Unfortunately, taxable income as defined by the IR Code does not recognize as a deduction for tax purposes the additional dollars required to maintain intact the capital of the enterprise. To the extent that the current tax burden of business is somewhat lightened by accelerated depreciation, LIFO, etc., some offset exists.

17. However, these tools are not adequate to offset the taxes paid on phantom profits and to this extent are not available to meet either growth or modernization requirements.

18. Phantom Profits Nonmonetary assets (e.g., inventory) Sales (Current) - COGS Operating profit (may be overstated)

19. Phantom Profits Depreciation on HC doesn't allow assets to be conserved for replacement May be understating assets on Balance Sheet. Possible liquidity problems What does this mean for the ability of the corporation to maintain the status quo? To grow? The Ant and the Grasshopper: A Fable!

20. 1978 United States $202 Billion in Earnings before Taxes $118 Billion in Earnings after Taxes Adjust COGS and depreciation for replacement cost, and After Tax Profit dropped about $42 Billion Taxes on Phantom Profits totaled $17 Billion Dividend Pay-out Ratio was 65% rather than 42% R/E increased by $27 billion, not $69 billion

21. DANGER! If a firm distributes its overstated earnings, there may not be sufficient resources retained to replace assets. Possible Example: Car Manufacturers Inventories and Property, Plant, and Equipment Original acquisition cost may understate value Understated asset values worsen solvency ratios May invite corporate raiders

22. Financial Strategies Inflation causes an increase in the cost of capital goods, which can be more rapid than the company's ability to generate cash flows to replace the capital goods, particularly machines. The consequences of this situation are any of the following, alone or in combination: some replacements must be deferred external financing must be increased other uses of funds, such as dividend payments and discretionary expenses must be curtailed

23. Investment Strategies Explore, buy and develop natural resources and build capital facilities as a hedge Take advantage of recessionary periods and negotiate better engineering, construction and labor contracts Be prepared to buy used facilities Look for "buys" in the stock market Forecast higher future selling prices to justify new investments

24. Financing Strategies Borrow as much long-term debt as you can for as long as you can In lease-finance transactions, retain residual equipment values

25. Operating Strategies Use LIFO inventory valuation During periods of oversupply increase inventory Negotiate long-term purchase contracts In new technology development, design away from energy-based processes because of anticipated escalating energy costs Measure performance in real terms by converting operating results via use of GNP deflator and wholesale price index

26. Issues that Standard Setters Would Consider: Mandatory versus discretionary revaluations Frequency of revaluations (Australia allows, but does not require revaluations. ) Some firms do not revalue, some revalue on an ad hoc basis, and some revalue on a stated cycle, e.g., every three years. In this sample, revaluation every three years was most common, but the year of initial revaluation varied across firms). Revaluations to income or to owners' equity In Australia, the net revaluation increment is treated differently than a net revaluation decrement The increment is credited to an asset revaluation reserve in Stockholders' Equity The decrement is charged against revenues in determining profit

27. Revaluations Revaluations are applied to classes of assets, defined on a firm-by-firm basis. There are no tax effects and usually no income effects of the revaluations. Tax depreciation is based on the initial acquisition cost using scheduled rates. Depreciation is taken on the new (revalued) asset value, so land is the most commonly revalued.

28. A gain or loss on the disposal is calculated as the difference between the carrying amount as revalued and the proceeds, and is included in income determination. The valuation reserve realized on disposal cannot be taken back to earnings. There is no specific requirement as to the method of revaluation to be used although company law requires disclosure of the year of valuation and whether the valuation was carried out by management or an independent appraisor.

29. Motivations for Revaluations Asset revaluations reflect management's attempt to comply with the requirement of company law that financial statements present a "true and fair view": Asset revaluations lower the debt-to-equity ratio, loosen debt constraints, and enhance financial flexibility Asset revaluations are undertaken as a takeover defense strategy to ensure that an underpriced bid id not successful Asset revaluations lower the return on assets and hence exposure to labor unions, price control administrators, and tax authorities.

30. Results Firms that revalued assets had price to book ratios closer to one than did firms that did not revalue. Revaluation of assets generally results in better alignment of market and book values. Revaluation activity is greater when misalignment of market value and book value is greater. There is some evidence that the reported increments in asset revaluation do not capture asset value changes in the year when the change occurred; revaluations do not appear to be timely.

31. Results Reporting asset revaluations in the balance sheet is particularly informative when the level of debt or the change in the debt level is high the level of revaluation activity to date or the level of revaluation activity during the reporting period is high

32. Standard Setting and Inflation So, What Do We Do? Financial accounting standard setters in different countries have developed two basic approaches for dealing with inflation in financial statements. Constant Dollar Current Cost There are differences in the way the two methods are applied and whether they are used in the primary statements or as supplementary data.

33. Constant Dollar General price level indices are used to adjust historical cost accounting records into monetary units of the same general purchasing power. Inflation effects are eliminated by changing the units of measure from the historical monetary unit, with different purchasing power at different dates, into a monetary unit with the same purchasing power. In practice, the GNP price level deflator developed by governmental economists has been suggested as the best measure of purchasing power in an economy. It measures the relative prices of all goods and services in the economy.

