The effects of hyper-inflation on accounting ratios - financing corporate growth in industrial economies

17077 Ausost Iqq7 TECHNICAL PAPER The Effects of Hyper-Inflation on Accounting Ratios Financing Corporate Growth in Industrial Economies Geoffrey Whittington Victoria Saporta Ajit Singh INTERNATIONAL FINANCE CORPORATION  INTERNATIONAL FINANCE CORPORATION TECHNICAL PAPER NUMBER 3 The Effects of Hyper-Inflation on Accounting Ratios Financing Corporate Growth in Industrial Economies Geoffrey Whittington Victoria Saporta Ajit Singh The World Bank Washington, D.C.  Copyrighte 1997 The World Bank and International Finance Corporation 1818 H Street, N.W. Washington, D.C. 20433, U.S.A. All rights reserved Manufactured in the United States of America First printing August 1997 The International Finance Corporation (IFC), an affiliate of the World Bank, promotes the economic development of its member countries through investment in the private sector. It is the world's largest multilateral organization providing financial assistance directly in the form of loan and equity to private enterprises in developing countries. To present the results of research with the least possible delay, the typescript of this paper has not been prepared in accordance with the procedures appropriate to formal printed texts, and the IFC and the World Bank accept no responsibility for errors. The findings, interpretations, and conclusions expressed in this paper are entirely those of the author and should not be attributed in any manner to the IFC or the World Bank or to members of their Board of Executive Directors or the countries they represent. The World Bank does not guarantee the accuracy of the data included in this publication and accepts no responsibility whatsoever for any consequence of their use. Some sources cited in this paper may be informal documents that are not readily available. The material in this publication is copyrighted. Requests for permission to reproduce portions of it should be sent to the Office of the Publisher, at the address shown in the copyright notice above. The World Bank encourages dissemination of its work and will normally give permission promptly and, when the reproduction is for noncommercial purposes, without asking a fee. Permission to copy portions for classroom use is granted through the Copyright Clearance Center, Inc., Suite 910, 222 Rosewood Drive, Danvers, Massachusetts 01923, U.S.A. ISSN: 1018-5097 ISBN 0-8213-4021-2 Geoffrey Whittington is Price Waterhouse Professor of Financial Accounting at the University of Cambridge, England. Victoria Saporta is an economist at the Bank of England, London. Ajit Singh is a professor of economics at the University of Cambridge and senior fellow at Queen's College, Cambridge, England. Library of Congress Cataloging-in-Publication Data Whittington, Geoffrey. The effects of hyper-inflation on accounting ratios : financing corporate growth in industrial economies / Geoffrey Whittington, Victoria Saporta, Ajit Singh. p. cm. - (International Finance Corporation technical paper 3) Includes bibliographical references (p. ). ISBN 0-8213-4021-2 1. Financial statements-Turkey. 2. Corporations-Turkey- Finance. 3. Accounting-Effect of inflation on-Turkey. 4. Financial statements-Developing countries. 5. Corporations- Developing countries-Finance. 6. Accounting-Effect of inflation on-Developing countries. I. Saporta, Victoria, 1969- II. Singh, Ajit, 1940- . III. Title. IV. Series: Technicalpaper (International Finance Corporation) ; 3. HF5681.B2W4679 1997 657'.95'09561-dc2l 97-30048 CIP  CONTENTS Forew ord ....................................................................................................................................v Abstract ....vii Acknowledgments ...................................................... ix 1. Introduction ...................................................... 1 2. Adjusting Company Accounts for Inflation ......................................................2 3. Adjusting the Accounts of Turkish Companies for Inflation ................................................ 13 4. The Effects of Inflation Adjustment on the Variables in the Two Studies ............................. 15 5. Analysis of the Measurement Bias in the Equity Financing Variable .................................... 20 6. Conclusion ..................................................... 21 Appendix ...................................................... 22 Tables ................................................................... 27 References ...................................................... 37 111   FOREWORD This is the third IFC Technical Paper. The series is designed to publish the results of an ongoing program of research in IFC's Economics Department, examining issues of importance to the private sector in developing countries. Inflation has plagued many of the developing countries in which IFC operates. In addition to the many real effects that inflation can have on an economy, it is also possible that accounting for the operations of firms is distorted by inflation. To date, however, little is known about the impact of inflation on the financial statements of firms in developing countries. This study examines the implications of inflation- induced effects on the financial statements of Turkish firms. The paper documents a bias in financial statements that is introduced by inflation and suggests a methodology for reducing that bias. As the largest multilateral institution lending to and investing in private enterprises in developing countries, IFC is uniquely well placed to examine this issue. The Corporation is also particularly interested in the results of the work, precisely because of the nature of its operations. Of course, these issues are of great relevance to the