What is Inflation Accounting How is it done and what are its advantages?
What is Inflation Accounting How is it done and what are its advantages
Inflation is defined as a continuous increase in the general level of prices. In addition to negatively affecting macro-economic balances in many ways, high inflation also causes erosion in the ability of financial statements to reflect reality, which is important for all stakeholders of companies. The primary reason for this is due to the constant erosion of the purchasing power of money due to high inflation; The nominal expressions of non-monetary assets are gradually moving away from revealing the current purchasing power.
If the inflation rate does not exceed certain limits, the misleading effect of inflation on non-monetary values will be limited in terms of financial statements. On the other hand, when inflation rates exceed a certain threshold, it becomes necessary to make inflation adjustments to the financial statements. Because the rapid change in the purchasing power of money causes records made at different times to lose their ability to reflect the real situation and be comparable. In such cases, the inflation adjustment application made on financial statements is called inflation accounting.
What is Inflation Accounting?
The purpose of financial reporting is to provide factual information about the company's financial position and performance to all stakeholders of a company, including investors. The ability of the company's financials to truly reflect the company's situation and performance is possible by expressing the financial items as closely as possible to the current purchasing power.
In this regard, inflation accounting; It can be defined as a correction made to ensure that company financial reports better reflect current purchasing power and to make comparisons with the past more meaningful.
In this respect, inflation accounting is a practice that arises from the need to adjust non-monetary assets according to a general price indices, as a result of the historical costs of non-monetary items moving away from reflecting the current purchasing power in a high inflation environment.
Among the advantages of inflation accounting: These include eliminating the fictitious profitability that occurs in the financial statements due to inflation, providing more realistic financial information to the company's stakeholders by showing the active and passive items subject to adjustment with current purchasing power, and allowing past comparisons to be made more consistently and accurately.
There are different conditions between VUK (Tax Procedure Law) and TMS 29 regarding when and under what conditions inflation accounting should be applied.
The Tax Procedure Law includes the provision that inflation adjustment must be applied if the PPI is more than 100% in the last three accounting periods, including the current period, and more than 10% in the current accounting period. Although these conditions have been met as of the end of 2021, this implementation has been postponed until the end of 2023 with the temporary article 33 added to the Tax Procedure Law by Law No. 7352. At the end of the 2023 accounting period, balance sheets will be subject to inflation correction according to VUK. However, the tax base for the 2023 accounting period will be calculated based on the profits determined according to the pre-adjustment financial statements; Starting from 2024, such adjustment differences, including the adjustment differences of the end of the 2023 period, will be associated with the income statement and affect the tax base.
On the other hand, according to TAS 29, which is within the scope of Turkish Financial Reporting Standards (TFRS), which is also used by publicly traded companies in financial reporting, the conditions that constitute a condition for inflation accounting are as follows;
(a) The majority of the population prefers to hold its wealth in non-monetary assets or in a relatively stable foreign currency. Local currency held is immediately invested, etc., to preserve its purchasing power;
(b) The majority of the population considers monetary amounts not in local currency but in a relatively stable foreign currency. Prices can also be determined in this currency;
(c) Prices for credit sales and purchases; It is determined to cover the expected losses in purchasing power during the loan period, even if the period is short;
(d) Interest rates, wages and prices depend on a 'price index' and
(e) The cumulative inflation rate of the last three years approaches or exceeds 100%.
As can be seen, according to TAS 29, inflation accounting and its conditions are not tied to a precise rate and the discretion to put it into practice is left to the authority of the Public Oversight, Accounting and Auditing Standards Authority (KGK).
Regarding the question of when inflation accounting will be applied for companies that need to prepare financial statements according to TFRS, KGK announced in its announcement dated 23 November 2023 that inflation adjustment will be made by the end of 2023.
In summary, annual balance sheets for 2023, prepared in accordance with both VUK and TFRS, will be prepared with inflation accounting application. On the other hand, the tax impact of inflation accounting will appear after 2024 (including the tax base to be calculated based on 2024 financials).
Companies whose functional currency is other than TL will not apply inflation accounting; because, as it is known, inflation is a variable related to the purchasing power of the local currency.
There is also another exception. Accordingly, in its announcement regarding the implementation of inflation accounting, KGK authorized the institutions authorized to regulate and supervise in their own fields to determine different transition dates for the implementation of inflation accounting.
Thereupon, the Insurance and Private Pension Regulation and Supervision Agency (SEDDK) announced in its statement dated December 6, 2023 that insurance, reinsurance and pension companies will not be subject to inflation adjustment.
Similarly, in the BRSA announcement made on December 12, 2023; banks; It was shared with the public that it was decided that the financial statements of financial leasing, factoring, financing, savings financing and asset management companies dated 31 December 2023 would not be subject to inflation adjustment required within the scope of TMS 29.
With the announcement made in its bulletin dated December 28, 2023, CMB announced that it was decided to apply inflation accounting to the financials dated December 31, 2023 of companies subject to their own financial reporting regulations.
In inflation accounting practice, non-monetary balance sheet items as of the end of the reporting period are adjusted using a general price index. There is no such need for monetary items, because although there is a change in the purchasing power of monetary assets as a result of inflation, there is no change in their nominal values.