34. General Price Level Adjustments General price level adjustments do not abandon the HC basis, they merely restate historical purchasing power exchanges. GPL adjustments will not necessarily reflect the actual market value changes of each specific asset relative to itself and to other assets the firm owns.

35. GPP GPP: Report financial statement elements in units of the same purchasing power; still based on HC, HC is adjusted for changes in general purchasing power. This method in its PURE state does not consider changes in value resulting from changes in supply and demand (economic value)

36. Composite Measures May be Misleading E.g. Wholesale Price Index rose 1.2% between 1985 and 1986. But Components of the Wholesale Price Index Included the following: Mineral Products, up 10.5% Pulp and Paper Products, up 8.7% Textiles, up 0.4% Rubber and Plastic, up 0.9% Lumber and Wood, down 0.9% Fuel, down 23.2% And, this is only U.S. data

37. Current Cost Attempts to arrive at an economic value for past transactions. Current cost is recommended by the FASB (FAS No. 89) Index: External price index for class or goods or services or internally generated price indices Direct Pricing: Invoices, price lists, quotes, estimates, standard manufacturing costs

38. Replacement Costs and Exit Value Replacement Cost value at what it would cost to replace asset current asset and condition or, similar asset with improved technology Exit Value value at NRV ( i.e. , what would be selling price of the asset?) liquidation value or �going concern� value

39. United States: Inflation Reporting US: Mandatory inflation reporting ended in 1986 with FAS 89 Encouraged, but not required to disclose supplementary information on the effects of changing prices. The statement acknowledged that inflation may recur at any time and included the following guidelines to assist enterprises deciding to continue reporting the statement effects of changing prices, to serve as a starting point for the development of any future inflation accounting standard.

40. Reporting enterprises are encouraged to disclose the following information for each of the five most recent years: Net sales and other operating revenues Income from continuing operations on a current cost basis Purchasing power gains or losses on net monetary items Increases or decreases in the current cost or lower recoverable amount of inventory or property, plant and equipment, net of inflation Any aggregate foreign currency translation adjustment, on a current cost basis, that arises from the consolidation process Net assets at year-end on a current cost basis EPS from continuing operations on a current cost basis Dividends per share of common stock Year-end market price per share of common stock Level of CPI used to measure income from continuing operations

41. IASC IAS 15 recommends that the following information should be disclosed by large public companies: The amounts of the adjustment to or the adjusted amount of depreciation of property, plant and equipment The amount of the adjustment to or the adjusted amount of cost of sales The adjustments to monetary items The overall effect on income The current cost of property, plant and equipment and inventories if the current cost methods is used The methods used to calculate the information as well as the type of indices used

42. IASC The IASC issued IAS 29, Financial Reporting in Hyperinflationary Economies, in 1989. It requires that financial statements of a company reporting in a currency of a hyperinflationary economy be restated at the balance sheet date for general purchasing power changes. This applies whether statements were based on historical cost or current value IAS 29 applies to primary financial statements. The gain or loss on the net monetary position should be included in net income and separately disclosed.

43. IASC and FASB have defined a concept for severe inflation, hyperinflation The general population prefers to keep its wealth in non-monetary assets or in a relatively stable foreign currency. Amounts of local currency held are immediately invested to maintain purchasing power; The general population regards monetary amounts not in terms of the local currency but in terms of a relatively stable foreign currency; Sales and purchases take place at prices that compensate for the expected loss of purchasing power during the credit period, even if the period is short; Interest rates, wages and prices are linked to a price index; The cumulative inflation rate over three years is approaching or exceeds 100% (IAS No. 29, IASC, 1989)

44. Risk Management in Hyperinflationary Economies Instinctive noninvolvement in hyperinflationary economies may reflect shortsighted business strategies. These economies often present their own unique opportunities for those committed to understanding how they work.

45. Example IN 1989, Latin America generated a US $30 billion trade surplus. US $18 billion was achieved in Brazil. Four of the five largest local banks posted REAL earnings of 70% or more. Unemployment in Brazil was negligible.

46. Cash Flows Reality to the investor in a hyperinflationary economy means cash flow, the ultimate driving force in valuation. Only cash receipts can be reinvested in the firm or paid to owners. An appropriate starting point for evaluating economic reality is an accurate measure of actual and projected cash flows.

47. Cash flow statements daily may be required; purchasing power can decline by whole percentage points daily. Cash flows may be a better measure of performance than taxable earnings.

48. ROI ROI is meaningful when inventory is adjusted to market value and depreciation is adjusted to reflect the replacement cost of assets being consumed.

49. The health of a firm in a hyperinflationary environment is predicated on responsive, decision relevant control systems. It is important to understand the local environment.

50. Inflation May Be Relative Switzerland has enjoyed a 0% inflation rate and may be concerned when the inflation rate �skyrockets� to 2%!