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Business valuation in hyperinflationary economies

Business valuation in times of hyperinflation takes extra consideration and skill. How do you account for the challenge? Chris West and Emma Williams outline the key issues.

What is hyperinflation?

The term ‘hyperinflation’ brings to mind the image of a wheelbarrow full of cash being towed to the shop to buy groceries, or the thought of the price of a loaf of bread increasing significantly between breakfast and lunchtime. Famous historical examples include Weimar Germany in the reparation period following the First World War, and Zimbabwe between 2007 and 2009, where a one hundred trillion dollar note became the largest currency denomination ever issued. It presents an urgent and deeply damaging situation to the population struggling to afford food and basic amenities.

Less critically, hyperinflation can make understanding financial performance, and therefore valuing a business, extremely difficult. International accounting standards (specifically IAS 29) provide a useful reference in this scenario.

Understanding financial performance amid hyperinflation

The accounting standards provide guidance for identifying whether hyperinflation is present, and if so, for restating the financial performance metrics to make them meaningful.

While a 50% monthly increase in prices is commonly cited as a threshold for hyperinflation, IAS 29 does not specify an absolute rate. Instead, it “allows judgement as to when restatement of financial statements becomes necessary”. Section 29.3 sets out key characteristics that indicate hyperinflation, such as that:

  • 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; prices may be quoted in that currency
  • sales and purchases on credit 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 approaches, or exceeds, 100%

If hyperinflation is found to exist, financial transactions must be restated by applying a general price index current at the balance sheet date. Section 29.9 says: “Items such as monetary items that are already stated at the measuring unit at the balance sheet date are not restated. Other items are restated based on the change in the general price index between the date those items were acquired or incurred and the balance sheet date.”

Such adjustments should be made to make the financial performance figures “meaningful”. In a hyperinflationary economy, money loses purchasing power at such a rate that comparison of amounts from transactions and other events that have occurred at different times, even within the same accounting period, would be misleading. The impact of the recommended inflation adjustment is that annual results will reflect the performance of businesses during that year. However, comparison of absolute results between years will be problematic as each will have been adjusted to the relevant year-end price indexing level.

Whether an economy is considered hyperinflationary according to the IAS 29 definition may change between financial years. In which case, these adjustments would no longer be required. Caution must be applied when comparing these financial years. Inflation may still be running at a high level even when hyperinflation is not present. And there may still be significant changes in the purchasing power of the currency across the financial year, making it hard to assess ongoing financial performance.

Using a stable currency for business valuation

In hyperinflationary economies, the local currency is, by definition, unstable; its value is eroding rapidly day by day. Local currency forecasts for the business will therefore be inherently unreliable, as both inflation levels and foreign exchange rates are impossible to predict with any accuracy. A stable currency must be used to understand future growth, especially if using an income approach (or discounted cash flow 'DCF' approach), which relies on financial forecasts.

In some cases, reliable foreign currency financials may have already been prepared. Where they haven’t, IAS 21 'The Effects of Changes in Foreign Exchange Rates' advises the local currency accounts should be translated, after the hyperinflationary restatements of IAS 29 have been made. In economies with typical levels of inflation, transactions would be translated at the foreign exchange spot rate at the date of transaction. 

However, as previously noted, transactions and balances in a hyperinflationary economy should already reflect the year-end purchasing power of the currency (in line with IAS 29). Therefore, the foreign exchange translation for these amounts should also occur at the year-end spot rate.

How to deal with multiple foreign exchange rates (for the same currencies)

One final complication... hyperinflation scenarios are often further complicated by the existence of various foreign exchange rates for the local currency, such as the official central bank rate and the ‘parallel’ rate. (This latter rate is the one that most of the population need to pay to change their money.) There could also be some commercial rate that businesses may be able to access, sitting somewhere between the two.

Again, we turn to the standards for guidance. IAS 21 advises that when there are several available exchange rates, the rate used should be that at which “the future cash flows represented by the transaction or balance could have been settled if those cash flows had occurred at the measurement date” (IAS 21.26). So, if the business could only obtain foreign currency from the central bank, then the official central bank exchange rate should be used. If in practice, the currency would have been obtained from the commercial banks, then the spot rate set by the commercial banks should be used. Care must be taken to consider the most likely conversion rate for the business at that time.

This guidance is relevant for translating the local currency accounts into a stable foreign currency, such as USD. However, the business may also have some trading in this or other foreign currencies, which may further distort the financial performance if not considered and translated carefully.

Applying caution in the real world

If the company is not able to access the exchange rates used for the translation for all its monetary transactions (for example as may occur in countries subject to currency controls), the differences are recognised in profit and loss (IAS 21.28).

In these types of economies, we have seen examples where revenues and operating costs are recognised at one rate – for example at a central bank rate – with differences to the accessible commercial bank rate being recognised through finance costs (which is below the EBITDA line in the trading results). This inflates revenues and EBITDA, which are key business valuation metrics, while costs are recognised in a part of the profit and loss statement that may not be subject to in-depth scrutiny and therefore may not be factored into the business valuation.

Applying good cross checks to the data becomes very important here. For example:

  • what do the forecasts imply about the average expenditure per customer?
  • does that make sense in this economy?
  • what do the forecasts imply about the level of investment in capital expenditure needed to support growth?
  • does this make sense given the existing infrastructure of the country?
  • how does it compare with the level of investment needed in similar geographies?

A good valuer needs to have one eye on the financial model and the other on the real world to ensure the business valuation makes sense.

For forensic accounting support with business valuation in complex scenarios, contact Chris West.

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