Andersen in Slovenia examined the impact of inflation on accounting. Inflation rates in the European Monetary Union are reaching and exceeding 10% yearly.

How and if higher inflation rates affect accounting and financial statements is explained by Ms. Mojca Gornjak, PhD, Finance and Accounting Director at Andersen in Slovenia in the following article: FinD-INFO - Mojca Gornjak: Inflation in 2022 and Accounting (findinfo.si)

You can also read the article below: 

Inflation in 2022 and accounting

In the aftermath of the covid-19 pandemic and geopolitical tensions, we hear the word inflation more often, with annual growth rates rising in recent months to over 10%, mainly due to energy and food price rises. Below we present the definition of inflation and its impact on financial statements. We will also present accounting in hyperinflationary environments.

1. Definition of inflation

Inflation is, by definition, a general increase in prices, not just an increase in the price of individual products, and a consequent decrease in the value of a currency over time, because inflation makes us buy less today than in the past. The change in prices, which represents the overall increase (or decrease) in prices, is measured in the goods and services consumers buy during the year and represent by a "shopping basket". The year-on-year inflation rate is calculated as the ratio of the price of the total basket in a given month compared to the price in the same month one year ago. In the basket, different products and services have specific weights, which depend on consumption. Products and services purchased more, such as electricity, have a higher weight.

In the EU, inflation is measured by the Harmonised Index of Consumer Prices, HICP (Eurostat, 2022), using a common methodology for calculating the index. The HICP is calculated by collecting the prices of a basket of products and services on a monthly basis (295 product categories), by setting weights for each product or service (the impact of spending in the average household budget is monitored regularly) and by setting country-specific weights (the impact of total consumption expenditure in the Euro area).

2.  Inflation and financial statements (IASB 16, IAS 12, IAS 16, IAS 29)

Inflation is also important when dealing with accounting data. Many people do not think about financial reporting under International Financial Reporting Standards when inflation increases. (European Commission, 2019) that will not change significantly due to inflation. However, internal reporting for decision-making might change, as higher input prices significantly alter costing and the determination of the selling price. International Financial Reporting Standards do not separately address accounting for inflation, nor do they define rules for the valuation of items in the financial statements. IAS 29 Financial Reporting in Hyperinflationary Economies addresses only external financial reporting in hyperinflationary environments for both corporate and consolidated financial statements.

Inflation is unlikely to have a material impact on the items in the financial statements and their valuation, but it may change the discount rates we use to measure items, leases and affect the potential provisioning of loss-making contracts, and have an impact on the carrying amount of property, plant and equipment if we have chosen the revalued cost or fair value method. The impacts on each category are described below.

The impact of inflation can be expected in discount rates where future cash flows are discounted, such as in leases or financial instruments where future cash payments are estimated. Typically, as inflation rises, so do interest rates, which means higher discount rates and a reduction in the present value of future payments.

In the case of leases, there is a possibility that the lease terms may be renegotiated, which may result in a change in the lease agreements. A change in leases shall be accounted for in accordance with IFRS 16 Leases if the leases do not contain a variable rent that varies with the increase in the cost of living (inflation).

The impact of higher prices is also reflected in higher operating costs. Where this is not possible, companies may operate at a loss on certain contracts - onerous contracts - which may require provisioning and valuation in accordance with International Accounting Standard 37 Provisions, Contingent Liabilities and Contingent Assets. The standard defines a provision as a liability of uncertain timing or amount that is a present obligation of the entity and arises from past events. The obligation is expected to give rise to an outflow when settled. The entity also does not have a realistic prospect of settling the obligation that can be estimated reliably.

The biggest impact on business performance will come from higher input prices. If companies value inventories using the FIFO method, they will carry forward to cost inventories at lower historical cost prices, which means that pre-tax profits will be higher. However, owners can also expect higher labour and service costs due to general price increases. The impact of inflation may also be seen in the valuation of fixed assets if an entity has chosen to use revalued cost or fair value instead of cost. In this case, the fair value of the fixed asset should be reviewed at each reporting date, and the revaluation adjustment should be disclosed separately. If the carrying amount increases, the increase is shown as a revaluation reserve in equity, and if it decreases, the revaluation reserve is first reduced, and the difference is recognized in profit or loss as an operating expense. It is also important to note that depreciation is charged on the new revalued amount, which means that depreciation is higher if the carrying amount increases and the impact on profit or loss are negative due to higher depreciation expense.