development and investment communities as a whole. Director, Economics Department & Economic Adviser of the Corporation v   ABSTRACT Hyper-inflation can have a severe distortionary effect on the pattern of corporate finance which is apparent from company accounts. A simple algorithm, based upon the method of inflation accounting applied in Brazil, is developed and applied to the accounts of Turkish listed companies for the period 1982-90. The adjusted figures give a more plausible picture of corporate profitability and growth, and this suggests that the adjustment method is substantially successful. The financing patterns emerging from the adjusted data support the proposition of Singh and Hamid (1992) and Singh (1995) that (a) the corporate sector in developing countries tends to rely more on external finance than on internal finance for growth and (b), among the external sources of funds, it uses new share issues to a surprisingly high degree. Further adjustments to the measurement of the external finance variable for Turkey and other countries also support this proposition. This contradicts the "pecking order" hypothesis, which suggests that retained profits are the preferred source of finance, and also runs contrary to the belief that the capital markets of developing countries are inadequate to support substantial corporate growth by external financing, including equity financing. vii   ACKNOWLEDGMENTS Funding for the research project on corporate finance in industrialising economies, from which this study emanates, has come from the IFC and the Research Committee of the World Bank in Washington DC; the Nuffield Foundation; and Price Waterhouse. The financial help of these bodies is gratefully acknowledged. We also wish to thank Mr Selim Soudemir of the Capital Markets Research Board, Ankara, for his generous help in making available to us detailed data on Turkish corporate accounts. We are also grateful to Mr Rudy Mathias for his expert research assistance. None of these institutions or individuals is responsible for the contents of this paper, which are entirely the responsibility of the authors. ix   1. INTRODUCTION In the first large-scale comparative studies of corporate financing patterns of large firms in leading developing countries (DCs), Singh and Hamid (1992) and Singh (1995) arrived at some rather surprising conclusions. This research showed that although there are variations in corporate financing patterns among developing countries, in general, corporations in the sample countries rely very heavily on (a) external funds, and (b) new share issues on the stockmarket to finance the growth of their net assets. These findings are opposite to what most economists would predict. In view of the low level of development of DC capital markets and their many imperfections, one would expect these corporations to rely much more on internal, rather than external finance. Moreover, for the same reasons, one would also expect them to resort to the stockmarket to a very small degree, if at all, to raise finance. The Singh and Hamid conclusions also run contrary to the "pecking order" pattern of finance which is thought to characterize advanced country corporations, whereby the latter mostly use retained profits to finance their investment needs; if more finance is required, they have recourse to banks or long-term debt, and go to the stockmarket only as a last resort. A potentially serious objection to Singh and Hamid's results, noted by the authors themselves, is that they might be distorted by measurement biases. Two of these are particularly significant: (a) the use of the historical cost method of accounting in periods of high inflation; and (b) in the absence of the necessary data, the bias in the indirect method used to assess the contribution of the equity financing variable. It is well known that high inflation rates cause historical cost accounts to produce a misleading picture of corporate performance by, for example, under- stating depreciation charges (which are based on lower historical asset costs rather than higher current costs) and over-stating interest charges (by ignoring the "gain on borrowing" which arises when the real value of debt is eroded by inflation). Since these two effects work in opposite directions, it can readily be appreciated that, as a result of inflation, historical cost accounting may either over-state or under-state real profits and, consequently, the amount of retained profits. Thus, the Singh and Hamid results, which are dependent upon the amount of retained profits, are open to challenge, in those cases in which no adjustment has been made.' With respect to (b), the basic problem is that in Singh and Hamid's studies, the variable "equity financing of corporate growth" is measured as a residual. The growth of net assets is equal by identity to the growth of internal finance plus the growth of external finance; the latter is equal to the growth of long-term liabilities and the growth of equity. In this research, the growth of internal finance was measured by retained profits from the profit and loss account. The growth of long-term liabilities was proxied by the growth of long-term debt. Equity finance was then measured as the residual from the accounting identity. What this means is that in the Singh and Hamnid analysis, the growth of equity will be overstated to the extent that some of the long-term liabilities and provisions (eg. for future tax and pensions) are not included in the debt financing variable. Similarly, revaluations which should be regarded as a part of internal finance would, on this method, get included in equity finance, because they do not pass through the profit and loss account, which is the source of the retained profits measure. 