The development of inflation accounting in Turkey

Critical Perspectives on Accounting 20 (2009) 568–590

The development of inflation accounting in Turkey Aylin Poroy Arsoy ∗ , Umit Gucenme Uludag University, Faculty of Economics and Administration, Business Administration Department, Uludag Universitesi IIBF Isletme Bolumu, Gorukle/BURSA, Turkey Received 2 August 2007; received in revised form 1 December 2007; accepted 11 January 2008

Abstract Turkey, as a developing country, suffered from high inflation rates for many years. However inflation accounting was not applied till the year 2003 because of some political reasons. The high rates of inflation heavily distorted the financial statements of the companies in Turkey. The companies tried to benefit from the incentives in the Turkish Tax Regulation negating the effect of inflation till the year 2003. At the beginning of 2004 inflation accounting was applied at last. The purpose of this study is to emphasize the effects of inflation on the companies in Turkey and what they did in order to protect from the distortions of inflation till the year 2003. Also the regulations of the Ministry of Finance and Capital Market Board considering inflation adjustment were examined and compared by illustrations. © 2008 Elsevier Ltd. All rights reserved. Keywords: Turkey; Inflation; Inflation accounting; Inflation adjustment; Turkish accounting system; Capital Market Board of Turkey; Turkish Ministry of Finance; Turkish accounting standards

1. Introduction Turkey experienced high inflation rates from 1950s to 2000s; even this was regarded as an economic policy. The Governments1 in Turkey postponed the economic stabilization program for reducing the inflation rates for years because the tax earnings of the State ∗ 1

Corresponding author. Tel.: +90 224 4428940. E-mail addresses: [email protected] (A.P. Arsoy), [email protected] (U. Gucenme). Since 1970s, Turkey has been governed by 22 Governments.

1045-2354/$ – see front matter © 2008 Elsevier Ltd. All rights reserved. doi:10.1016/j.cpa.2008.01.006

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will be reduced if the inflation rates decrease. Although the Governments tried to reduce the inflation rates by several disinflation attempts, they were not successful and efficient enough, therefore, the continuous high inflation rates2 seemed like a confidential aim of the Governments. High inflation rates in Turkey directed management policies of companies for years and made distortions on the financial statements of the companies. The incentives in the Tax regulations negating the effect of inflation on taxable profits were applied by companies till the year 2003. In the year 2003 inflation adjustment was applied to the financial statements of the companies that follow Turkish Capital Market Law.3 For the other companies, Ministry of Finance made a regulation that requires inflation adjustment on the balance sheets of 2003. According to this regulation, balance sheets of the companies as at December 31st, 2003 are required to be adjusted for the past years, however the resultant profit of loss would not be taken into account for tax purposes. Ministry of Finance announced that if the conditions explained in the international accounting standards about hyperinflation4 exist, in the following year’s inflation adjusted income will be accepted as taxable income. The year 2003 was a turning point for inflation accounting in Turkey. Inflation adjustments were made on financial statements, consequently understandable and comparable financial information was presented by these statements. Also the application of international accounting standards from the year 2003 as a part of convergence process in Turkey and abolishing the hyperinflation in Turkish economy through economic stabilization programs lead the financial statements of Turkish companies to become comparable with the financial statements of the foreign companies. The aim of this study is to examine the history of inflation accounting and its applications in Turkey. The incentives in the Tax regulations negating the effect of inflation which were applied till the year 2003 and the inflation adjustments which were regulated by Ministry of Finance and Capital Market Board by the year 2003 explained and compared by illustrations. We tried to emphasize the effects of inflation on accounting data in the framework of inflation–financial accounting relationship. High inflation rates effect the tax amounts paid by the tax payers5 through increasing the term profits of the companies; hence we also focused on the inflation–tax accounting relationship.

2 The average of about 20% inflation rate in the 1970s, and 60% in the late 1980s and early 1990s, and finally, 80% in the late 1990s clearly show the persistence and the upward trend in inflation. The inflation rates in Turkey reached its peak of 120% in 1994 as stated later. 3 The publicly traded companies and listed companies are subject to the Turkish Capital Market Law. Companies that have more than 250 shareholders are defined as listed companies. 4 According to IAS 29 article 3, hyperinflation exists if the cumulative inflation rate over 3 years approaches, or, exceeds 100%. 5 In the study we used the term “tax payers” just for companies. The individual tax payers are not in the scope of our study. The taxes paid by the individual tax payers might also be effected by the high inflation rates in Turkey, but our purpose is to emphasize the effect of inflation on the accounting data of the companies.