3.  Hyperinflation and financial statements (IAS 29)

As mentioned earlier, IAS 29 Financial Reporting in Hyperinflationary Economies deals with accounting in hyperinflationary economies. The standard is applied in preparing both entity financial statements and consolidated financial statements, where the functional currency of the entity is the currency of the hyperinflationary economy. A hyperinflationary economy is defined as an economy in which, because of a decline in purchasing power, comparisons of amounts arising from transactions and other events that occurred at different times or even within the same accounting period are misleading. The translation of amounts in the financial statements is a matter of judgement, as the standard does not specify an absolute rate that determines hyperinflation but rather takes into account the characteristics of the country's economic environment, which include, but are not limited to:

• the general population prefers to keep their wealth in non-monetary assets or in a relatively stable foreign currency. Amounts denominated in local currency are invested immediately to maintain purchasing power;
• the general population does not treat monetary amounts in local currency but in a relatively stable foreign currency. Prices may be quoted in this currency;
• sales and purchases on credit are made at prices that compensate for the expected loss of purchasing power during the credit period, even if this period is short;
• interest rates, wages and prices are linked to a price index; and
• the cumulative rate of inflation over three years approaches or exceeds 100%.

The information in the financial statements shall be presented in the unit of measurement applicable at the end of the reporting period and shall be back-translated. The restatement may use either the historical cost or the day-count method. The standard specifies the procedures and judgement and prompts consistency of application from period to period.

Statement of financial position at historical cost

The amounts in the statement of financial position should be presented in the unit of measurement current at the end of the reporting period and translated using the general price index. This method is also referred to as current or current purchasing power. The index is calculated as the quotient between the index at the end and the beginning of the period. Nonmonetary asset items (those already recorded in the monetary unit at the statement date) are multiplied by the coefficient. The adjustment affects net profit or loss and is disclosed separately.

Non-monetary items are recognised at cost or cost less valuation allowance, which means that the items are at the amounts at the date of acquisition. The cost or cost less valuation allowance must be recalculated for each item. The restatement is made by applying the change in the general price index from the date of acquisition to the statement of financial position date. Property, plant and equipment, investments, inventories of raw materials and supplies, goodwill, patents, trademarks and similar types of assets are restated from the date of acquisition. The value of intermediate and finished goods inventories is recalculated from the dates on which the costs of acquisition and conversion are incurred.

Income statement and statement of comprehensive income

All items of profit or loss and comprehensive income shall be presented in the unit of measurement current at the statement of financial position date, which means that all amounts shall be restated using the changes in the general index of price inflation since the date on which the entity first included the items of income and expense in the financial statements.

Cash flow statement

Items in the cash flow statement are also presented in the unit of measurement at the statement of financial position date.

Taxes

The restatement of amounts in the financial statements may result in differences between the carrying amounts of assets or liabilities and their tax bases. Differences are accounted for in accordance with IAS 12 Income Taxes.

Consolidated financial statements

A parent reporting in the currency of a hyperinflationary economy may have subsidiaries that also report in the currencies of hyperinflationary economies. The financial statements of subsidiaries shall be translated using the country's general price index and the country's currency in which the entity reports. Only after translation are the figures included in the consolidated financial statements. The restated financial statements should be translated at closing rates if the subsidiary operates abroad. When consolidating financial statements, reporting dates may differ, and all items, monetary and non-monetary, should be translated into the unit of measurement applicable at the date of the consolidated financial statements.

 4.  Conclusion

 The purpose of this article is to review the potential impact of inflation on items in financial statements. Businesses need to address and detect inflation risks and assess the impact on operations and performance. The restatement of the amounts in the financial statements is not yet necessary as inflation in the

Euro area has not yet reached 100% over the last three years, and we do not qualify as a hyperinflationary economy.

 5.  Sources and literature:

 Eurostat. (2022, September 13). EUROPEAN STATISTICAL RECOVERY DASHBOARD.

EUROPEAN STATISTICAL RECOVERY DASHBOARD.

https://ec.europa.eu/eurostat/cache/recovery-dashboard/.

Eurostat. (2022, September 13). Harmonised Indices of Consumer Prices (HICP).

https://ec.europa.eu/eurostat/web/hicp.

European Commission. (2019). Commission Regulation (EC) No 1126/2008 of 3 November 2008 adopting certain international accounting standards in accordance with Regulation (EC) No 1606/2002 of the European Parliament and of the Council (Text with EEA relevance). http://data.europa.eu/eli/reg/2008/1126/2019-01-01/slv.