'Such adjustments were made, as part of standard accounting practice, in Brazil and in Mexico, two of the ten countries in Singh's (1995) sample. The other eight were: Turkey, Korea, Malaysia, Thailand, Jordan, Pakistan, India and Zimbabwe. The sample frame in this study normally consisted of the top hundred listed marnfacturing companies in each country. Tbe earlier study, Singh and Hamid (1992), did not include Brazil and was confined to the fifty largest quoted manufacturing companies in each country.  This paper explores the nature and extent of both these potential measurement biases to see whether they are serious enough to overturn Singh and Hamid's anomalous findings. Although the present study has been motivated by this consideration, it inter alia, also makes a more general contribution. The latter lies in evaluating the impact of inflation on corporate accounts in developing countries, which is of interest in its own right as there are hardly any studies on the subject. Equally importantly, the study develops and implements a simple and parsimonious method of inflation adjustment which can be applied to other countries. The paper proceeds as follows. In Section 2, we explain the methodology adopted for making inflation adjustments to the accounts. Section 3 applies the chosen technique to the company sector of Turkey, the country with one of the highest rates of inflation in the Singh and Hamid samples. Section 4 and the Appendix explore the theoretical and empirical consequences of this methodology for the main Singh and Hamid ratios. The question of the possible measurement bias in the indirect estimation of the equity financing variable is examined in Section 5. Section 6 concludes. 2. ADJUSTING COMPANY ACCOUNTS FOR INFLATION (i) Problems caused by inflation Accountants have traditionally recorded items in the accounts by reference to the monetary consideration in the transaction which originated them. Thus, assets are recorded at what was paid for them and liabilities are recorded at what was received in exchange for creating them. This is the historical cost method of accounting, and it is still the basis of most financial accounting systems, despite an increasing tendency to modify historical costs to reflect current values. In a period of general inflation, the relevance of historical costs is brought into question because they do not reflect consistently the current financial position or recent performance of the firm. In so far as historical costs are established at different dates, when the currency unit represented different real purchasing power, it can be argued that accounts drawn up on this basis create the fundamental measurement error of aggregating heterogenous measurement units. With regard to monetary items, ie those items which are denominated in nominal money terms which do not vary with inflation, the consequence of inflation is that historical cost accounts fail to recognise the so-called "gain on borrowing" and "loss on holding money". The gain on borrowing arises from the need to re-pay a lender only in nominal units. Thus, if a loan L is taken out at time t and is repaid at time t+l when the general price index has increased by a factor (1+i), then the gain on borrowing is Li.2 The loss on holding money is symmetrical with the gain on borrowing: this arises because money 21Te real value at t+l of the amount borrowed is L(l+i), but the repayment required is only L, since it is fixed in nominal terms. 2  and other items denominated in money terms, are not adjusted to compensate for their loss of real purchasing power in a period of inflation. Thus the loss on holding money can be measured as -Mi. Thus, if a company's monetary assets exceed its liabilities (M>L) in a period of inflation it will have a net loss on these items which will not be recorded in its historical cost accounts. If it is a net borrower (M<L), it will have an unrecorded net gain. Of course, it will also have interest payments and receipts, which will be recorded in the historical cost accounts. If interest rates correctly anticipate inflation (due to the so-called "Fisher effect"4), then the "loss on holding money" is best regarded as a deduction from interest received (as the element of interest which compensates for the loss of purchasing power of the principal) and the "gain on borrowing" should similarly be regarded as a deduction from interest paid. Real assets (those not denominated in money terms) pose a different problem. In this case, it is not possible to assume that their monetary amount is fixed, because their prices in money terms will fluctuate as a response to changing market conditions. There are two alternative approaches to the measurement of real assets in response to changing prices: re-statement by reference to a general price index and re-statement by reference to the market price of the specific asset, which may be approximated by an appropriate specific price index. Under the former approach, general price index adjustment, the historical cost is re-stated by reference to general inflation, so that no real gain or loss can be reported as a result of inflation. Thus, the effects of relative price changes are ignored, but pure inflation is adjusted for. If a specific real (or "non-monetary") asset was bought for Nt at Time t, and the general price level rises by l+i at t+l, we re-state the original cost as Nt+l = Nt(l+i), ie we assume that its value has just kept pace with inflation with no real gain or loss in value, preserving the real value of the historical cost of acquisition. Under the alternative method we assume that Nt has changed as a result of specific market price changes which can be measured by reference to a specific index or price, s, so that Nt+l = Nt(l+s). In this case, there is a gain or loss in real terms if s