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2. Turkey—a profile Occupying some parts of two of the continents, Turkey seems like a bridge between Asia and Europe. The Country has a total land are of approximately 779,452 km2 . According to the last census taken in 2000 the population of the Country was 67,803,927. The official national language is Turkish and nearly all Turks are Muslims. The Turkish Republic was established in 1923 by Mustafa Kemal Ataturk who was the first Prime Minister, after the collapse of the Ottoman Empire. The Parliament (The Grand National Assembly) is the sole legislative power in Turkey and consists of 550 representatives who are elected directly by adult suffrage for every 5 years. The average GNP Per capita was 4172 US $ in 2004 and 5008 US $ in 2005. The establishment of the Turkish Capital Market was performed by the Capital Market Law (CML) which was enacted in 1981. Through the CML the Capital Market Board (CMB) was established and the Board has been making detailed regulations for organizing the capital market and developing capital market instruments and institutions. The Turkish Capital Market Board (CMB) and the Istanbul Stock Exchange (ISE) are the major institutions of the Turkish Capital Market. The legal framework of the Turkish Capital Market consists of three major legislations: (1) Capital Market Law (CML), (2) the Decree with force of Law no. 91, and (3) Turkish Commercial Code. CMB also issues several regulations (known as Communiqu´es) in order to enhance and revise the quality of the legal framework. The CMB is the regulatory and supervisory authority in charge of capital market in Turkey. The CMB, empowered by the CML is authorized and responsible for: (a) regulation and supervision of the securities markets and institutions within the scope of the CML, (b) determination of the operational principles of the capital markets, and (c) protection of the rights and interests of the investors. The CMB has the authority and responsibility to supervise both the organization and the operation of the stock exchanges. Furthermore, the CMB undertakes the responsibility for the completion of the regulatory framework and the establishment of the necessary mechanisms for improving the efficiency of the stock exchange and the secondary markets. The Turkish Commercial Code, enacted in 1956, regulates the establishment and operation of companies and defines and regulates financial instruments in general. Thus, joint stock corporations subject to the CML are required to comply with the provisions of the Commercial Code whenever there is no provision in the CML. The principles for the establishment, operation and the auditing of the stock exchanges are determined by the Decree with force of Law No. 91 enacted in 1984. The purpose of the Decree is to secure and provide for the transparent, coherent and prudent operation of the securities exchanges for the objective of transacting securities in a medium of confidence and stability and to lay the foundations for the securities exchanges to assume an effective role in the capital markets by arranging for their establishment, management, administration and operation principles and eventual supervision. The Istanbul Stock Exchange (ISE) is a public, non-profit organization established in 1986. The companies traded on the ISE are obliged to present their financial statements on a quarterly basis according to the standards required by the CMB. Independently audited year-end financial statements and reports prepared in accordance with the Capital Markets

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Board’s accounting standards shall be submitted to the Exchange within a period of 10 weeks following the end of the accounting period. ISE includes five stock markets: National Market, Second National Market, New Economy Market, Watch List Companies Market and Wholesale Market. All companies included in the National Market fulfill the listing requirements pre-determined by the ISE. Currently, 100 companies selected from among the listed companies in the National Market are included in the ISE National 100 Index, which is the main index of the ISE Stock Market. ISE National-100 Index contains the ISE National-50 and ISE National-30 Index companies. The number of companies traded on the ISE was 306 as of December 31, 2005 and 322 as of December, 31,2006. The market capitalization of ISE was 162,814 billion US $ and 163,775 billion US $ in 2005 and 2006 respectively. Average free float rates were 30.9% and 31.6% in 2005 and 2006 respectively.

3. An overview of Turkish high inflation Turkey experienced a short period (1955–1959) of high inflation in the second half of the 1950s but the history of high and persistent inflation goes back to the first half of the 1970s (Kibritcioglu, 2002). High inflation rates have damaged the performance of Turkish economy in different ways. Instability of economic growth trend due to high increases of inflation (see Cetintas, 2003; Ozcicek, 2002; they both provide evidence that inflation negatively effected economic growth in Turkey), and socioeconomic effects arising out of disrupted income distribution are the main damages. Inflation has led to loss of confidence in the Turkish Lira; high and unstable interest rates have increased speculation and arbitration; and globalization of international markets and technological innovations have increased the flow of liquid money into and out of Turkey (Serin and Arican, 2002). Year-to-year changes in inflation rates from 1951 to 2003 are presented in Fig. 1. Turkey experienced much acceleration in inflation since 1970s. Over the past 30 years, Turkey has been governed by 22 governments, while high and persistent inflation became a major feature of the Turkish economy. Several disinflation attempts since late 1970s seem to have failed one after another. The Turkish economy never experienced hyperinflation like Argentine or Israel in the period of global inflation from 1973 to 1994 but she felt into a unique situation after 1994. Inflation rates reached its peak of 120% in 1994 in the aftermath of an exchange market crisis. In 2002, the Turkish annual inflation rate was still 13 times higher than the average rate of inflation in the world, while global inflation rate has dropped from 25.3% in 1994 to 3.2% in 2002 (Kibritcioglu, 2004). The evolution of inflation in Turkey can be divided into four sub-periods (Domac, 2004): • The period during which price developments6 were influenced by financial liberalization and the deteriorating current account outlook (1989–1994); 6

Here the term “price development” is used to refer the changes in general price levels.

