Inflation and Financial Statements

I hear the same sentence from managers again and again: "We made a profit but we have no money." In a high-inflation economy that contradiction is the rule, not the exception. This article explains where reported profit becomes inflated, which part of it is not real, and what can be done about pricing, dividends and tax.

The root of it: historical cost

Conventional accounting records each transaction at the amount prevailing on the day it occurred and does not revisit it. That is reasonable when prices are stable. When the price level rises by tens of per cent a year, the balance sheet becomes a collection of numbers from different years whose sum has no clear economic meaning — land bought years ago sitting beside inventory bought last week.

The distortion is sharper in the income statement: revenue is recognised at today's prices while cost of sales and depreciation are measured at yesterday's. The gap is reported as profit.

Three sources of illusory profit

Inventory

Sell goods bought three months ago and the difference between purchase and selling price is booked as profit — yet part of it is needed simply to buy the same goods again at the new price. That part is a holding gain, not operating profit. The slower your inventory turnover, the larger the effect.

Depreciation at historical cost

Machinery purchased years ago is depreciated on a fraction of its replacement value. Depreciation expense is understated and profit overstated, and when the equipment must be replaced there is no reserve matching current prices.

Monetary items

Holding monetary assets such as cash and rial receivables produces a purchasing-power loss under inflation; monetary liabilities produce a gain. Neither appears in a conventional income statement.

A simple example

You buy goods for 100 and sell them six months later for 160, while the replacement cost of the same goods is now 145.

If tax and dividends are based on the 60, there is nothing left to repurchase the goods at 145. This is precisely the mechanism that shrinks profitable companies year by year.

The tax effect

Taxable income is derived from adjusted book profit and the 25 per cent corporate rate under Article 105 applies to it. Because illusory profit sits inside that book profit, part of the tax is effectively paid out of capital. That cannot be eliminated, but it can be managed:

1. Choose the inventory valuation method deliberately. The permitted methods are FIFO and weighted average; under inflation, weighted average generally reports a lower gross margin. Any change of policy must be documented and applied consistently.
2. Document every deductible expense fully. In the files I have handled, most tax increases came not from the rate but from expenses disallowed for missing documentation.
3. Apply depreciation completely in line with the prescribed schedule and write off scrapped assets on time.
4. Examine asset revaluation. At certain times and under specific conditions this has carried tax incentives; check the rules currently in force before acting.
5. Separate realised from unrealised FX translation results so unrealised gains do not create a tax base.

For rates, ceilings and conditions that change annually, rely on the latest circular of the tax administration rather than on last year's practice.

What to do in management reporting

You cannot restate the statutory accounts, but you can fix the internal report. Four practical steps:

• Calculate margin on replacement cost, not historical cost. That is the correct basis for pricing decisions.
• Report everything in quantities as well: tonnes, units, metres, labour hours. Quantities do not lie.
• Measure growth against inflation. Sales growth below the inflation rate is contraction.
• Read operating cash flow alongside profit. Under inflation the two diverge quickly, which is why the cash flow statement matters more here than anywhere else. The pricing consequences are covered in pricing under inflation.

If you want to know how much of last year's profit was real, and what that means for your dividend and tax estimates, the analysis can be done with the data you already have.

Key takeaways

• Book profit under inflation contains inventory holding gains and understated depreciation, overstating real capacity.
• Monetary items create purchasing-power gains and losses that conventional statements never show.
• Distributing full book profit under inflation is, in substance, distributing capital.
• Manage the tax effect through deliberate inventory valuation, complete depreciation and rigorous documentation.
• Add replacement-cost margins and quantity data to internal reporting.