RESTATEMENT OF FINANCIAL STATEMENTS: METHODS AND EXAMPLE - DUDAS - 2024

The restatement of financial statements is a special technique used to take into account the impact that the rise or fall of the costs of products has on the figures reported in some regions of the world by international companies.

Financial statements are adjusted according to price indices, rather than relying solely on a cost accounting basis, in order to show a clearer picture of a company's financial position in inflationary environments.

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IAS 29 of the International Financial Reporting Standards (IFRS) is the guide for entities whose functional currency is the currency of a hyperinflationary economy. This is the financial statement restatement model required in International Financial Reporting Standards, implemented in 174 countries.

Companies entering inflationary statements may be required to periodically update their statements to be relevant to current economic and financial conditions, supplementing financial statements based on historical costs with restated financial statements.

Advantages and disadvantages

Restatement of financial statements comes with many benefits. Chief among these is that matching current income to current costs provides a much more realistic breakdown of profitability than other alternatives.

On the other hand, the process of adjusting the accounts to attend to price changes can cause financial statements to be constantly updated and modified.

Background

Accountants in the United Kingdom and the United States have discussed the effect of inflation on financial statements since the early 1900s, starting with the theory of index number and purchasing power.

Irving Fisher's 1911 book "The Purchasing Power of Money" was used as a source by Henry W. Sweeney in his 1936 book "Stabilized Accounting," which dealt with the constant accounting of purchasing power.

This Sweeney model was used by the American Institute of Certified Public Accountants for its 1963 research study, reporting the financial effects of changes in the price level.

It was later used by the US Board of Accounting Principles, the US Financial Standards Board, and the UK Accounting Standards Steering Committee.

Sweeney advocated the use of a price indicator that covers the entire gross national product.

During the Great Depression, inflation reached about 10%, prompting some corporations to restate their financial statements to reflect this change.

Final stages

During a period of high inflation in the 1970s, the Financial Accounting Standards Board (CNCF) was reviewing a draft proposal for financial statements restated at the price level, when the Securities and Exchange Commission (CBV) issued the ASR 190.

The CBV required about 1,000 of the largest US corporations to provide supplemental information based on replacement value. The CNCF withdrew its draft proposal.

In March 1979, the CNCF wrote the document "Constant Dollar Accounting", which recommended the use of the Consumer Price Index (CPI) so that all urban consumers could settle the accounts, because it is calculated every month.

IAS 29 (Financial Reporting in Hyperinflationary Economies) is the financial statement restatement model of the International Accounting Standards Board, authorized in April 1989.

What is the restatement of financial statements?

When a company operates in a country where there is a significant amount of inflation or price deflation, the historical information in the financial statements is no longer relevant.

To counteract this problem, in certain cases companies are allowed to use figures adjusted for inflation, reframing the figures to reflect current economic values.

Under a historical cost-based accounting system, inflation leads to two basic problems. First, many of the historical amounts that appear in financial statements are not economically relevant, because prices have changed since they were incurred.

Second, since the amounts in the financial statements represent money spent at different times and, in turn, represent different amounts of purchasing power, they are simply not summable.

Example

Adding the cash of $ 10,000 as of December 31, 2018, with $ 10,000 representing the cost of land acquired in 1955, when the price level was vastly lower, is a dubious transaction due to the significantly different amount of purchasing power represented by the two amounts.

When adding amounts in currencies that represent different amounts of purchasing power, the resulting sum is misleading. It would be like adding $ 10,000 to $ 10,000 to get a total of $ 20,000.

Similarly, by subtracting amounts of money that represent different amounts of purchasing power, it can result in an apparent capital gain that is actually a capital loss.

If a building purchased in 1970 for $ 20,000 is sold in 2016 for $ 200,000, when its replacement value is $ 300,000, the apparent gain of $ 180,000 is totally illusory.

Inflationary distortions

Ignoring changes in the general price level in financial information creates distortions in financial statements such as:

- Reported earnings could exceed earnings that could be distributed to shareholders without impairing the normal operations of the company.