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Fig. 1. Annual inflation rates in Turkey 1951–2005. Source: Turkish Statistical Institute.

• The 1994 currency crisis and worsening debt dynamics (1995–1999); • The exchange-rate based stabilization program and its collapse (2000–February 2001); and • The adoption of the floating regime in February 2001, which was followed by the inception of the Economic Program for Strengthening the Turkish Economy in May 2001. The period from 1989 to 1994 is when the inflation dynamics were mostly driven by high support prices. During this period, frequent resort to short-term advance from the Central Bank of the Republic of Turkey (CBRT) to the Treasury (Undersecretariat of Treasury of the Turkish Republic) has been prevalent in the face of increasing fiscal deficit, while monetary policy has been accommodative and there has been increasing inflationary inertia. The second period from 1995 to 1999 can be illustrated by increased risk premium in the aftermath of 1994 financial crisis as well as strong inflation–devaluation spiral fed by implementation of implicit real exchange rate targeting policy. The Disinflation Program of the third period from 2000 to February 2001 even strengthened the exchange rate passthrough given the intrinsic nature of the program where exchange rate has been used as the nominal anchor. Finally, the last episode is after the adoption of the floating rate regime in February 2001, which then was followed by the launching of the Economic Program for Strengthening the Turkish Economy in May 2001 and the introduction of the Medium-Term Economic Program in January 2002 (Karasoy et al., 2005). Turkish governments tried to stabilize the economy after the 1994 financial crisis with new disinflation measures. However, these efforts in 1995, 1998 and 2000 failed to reduce the inflation rate to levels below 25% per year. Although the government introduced a

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3-year program7 in December 1999, the program had to be revised in light of the two successive liquidity and interest-rate crises; first in November 2000, and then in February 2001. The revised 3-year plan adopted in early 2002 contained provisions for fiscal adjustment to help bring about debt sustainability, reform of the banking sector through an operational and financial restructuring of public banks, and regulation and supervision of private banks. The early elections on November 3, 2002 dramatically changed the political climate in Turkey; The Government was in contact with the International Monetary Fund (see Serin and Arican for IMF stabilization programs) to make minor changes in the program to dissimulate and restructure the Turkish economy (Dibooglu and Kibritcioglu, 2004). The Government achieved to decrease the high rates of inflation by the disinflation policies. The stand-by agreement with the International Monetary Fund and the re-functioning of the domestic debt market aimed to diminish the strength of the inflation. The inflation rates in Turkey have been 29.7%, 18.4% and 9.3% in 2002, 2003 and 2004 respectively. The downward trend in inflation which has been going on for the last 3 years, continued throughout 2005 as well. By the end of 2005, the inflation rate has been 7.7%. Turkey is getting more stabilized and moving to a new phase of structural evolution that will be led by European Union harmonization and should bring greater transparency at both macro and micro levels. Foreign exchange rates have been stabilized; and interest and inflation rates have declined to reasonable levels (Pricewaterhousecoopers, 2004a).

4. The distortions of inflation and inflation accounting applications in Turkey The lack of successful policies to reduce the high inflation rates caused to live companies with inflation for years in Turkey. Consequently, the incentives in tax regulations negating the effect of inflation (i.e. LIFO, accelerated depreciation) were applied by companies. Nowotny (1980) stated that in hyperinflationary periods, creditors as well as holders of money suffer real losses, where as debtors experience real gains. This is commonly known as “debtor–creditor hypothesis” which was supported by the evidence found by Alchion and Kessel (1959). The companies in Turkey tended to avoid holding money and use large debts. The behaviors of these companies made hard to find debts; the interest rates increased; and the maturity of the debts were shortened. The companies generated funds by only debts; hence the debt/equity ratios of companies were damaged. The savings were invested to inefficient instruments such as real estates and gold. The Government applied discount policies in order to control inflation; however these policies caused the companies to have liquidity problems and the production volume decreased (Uman, 1980). The high inflation rates have distortions on the meaning of company accounts. Shoven et al. (1975) states that: “The distortion arises primarily because under current accounting practice firms carry many physical and financial assets and liabilities at original cost of book value, figures that are expressed in dissimilar units and that may deviate widely from current market value or replacement cost.” 7

Turkey initiated an extensive stabilization program to restore its macroeconomic balances in December 1999.

