September 30, 2022

HOW HYPERINFLATION AFFECTS FINANCIAL REPORTING

Inflation is one of the main economic problems faced by developing and developed economies. These problems are embodied in the high level of prices due to various reasons such as the increase in the money supply, the increase in prices due to the increase in production costs (raw materials and wages), the depreciation of the currency, etc. The Sri Lankan economy is highly dependent on imports. For example, according to the Central Bank report, import expenditure in 2020 was US$16,055 million and in 2021 it was US$20,637.4 million. Import expenditure in Sri Lanka increased by 28.54% in 2021 compared to 2020. According to the Central Bank’s 2022 report, the highest import expenditure was incurred on intermediate goods. Intermediate goods include fuel, textiles and textile articles, chemicals, basic metals, plastics and articles thereof, paper and cardboard and articles thereof, wheat and maize and other intermediate goods.

In line with IMF Executive Board Article IV on Sri Lanka, the Executive Summary shows that “COVID-19 has severely hit the economy, resulting in loss of tourism revenue and necessitating several strict closures. pre-pandemic taxes and the impact of COVID-19 led to budget deficits exceeding 10% of GDP in 2020 and 2021 and a rapid increase in public debt to 119% of GDP in 2021. Access of Sri Lanka to international capital markets was lost in 2020, leading to international reserves falling to extremely low levels and large-scale direct lending to the government by the Central Bank of Sri Lanka (CBSL). and a growing current account deficit have led to shortages of foreign exchange (FX), while the official exchange rate has been de facto fixed since April 2021. Inflation is on the rise, reaching double digits in December 2021, reflecting imported inflation, supply shocks and a recovery in domestic demand in a context of accommodative monetary policy”.

Due to the depreciation of the Sri Lankan rupee against the US dollar, there are bad consequences on the Sri Lankan economy. For example, it leads to high inflation as Sri Lanka is heavily dependent on imports. The Central Bank of Sri Lanka has allowed currencies to float. As a result, the Sri Lankan Rupee was heavily depreciated with effects from March 8, 2022. Prior to this date, the exchange rate was constant within the range of LKR 190 to LKR 200 per 1 US dollar. However, with the floating decision of the Central Bank of Sri Lanka, the exchange rate has been reduced from LKR 370 to LKR 380 in the last two months. (March to May 2022).

Increase the price of goods and services

As there is a sharp depreciation of the LKR against the US dollar, fuel prices have been significantly increased several times in the short term. As a result, the price levels of almost all goods and services are greatly increased in Sri Lanka. As there is significant inflation in the country, it has a high impact on financial reporting (Konchitchki, 2011; Kramarova, 2021).

According to the conceptual framework of financial reporting, investors, potential investors, lenders and other creditors are the interested parties in financial reporting. These parties may make inappropriate decisions if the financial statements are not adjusted for inflation. In addition, there is a negative effect on “comparability”, which consists of improving the qualitative characteristics of useful financial information. Thus, the International Accounting Standards Board (IASB) issued an accounting standard to address the above problem in July 1989, under the name Financial Reporting in Hyperinflationary Economies (IAS 29) (according to Sri Lanka Accounting Standards, LKAS 29).

Application of LKAS 29

LKAS 29 Financial Reporting in Hyperinflationary Economies applies when an entity’s functional currency is that of a hyperinflationary economy. Functional currency refers to the currency of the primary economic environment in which the entity operates. In the Sri Lankan context, the functional currency is the Sri Lankan rupee, which has been strongly inflated over the past two months. LKAS29 does not prescribe when hyperinflation occurs. However, it requires that the financial statements (and corresponding figures for prior periods) of an entity whose functional currency is hyperinflationary be restated for changes in the general pricing power of the functional currency.

Which jurisdictions are hyperinflationary? LKAS 29 defines and provides general guidance for assessing whether the economy of a particular jurisdiction is hyperinflationary. But the IASB does not identify specific jurisdictions. However, there are two reliable sources for seeing hyperinflationary information. The first is that the International Monetary Fund (IMF) publishes inflation forecasts and the second is the International Practices Task Force (IPTF). According to the International Monetary Fund (IMF) inflation forecast, the following economies were considered hyperinflationary economies for the purposes of applying LKAS 29 for the year ending December 31, 2021: Argentina, Islamic Republic from Iran, Lebanon, South Sudan, Sudan, Suriname, Syrian Arab Republic, Venezuela, Yemen, Zimbabwe. In addition, the following countries have been listed according to the GIP report published on November 6, 2021 as hyperinflationary economies. Argentina, Iran, Lebanon, South Sudan, Sudan, Venezuela, Zimbabwe, Suriname, Yemen, Angola and Haiti.

Fortunately, Sri Lanka has not been listed as a hyperinflationary economy according to the above reports. However, there is a high chance that Sri Lanka will be listed as one of the hyperinflationary economies in the upcoming reports. Therefore, it is crucial to investigate the application of LKAS 29 to Sri Lankan companies. The purpose of LKAS 29 is to establish specific standards for entities reporting in the currency of a hyperinflationary economy, so that the financial information provided is meaningful. In the Sri Lankan context, this standard has not been used frequently in history, but nowadays many people talk about the application of this standard to Sri Lankan businesses. The basic principle of LKAS 29 is that the financial statements of an entity that publishes its reports in the currency of a hyperinflationary economy must be expressed in the unit of measure current at the closing date. Comparative figures for prior periods should be restated to the same current unit of measure.

Restatements are made by applying a general price index. Items such as monetary items that are already expressed in the unit of measurement at the closing date are not restated. The other items are restated based on changes in the general price index between the date of acquisition or commitment of these items and the closing date. For example, trade receivables, trade payables, cash and cash equivalents are examples of monetary items, while property, plant and equipment and inventory are examples of non-monetary items. Monetary items are not restated while non-monetary items are restated from the general price index.

When an economy ceases to be hyperinflationary and an entity ceases to prepare and present financial statements in accordance with LKAS 29. In accordance with LKAS 29, the following information must be disclosed. The fact that prior period financial statements and other data have been restated to take into account changes in the general purchasing power of the reporting currency, whether the financial statements are based on a historical cost approach or a current cost approach and on the identity and level of the price index at the reporting date and movements during the current and previous reporting period.

(The author has a Ph.D. in Accounting, B.Sc. in Accounting, FCA)