Inflation is one of the most prominent economic challenges affecting companies’ financial statements. Although the State of Kuwait, praise be to God, is not currently suffering from high inflation or hyperinflation, many of the major Kuwaiti groups own investments, subsidiaries or associates operating in other countries that are experiencing high or hyperinflationary rates of inflation, such as Iraq, Sudan, Iran and Lebanon, where the application of IAS 29 has become a daily reality.
Understanding the requirements of IAS 29 is therefore no longer a theoretical matter; it has become a practical necessity for ensuring the integrity of the consolidated financial statements and for presenting information that fairly reflects the financial and economic reality.
Scenario One: High but Not Hyperinflationary Inflation – The Game of Choosing the Method
In this case, companies continue to apply IAS 2 “Inventories”, and the choice of method for calculating the cost of inventories has a tangible effect on reported profits and on tax:
| Method | Effect on profit in times of inflation | Effect on closing inventory | Permitted under IFRS | Tax note |
|---|---|---|---|---|
| First-in, first-out (FIFO) | Higher accounting profit, because the cost of goods sold is based on the older, lower costs | The value of inventory is closer to current (market) prices | Yes | May lead to higher tax as a result of the higher accounting profit, depending on the tax legislation in each country. |
| Weighted average | Moderate and more stable profit | The value of inventory falls between the old and the new costs | Yes | Helps to absorb the effect of price fluctuations and produces more stable results. |
| Last-in, first-out (LIFO) | Lower profit, because the cost of goods sold is based on the most recent, higher costs | The value of inventory is based on the old costs and may be lower than current value | No | Not permitted under IFRS, but still permitted under some standards such as US GAAP. |
Scenario Two: The “Lower of Cost and Net Realisable Value” Rule
- IAS 2 affirms that inventories are measured at the lower of cost and net realisable value (NRV).
- The value of inventories may not be raised above their original cost, even if NRV rises because of inflation.
- A previous write-down may be reversed only up to the original cost.
For this reason, in times of inflation NRV must be reviewed monthly rather than annually, because selling prices change quickly.
Scenario Three: When Inflation Reaches the Level of Hyperinflation – IAS 29
In cases of severe inflation, the currency loses a large part of its purchasing power, which makes conventional financial statements misleading and causes them to show illusory profits. IAS 29 is applied when cumulative inflation reaches approximately 100% or more over three years, taking into account several other indicators (such as the stability of the currency and interest rates). The matter requires professional judgement on the part of accountants and auditors.
This is no longer a theoretical scenario but a reality that a number of countries are living through: Iraq, Sudan, Iran, Lebanon, Turkey, Argentina, Egypt and Venezuela. For any Kuwaiti group with branches or associates in these countries, applying IAS 29 has become a necessity, not an option.
The key features of IAS 29:
- Restating all non-monetary items, including inventories, using a general price index (CPI) so that they reflect current purchasing power.
- Calculating the purchasing power gains or losses on monetary items as a natural consequence of hyperinflation.
- Presenting the financial statements in the current measuring unit before translating them, in accordance with IAS 21, into the presentation currency of the parent group.
A Simplified Practical Example – Exposing the “Illusory Profit”
A company bought goods at a cost of KD 100. The price index rose by 50% during the year. The goods were then sold for KD 200. The result: despite the appearance of an accounting profit of KD 100 (or KD 50 after IAS 29), the company has in fact lost part of its purchasing power. For example, the KD 50 of profit is equivalent to only about KD 33 at beginning-of-year prices.
| Item | Without IAS 29 | After applying IAS 29 |
|---|---|---|
| Cost of goods sold | KD 100 | KD 150 after CPI adjustment |
| Sales | KD 200 | KD 200 |
| Accounting profit | KD 100 | KD 50 |
| Loss of purchasing power | Not shown | About KD 17 (approximate, based on net monetary assets) |
Practical Advice for the CFO and the Audit Committee:
- Assess the suitability of the weighted average method and move it from an annual to a monthly basis in times of inflation.
- Review net realisable value (NRV) regularly, every month.
- Disclose clearly in the notes the effect of inflation and the “illusory profit”.
- Prepare early for the application of IAS 29 for any subsidiary in hyperinflationary countries.
- Develop the accounting systems to track economic indicators (CPI) automatically.
- Train accounting teams on the requirements of IAS 29 + IAS 21 for translation.
- Have audit committees and boards of directors monitor the effect of inflation on liquidity and tax.
- Dedicate a separate accounting team to subsidiaries in hyperinflationary countries.
Conclusion
In modern business environments, inflation is no longer merely an economic indicator; it has become a factor that directly affects the measurement of performance, the valuation of inventories and the calculation of profits. As the application of IFRS 18 in 2027 approaches, it will become mandatory to separate the effect of remeasuring inventories to NRV within the operating performance line, which will increase the transparency of the effect of inflation on the financial statements.
Hence the importance of the proper application of IAS 2 and IAS 29 in ensuring the presentation of financial information that reflects the financial and economic reality fairly and transparently, and strengthens the confidence of investors and regulators.
The final question for management: is your 20% profit real, or merely paper, the product of rising prices? Review your company’s inventory policy today, before the external auditor reviews you.