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The inflation in Turkey caused the financial statements of companies to give unreliable information (see Akdogan, 2004; Erkan, 2005; Gokcen, 2004; Gucenme, 2002a; Karapinar and Zaif, 2005; Kishali and Isiklilar, 2002; Sayari, 1999 for the inflation-Turkish financial reporting framework relationship). The managers of the companies made wrong investment decisions, followed defective pricing policies, paid excessive salaries by the effect of high nominal profits. Also in Turkey the companies faced the problem of inflationary tax distortions for years. The relationship between inflation and tax system has considerable effects on companies’ taxes (see Oner, 1994; Ozbilen, 1997 for tax–inflation relationship in Turkey). Badr and Ara (1981) suggested that the impact of inflation on taxable income of corporations leads to an overtaxation of real income and reduces the availability of corporate savings for investment and found strong evidence that firms paid more taxes than they would have paid if the tax payments were based on inflation adjusted accounting income. Gonedes (1981) suggests that the use of historical cost methods implies that real rates of income tax will vary directly with the rate of inflation. However for Davidson and Weil (1978) “efficient tax administration cannot be based on replacement cost attribute beacuse there is too much subjectivity.”. There are two important effects of inflation on accounting data (Baxter, 1975): 1. Figures of different dates, even if each was correct at its own date, are not comparable. 2. If a year’s accounts contain figures found by adding or subtracting unlike units (e.g., a profit found by subtracting an old cost from current revenue), then these figures are incorrect. The distortions of inflation on accounting data and taxable income should be reduced or removed in order to provide companies have a healthy life. There are two different approaches for inflation adjustment (FASB, SFAS 33 1979): • Adjusting the recorded historical data for changes in the value of the monetary unit since each item was acquired. This method deals with the changes in general price level. • Carrying the recorded historical cost data of each of the items in the financial statements to their current values. This method deals with specific price changes of individual items. Inflation accounting has been largely discussed in international literature. Most of the studies were concerning with the reaction of stock returns to inflation (e.g. Cohn and Lessard, 1981; Hong, 1977; McDonald and Morris, 1984; Modigliani and Cohn, 1979; Noreen and Sepe, 1981; Papps, 1982; Sharpe, 2002). Some of them was focused on the inflation–financial ratio relationship. (Ketz, 1978; Norton and Smith, 1979) There are also studies analyzing the impacts of adjusting for general price level changes on financial statement data (Davidson and Weil, 1975; Parker, 1977).

5. The inflation accounting regulations in Turkey Accounting in Turkey has traditionally been strongly influenced by the need to produce information, which is acceptable to the fiscal authorities and is in accordance with commercial and tax regulations. The aim of these legal requirements is to protect the

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interests of the Treasury. Consequently, little consideration is given to the concept of full disclosure from the point of view that financial statements should be clear and comprehensive for users to make decisions. The financial statements of the companies only include items necessary to calculate taxes. Therefore companies in Turkey interpreted the term “financial statement” as “tax statement” (Cooke and Curuk, 1996) and accounting was treated as identical with tax accounting (Simga-Mugan and Hosal-Akman, 2005). According to the results of a recent study (Ozkan, 2006), in Turkey the accountants largely adopt the “tax accounting approach” by following tax legislation while preparing the financial statements. In Turkey financial reporting for companies is regulated by the regulations of Ministry of Finance, Capital Market Board rules, the Commercial Code and the Procedural Tax Law. The Commercial Code and the Procedural Tax Law establish the disclosures required in the financial statements of all profit oriented companies. These companies must also meet the requirements in the Ministry of Finance’s communiqu´e of 1992.8 On the other hand, publicly traded and listed companies are regulated by the Capital Market Board rules as well. “Communiqu´e XI/25 on Accounting Standards in Capital Market” dated October, 15th, 2003 has been issued by Capital Market Board in order to make our accounting standards compatible with international financial reporting standards. This communiqu´e is the most important step taken to harmonize international accounting standards in our country. This Communiqu´e is consists of 33 IFRS will become effective covering the periods after January, 1st, 2005. The aim of the Communiqu´e is stated in article 1: “The aim of this Communique is to determine the accounting principles concerning the preparation and presentation of financial statements and reports by the companies following Capital Market Law” Turkish Accounting and Auditing Standards Board (TAASB) was founded in 1994 with the support of Union of Chambers of Certified Public Accountants in Turkey. TAASB was the first step taken to determine the accounting principles that should be followed by all companies and to accomplish uniformity in Turkey. TAASB issued 19 Turkish Accounting Standards (TAS) which had never become effective. These standards were compatible with both international accounting standards and economic conditions in Turkey. However TAS were not included in to legislation, so they were not mandatory. TAASB was dissolved and re-formed as the Turkish Accounting Standards Board (TASB) under the Prime Ministry in April 2002.The aims of TASB are; (a) to develop and adopt national accounting principles which will make financial statements real, reliable, balanced, comparable and understandable, (b) to set national accounting standards which will be applied to the interest of public. TASB has been active since 2002. The Lack of the uniformity in accounting practices in Turkey has led to the foundation of this Board. TASB accepted the TAS which were issued by TAASB as exposure drafts. After examining these exposure drafts TASB presented them 8 In December 26, 1992, Ministry of Finance published a communiqu´ e establishing the principles and the unifrom chart of accounts to be in effect starting January 1st, 1994. All companies except banks, brokerage firms, insurance companies are required to follow to the guidelines stated in the communiqu´e (see Ministry of Finance 2002 for further information).