Therefore, the application of inflation accounting begins with the determination of monetary and non-monetary items.
Then, the dates to be taken as basis for inflation adjustment for non-monetary items are determined.
After the dates for correction are determined, the correction coefficient that will ensure indexation to the date on which inflation accounting is applied is calculated by the date in question and this coefficient is multiplied by the amount to be corrected.
In accordance with the KGK guidance, the index to be used in adjusting financial statements for inflation has been determined as the Consumer Price Index (CPI), published monthly by the Turkish Statistical Institute (TUIK), as it is the price index that best reflects purchasing power. The indicator taken as basis in the inflation adjustment application within the scope of the Tax Procedure Law will be PPI.
As a result of inflation adjustment, there will be an increase in non-monetary items on both the asset and liability sides of the balance sheets. Therefore, it can be expected that there will be a positive effect on monetary earnings on the balance sheets of companies whose balance sheet assets have a higher amount of non-monetary items than the balance sheet liabilities. In this regard, especially companies with high Fixed Asset/Equity ratio (as fixed asset items contain the largest non-monetary items for many companies), define the difference between fixed asset adjustment and capital adjustment as monetary gain; can write this as retained earnings in the opening balance sheet.
Increased equity reduces the P/DD ratio to a lower and more attractive level; However, the increase in equity capital also has a decreasing effect on the return on equity capital under the same profitability assumption. In this respect, a holistic analysis of the effect to be achieved must be made.
Another important point to consider here is that the coefficient to be used in the correction of each non-monetary item in assets and liabilities may change due to the different dates on which the correction will be taken as basis. Therefore, it should not be forgotten that the inflation adjustment effect on all non-monetary items will not be at the same rate in any company's balance sheet. Therefore, when a company writes monetary gain on its balance sheet with inflation adjustment; The weight of fixed assets in the assets in the balance sheet composition and the weight of foreign resources on the liabilities side; How old the fixed assets in question are recorded is also an important factor.
The picture that emerges after inflation accounting may have positive and negative reflections on the income statement.
First of all, it is likely that a different outlook will emerge in the growth performance of companies as a result of inflation adjustment. The reason for this is that there is a difference between real growth and nominal growth in historical financial comparisons. For example, a company that increased its sales by 100% annually without any adjustments may see that the real growth in its sales decreased to a lower level after the previous income statements were indexed.
Secondly, recording depreciable assets at historical cost in a high inflation environment causes the depreciation amount to appear lower than its purchasing power. If depreciations do not reflect the real situation, it causes profit and profit margins to be overestimated and the tax base is high.
On the other hand, the method adopted for inventory valuation also affects reported net income in different ways. During periods of high inflation, the first-in, first-out (FIFO) method overstates the calculated profit because the cost of goods sold moves away from reflecting purchasing power. In this regard, during inflationary periods, the last-in, first-out (LIFO) stock valuation method has a greater disinflation function in terms of the income statement. However, while this method causes the stocks on the balance sheet to appear at low amounts compared to the current purchasing power; this causes an upward trend in return on assets (ROA) and indirectly in return on equity (ROE). However, as a result, in all cases, there is a certain degree of separation from the real situation representation on the basis of income and assets.
In this respect, an inflation adjustment that makes depreciation and stock valuation reflect purchasing power also better reflects the company's profitability and growth performance. This may seem to have caused gross and operating profit margins to be negatively affected in some companies as a result of inflation adjustment. However, when making comparisons at this point, the main thing to look at should be the tables where inflation accounting is applied. On the other hand, it can be expected that the impact on the gross profit margin based on the cost of goods sold will be lower in companies with a high stock turnover rate and stock valuation using the LIFO method. However, in terms of the balance sheet effect, high stock turnover limits monetary gain, because high turnover means low stock holding time. This brings stock values closer to current prices. In terms of the stock valuation method, the opposite is true; Because in companies that keep inventory with the LIFO method, the inventory item on the balance sheet is dated further back since the last items appear to have been sold. This strengthens the increase experienced as a result of stock indexation and therefore the possibility of making monetary gains.
Another reflection of inflation accounting on the income statement is the element of monetary gain and loss. This item in the income statement is also referred to as "net monetary position gain or loss" in the literature. During inflationary periods, businesses that hold more monetary assets than their liabilities suffer a loss of purchasing power. On the contrary, businesses with more debts than monetary assets provide an increase in purchasing power. Therefore, companies with a short net monetary position (the difference between monetary assets and monetary liabilities) can be expected to write monetary earnings with inflation adjustment, which will contribute to the net profit amount.
As a result, inflation adjustment affects the income statement through cost of goods sold, depreciation amounts, monetary losses and gains. This may cause changes in companies' earnings-related ratios such as P/E.
On the other hand, it should be known that inflation accounting will not create an actual difference in the cash flow of companies until its impact on the tax base comes into play. However, with the inflation adjustment to be made, the expression of the current situation will differ and will affect the inferences and interpretations in the analysis. In the analyzes made at this point, it would be beneficial to conduct a company-specific analysis and consider the impact of inflation accounting on financials from a multifaceted perspective.