- The values ​​of the assets for inventory, equipment and plant do not reflect their economic value for the business.

- Future earnings are not easily projected from historical earnings.

- The impact of price changes on monetary assets and liabilities is not clear.

- They are difficult to forecast future capital needs and can lead to higher leverage, increasing business risk.

Methods

CNCF method

This method was proposed in December 1974 by the Financial Accounting Standards Council (CNCF).

Converts the amounts that appear in the financial statements to equal units of current purchasing power, so that the current financial statements and those of the previous year would be comparable in terms of purchasing power.

Under this proposal, all items in the companies' balance sheets and income statements will be restated in terms of units of money of equal purchasing power. These statements will be presented, along with the traditional statements prepared in terms of historical costs, of unequal purchasing power.

When applying this accounting method, the first step is to separate all current balance sheet items into monetary items, such as cash, accounts receivable, accounts payable, and long-term debt, and non-monetary items, such as inventories and fixed assets.

Since monetary items are already expressed in units of current purchasing power, no further adjustments are required. However, monetary items on prior period balances must be expressed in terms of their current purchasing power.

Numerical example

For example, if the cash on last year's balance sheet was set to $ 1,000 and the purchasing power of the currency has decreased by 10%, the cash on last year's balance sheet will now be taken to $ 1,100.

Non-monetary items on the current balance sheet should be analyzed to determine when they were acquired. Therefore, a fixed asset with a historical cost of $ 1,000 on the current balance sheet, and that was acquired ten years ago, when the purchasing power of the dollar was 75% higher, would be reported as $ 1,750.

After the calculations are made in the first year of application for the non-monetary assets and liabilities acquired in previous years, the update for subsequent years is relatively simple and straightforward.

Current Cost Accounting (CCA)

The CCA approach values ​​assets at their fair market value, rather than historical cost, which is the price that was incurred during the purchase of the fixed asset.

Under the CEC, both monetary and non-monetary items are updated to their current values.

Example

Inflation can have its biggest impact on reported earnings with sizable inventories. Consider the following example:

Patrick's PC Shop reported sales of $ 100,000 last year. Its cost of sales was $ 75,000, which was a gross profit of $ 25,000.

Now let's say Patrick's PC Shop sells exactly the same number of units this year, but due to 5% inflation, it raised its prices by 5%.

It is also assumed that the cost of the merchandise also increased by 5%, but half of your sales will be made from "old" inventory that was purchased last year, at last year's cost.

Therefore, for the current year, Patrick's PC Shop reported sales of $ 105,000 and a cost of sales of $ 76,875 ($ 75,000 + 5%). This means a gross profit of $ 28,125.

From one year to the next, Patrick's gross earnings increased by $ 3,125 ($ 28,125- $ 25,000), even though his level of business activity was unchanged.

Conclusions

Patrick's PC Shop's increased earnings in the example cannot be attributed to better performance. They are simply "inflationary earnings."

Inflation also distorts reported income when the costs of fixed assets are charged to income through depreciation. The increase in the replacement values ​​of fixed assets is not reflected in the depreciation charge.

Inflation has an impact on the way investors and potential buyers value a business if they do not value inflation earnings.

A company that does not take this factor into account in its financial planning may see the value of the company decline. This would occur despite constant or moderately increasing earnings.

References

1. Daniel Liberto (2019). Inflation Accounting. Investopedia. Taken from: investopedia.com.
2. Wikipedia, the free encyclopedia (2019). Inflation accounting. Taken from: en.wikipedia.org.
3. Thomas D. Flynn (1977). Why We Should Account for Inflation. Harvard Business Review. Taken from: hbr.org.
4. Bizfilings (2019). Inflation and Accounting Procedures Can Reduce the Accuracy of Financial Analysis. Taken from: bizfilings.com.
5. Steven Bragg (2018). Inflation accounting. Accounting Tools. Taken from: accountingtools.com.
6. Global Finance School (2019). Financial Statements Adjusted For Inflation. Taken from: globalfinanceschool.com.