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to the public. By means of the revision in international accounting standards, TAS were revised in 2004. The second exposure drafts (revised exposure drafts) were presented to the public. Since January 2005 those exposure drafts have begun to be issued in Official Gazette as TAS. TAS will become effective for the private and public sector companies after 2007. As stated before, in Turkey, companies applied the incentives in the Tax regulations negating the effect of inflation on taxable profits till the year 2003. At the year 2003 Ministry of Finance and Capital Market Board regulated inflation adjustment with two different regulations: The Law 5024 and Communiqu´e XI/20. Recently, Turkish Accounting Standards Board published Turkish Accounting Standard (TAS) 29 in Official Gazette in December, 31st, 2005. TAS 29 is compatible with the IAS 29. However it will not be effective until the year 2007. Consequently, the incentives in the Tax regulations which negate the effect of inflation and the Ministry of Finance and Capital Market Board regulations considering inflation adjustment will be examined in this study.

6. The incentives in the tax regulations negating the effect of inflation In hyperinflationary periods, accounting techniques such as LIFO and accelerated depreciation are often selected as a partial solution of overstating profits, since they temporarily reduce reported profits relative to alternative accounting methods that could be chosen (McIntyre, 1982). These accounting techniques are the way of “mitigating” the distortions caused by inflation without changing the cost basis from historical cost (Archambault and Archambault, 1999). With the lack of inflation adjustments regulations, the companies in Turkey applied incentives in the Tax regulations such as LIFO and accelerated till the year 2003. However in the hyperinflationary periods, some multinational companies applied inflation adjustment to their financial statements according to international accounting standards. The incentives in the Tax regulations negating the effect of inflation are stated below.9 These incentives have not led to permanent solutions to remove the effects of inflation on financial statements hence neither of these incentives are regarded as completely satisfactory.10 Only revaluation among these incentives is about adjustment of some balance sheet items. -

LIFO Renewal fund Accelerated depreciation methods Holding funds by expenses not require fund flow Revaluation Cost revision fund Indexation in investment allowance

9 Most of these incentives were abolished at the year 2003 by the inflation adjustment regulation of Ministry of Finance. 10 40% of 105 accountants in the study of Ozulucan (2002) mentioned the incentives as “insufficient”.

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6.1. Application of LIFO In traditional accounting approach, costs are undervalued because they are based on amounts which had been realized before. As a result, nominal margin is overvalued because it does not include real costs.11 The solution is to calculate the costs close to their fair values. To achieve this, LIFO method in inventory valuation is being used. According to this method, inventories which are sold or sent to production process primarily are the ones which have the highest historical cost. Under these conditions, cost of goods sold approximates current costs. Thus sales margin (gross margin) will be calculated more correctly. LIFO is a device to reduce the reported profits below what they would otherwise be in a period of inflation under almost any other method of inventory pricing (Moonitz, 1970). Reducing the reported profits will lead to decrease the taxable income. However generally LIFO ending inventory will contain costs of items acquired many years ago.12 In Turkey the companies largely used LIFO method in order to reduce the sales profit and taxable income in high inflation periods and prevented the inflation profits to serve as taxable income. In the year 2003 LIFO method in inventory valuation was abolished by the inflation adjustment regulation of Ministry of Finance. According to the regulation of Ministry of Finance, companies are currently required to measure their inventory with their current market values. 6.2. Renewal fund Fixed assets are recorded on the balance sheet with their historical values and the selling price will possibly be their fair values. The difference between the fair value and the historical value of the fixed asset will be recorded as fixed asset disposal gain and this figure will increase the reported profit. In hyperinflationary periods, the recorded fixed asset disposal gain will not be the real gain; because this gain includes inflation profits. Renewal fund is an item in the equity that could be allocated under Tax regulations in Turkey. Companies are allowed to create a renewal fund reserve with the capital gains arising from the disposal of fixed asset if they decide to renew the asset sold within 3 years. The depreciation charge on the new asset should be offset against the reserve created. If the asset is not renewed in 3 years then the reserve should be included into the taxable of the third year. As asset disposal gain is not recorded as income, the tax related to this amount will be postponed. Also, renewal funds will reduce the profit of the period. In Turkey companies largely used renewal fund account in order to reduce their profits in the hyperinflationary periods. Company X sold equipment for 150,000 TL (Turkish Liras) to renew it. The equipment has 100,000 TL cost value and 20,000 TL accumulated deprecation. The following records would be made: Cash Accumulated depreciation Equipment Renewal fund

11 12

Debit 150,000 20,000

Here the real cost term is referred as current costs or fair values. This is not so for the high technological corporations.

Credit

100,000 70,000

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The asset disposal gain of 70,000 TL is recorded as renewal fund instead of income. This method allows Company X to understate its profit and tax and negate the effect of inflation on this disposal gain. 6.3. Accelerated depreciation methods High rates of inflation reduce the real value of depreciation deductions based on historical cost and therefore overstated reported profits and taxes. In periods of inflation, depreciation based on historical costs will be lower than depreciation based on replacement costs. Consequently, inflation profits causing from lower depreciation deductions will serve as a tax base and taxes therefore be excessive. By using accelerated depreciation methods higher depreciation charges can be allocated in early years. Accelerated depreciation deductions are not satisfactory substitute for inflationary accounting. However the accelerated depreciation methods will make an adequate correction for inflation only at some particular rate of price increase (Shoven et al., 1975). According to the Tax regulations in Turkey, depreciation may be calculated by applying either straight line or declining balance method. Depreciation is calculated based on the useful life of the assets, determined by the Ministry of Finance. The rates differ from 2% to 33% per year for the straight-line method depending on the type of the assets. Declining balance rates are twice of the straight-line rates, however they may not exceed 50% per year. In Turkey companies used declining balance method in order to allocate larger deprecation deductions in hyperinflationary periods. The depreciation deductions effect reported profit hence they are recorded as expenses. Allocating larger depreciation charges cause to reduce the reported profit and negate the effect of inflation. 6.4. Holding funds by expenses not require fund flow Under the Turkish Tax Regulations, notes receivables should be treated as bad debts and, then, expenses should recognized for them in the fiscal period when legal collection proceedings have been commenced. For insignificant notes receivables not worthy of taking to court, bad debt provisions can be made only after being requested at least two times in writing and still have not been collected. The bad debt expenses provide companies in Turkey the advantages of reducing the reported profit. According the Turkish Tax Regulations, notes receivables and notes payables that are immature would be adjusted to new values as of the revaluation dates by using the rates announced by the Central Bank of Turkey. This adjustment procedure is referred as rediscount of notes receivables and notes payables. Rediscount expenses resulting from the adjustment of notes receivables is expense figures which do not requires fund flow and reduce the reported profit as well unless their notes receivable amounts are bigger than notes payable amounts. Expenses which do not require fund flow such as depreciation charges, bad debt expenses and discount on receivables can lead to hold on company funds by paying less taxes because of reduced reportable profit13 (Gucenme, 2005). In Turkey companies largely recorded these 13 These methods are not unique to the inflation accounting, but it reduces the profit in hyperinflationary periods. The methods which contributed companies to hold funds by expenses not requiring fund flow largely followed by

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expenses in order to reduce the recorded profit and took the advantage of negating the effect of inflation in hyperinflationary periods. For example if the incomes and the expenses of a company are as follows: Incomes (require to fund flow) Expenses (require to fund flow)

100,000 TL (50,000) TL 50,000 TL (30,000) TL 20,000 TL

Expenses not require to fund flow Net Income

As seen in the example, the company is able to reduce its reportable profit by 30,000 TL without using any funds. 6.5. Revaluation Revaluation of fixed assets under Turkish Tax Regulation was an optional application for tax payers. A statutory revaluation rate, which is approximation of the inflation rate, could be applied to both fixed assets and accumulated depreciation. Increase in the value of asset resulting from revaluation was recognized as revaluation surplus in equity. By means of revaluation higher depreciation charges could be allocated from revaluated assets. Thus, revaluation was an incentive negating the effect of inflation on tangibles. Revaluation of an asset with 100,000 TL cost value and 20,000 TL accumulated depreciation will be as follows: (revaluation rate 56%) Cost value Accumulated depreciation

Equipment Accumulated depreciation Revaluation surplus

Before revaluation 100,000 TL x 0.56 = 20,000 TL x 0.56 = 80,000 TL Debit 56,000

Increase 56,000 TL 11,200 TL 44,800 TL Credit

After revaluation 156,000 TL 31,200 TL 124,800 TL

11,200 44,800

With the application of revaluation, the new value of the equipment is raised to 156,000 TL. The depreciation expense of the period will be allocated based on this figure hence it will be higher than the historical value based amount. Revaluation in Turkey protected fixed assets and depreciation charges from the high rates of inflation. Some Turkish companies either did not benefit from this option and/or did not take advantage of it. However, at the year 2003, this revaluation option was abolished by Ministry of Finance. 6.6. Cost revision According to the application of cost revision under Turkish Tax Regulations, in determining the profits from disposal of depreciable assets that have been held by the company at least for 2 years it was possible to revalue the costs of the fixed assets by revaluation rates announced by the Ministry of Finance. The profits arising from the revision of the costs the Turkish companies in high inflation periods because of lack of inflation accounting. These methods were even named as “partial solutions for inflation accounting” in Turkey.

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were not taxable profits. Instead they were treated as special reserves and might only be used to increase the equity capital. In case they were distributed or transferred to another account, they were subject to taxation in the year in which the distribution or transfer takes place. The difference between the sale price and adjusted costs were included to taxable corporate income. For example, Company X disposed a building for 2,000,000 TL in the year 1999 which was acquired in 1996 for 500,000 TL (revaluation rates 80.4% in 1997 and 77.8% in 1998). 1997 1998

Revaluation rate 80.4% 77.8%

Increase in cost value =1,603,756–500,000 = 1,103,756 Debit Cash 2,000,000 Accumulated depreciation 30,000 Building Cost Revision Fund Gain from sale of assets If increase in cost value was not applied; Debit Cash 2,000,000 Accumulated depreciation 30,000 Building Gain from sale of assets

The basic value of increase 500,000 TL 902,000 TL

Increased cost value 902,000 TL 1,603,756 TL

Credit

500,000 1,103,756 426,244 Credit

500,000 1,530,000

As seen in the example, if the company did not apply cost revision, the disposal gain would be recorded as 1,530,000 TL instead of 426,244 TL. In other words, not applying cost revision cause an increase of 1,103,756 TL in the recorded profit. This amount includes unrealized profits in the hyperinflationary periods. The cost revision was applied by the companies in Turkey as an incentive negating the effect of inflation on the disposal of fixed assets. At the year 2003 cost revision was abolished by the inflation adjustment regulation of Ministry of Finance. Actually, revaluation and cost revision methods almost provide similar results. Revaluation method relates to the existing depreciable long-term assets while they are in use and cost revision method relates to the same type of assets when they are sold. Thus, when a corporation uses revaluation of its assets, it allocates revaluation effects on reported income through out the years verses a corporation that does not use it but uses the cost revision, only, will affect its that year’s reported income. This is seems to be the only difference. Thus, one can understand why some companies did not utilize revaluation method because they could still use the cost revision when they sell these type assets. 6.7. Indexation in investment allowance The privilege in investment allowance under Turkish Tax Regulations provides tax exemption for companies through decreasing taxable income. The amount of investment expenses which is determined by multiplying the investment allowance rate granted by the Treasury with the total investment amount is deductible in determining corporate income subject to corporation tax. Investment allowance must be consumed when companies have

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sufficient taxable income. Unconsumed investment allowance is subject to indexation in the following years until it is fully utilized. The rate used in the indexation is the revaluation rate which is, in general, slightly below the inflation rate. However, this provision is applicable for investment expenses incurred under investment incentive certificates obtained after January, 1st, 1998. For the investment certificates obtained between January 1st, 1995 and January 1st, 1998, the investment allowance that could not be deducted in the related year can be revalued only for 3 years using the revaluation rate announced by Ministry of Finance. The aim of the application is to negate the effect of inflation on investment expenses by revaluating them. So, companies can really benefit from investment allowances. For example, in February 2000, investment allowance was calculated for an investment of Company A with 100.000 TL cost value. Incomes before taxes of the company and indices are as follows: Years 2000 2001 2002 Years

2000 2001 2002

Indices 40.0 88.6 30.8 Allowance that cannot be extracted

Indexation

20,000 TL 7720 TL

1.886 1.308

Income before taxes 20,000 TL 30,000 TL 40,000 TL Investment allowance 40,000 TL 37,720 TL 10,098 TL

Income before taxes 20,000 TL 30,000 TL 40,000 TL

Taxable income

29,902 TL

As seen in the example, Company A did not pay taxes in the years 2000 and 2001 by means of investment allowances. Also in 2002 the income before taxes reduced to 29,902 TL. 7. Inflation adjustment regulation of ministry of finance The incentives in the Turkish Tax Regulations which were discussed above have not brought permanent solutions to negate the effects of inflation on the accounting data of the companies. Inflation accounting system has been introduced in Turkey at the beginning of the year 2004 by the regulations of the Ministry of Finance and the Capital Markets Board. The inflation accounting regulations has been largely discussed in Turkish accounting literature (see Gucenme, 2002b,c; Gurdal, 1999; Kishali, 2000; Selimoglu, 2001; Yucel, 2002). Through the application of inflation accounting the financial statements would be more reliable, since the financial statements will be adjusted against the distortions of inflation using Wholesale Price Indexes.14 The Law numbered 5024 of the Ministry of Finance on inflation adjustment has been enacted by Turkish Parliament on December 17, 2003, approved by the President and announced in the Official Gazette numbered 25332 on December 30, 2003. The Law numbered 5024 makes amendments to the Procedural Tax Law, Income Tax Law and Corporate Tax Law. The Law regulates the repeated article 298 of the Law numbered 213 of Tax 14 The data of the wholesale price index are obtained from a survey of approximately 1816 firms, representing coverage of 70–80% of the nationwide share in total production. The weights used for the index are based on the industrial production data and agricultural and mining and energy censuses. The index is updated every year.

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Procedural law as “Inflation Adjustment and Re-evaluation”. The tax payers who calculate their earnings based on a balance sheet method, shall apply inflation adjustment on their financial statements if the conditions explained in the Law numbered 5024 exist. According to the Law, if the cumulative inflation rates exceed 100% in the last three annual tax periods and if the inflation rate exceeds 10% in the current tax period, the inflation adjustment will be terminated if both of these conditions are not realized simultaneously. The taxpayers shall also apply inflation adjustment for quarterly estimated taxes.15 For advance tax periods the annual period is calculated as the previous 36 months including the last month of the quarterly period and the current period is calculated as the previous 12 months including the last month of the quarterly period. If inflation adjustment is made in any advance tax periods, it should continue during the following advance tax periods and at the end of the financial period. Also the Law numbered 5024 adds the temporary article 25 to the Tax Procedural Law about the adjustments to be made on the financial statements of December 31, 2003. According to this regulation, balance sheets of the companies as at December 31, 2003 are required to be adjusted for the past years, however the resultant profit or loss would not be taken into account for tax purposes. On the other hand, inflation adjustments made after January 1, 2004 will effect the tax calculation (Pricewaterhousecoopers, 2004b). Inflation adjustment is recalculating the financial amounts of the non-monetary assets by multiplying them with the calculated adjustment rate in order to show their real values at the time when the financial statements are presented. The adjustment rates are calculated through the Wholesale Price Indexes announced by the Turkish Statistical Institute. The amounts found as a result of the calculations realized through the Law 5024 should be recorded in legal accounting books.16 Two different accounts should be used for the inflation adjustment; • Inflation differences account; to record the differences between the values of the nonmonetary assets before and after the inflation adjustment. • Inflation adjustment account; the corresponding entry of the inflation differences account. This account is off set by transferring balance of the account to the income statement. Appendix A presents a simple illustration of the inflation adjustment regulation of the Ministry of Finance.

8. Inflation adjustment regulations of Capital Market Board The Capital Market Board (CMB) determines the accounting standards for publicly held and/or traded companies, listed companies and capital market institutions and also regulates independent auditing standards for these companies and institutions. 15 According to the Tax system in Turkey, the companies must pay advance taxes in 3-month periods throughout the accounting period which is credited against the tax liability of the same period that is caluculated by the income of that tax year. 16 The Turkish companies are obligated to keep their accounting records in three types: the journal entries, the general ledger and the inventory records. These records are referred as legal accounting books in Turkey.

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In November 2001, CMB issued Communiqu´e XI/20 “Principles for Adjustment of Financial Statements in Hyperinflationary Periods”. This Communiqu´e is effective for the fiscal years ending after January 1, 2003. Effective from the first interim financial statements starting from January 1, 2005, CMB has also issued Communiqu´e XI/25 which includes the standards identical with international accounting standards. The companies that follow CMB regulations are required to prepare and present their financial statements starting from January 1, 2005 in accordance with Communiqu´e XI/25 which makes the financial statements more comparable and similar with international accounting standards. The Section 15 of Communiqu´e XI/25 is titled as “Adjustment of Financial Statements in Hyperinflationary Periods” and the articles of this section are compatible with IAS 29. Also the articles of Communiqu´e XI/20 and Communiqu´e XI/25 are compatible with each other. According to the CMB communiqu´es considering inflation adjustment, the first step to be taken in inflation adjustment is the separation of monetary and non-monetary items. Based on this separation these transactions should be made: • Net monetary position gain/loss statement should be prepared and net monetary position gain/loss should be calculated. By the help of this figure determination of real gain/loss is possible. Net monetary position is the difference between monetary assets and liabilities. In hyperinflationary periods, companies holding monetary assets (liabilities) whose capital and earnings does not change due to inflation obtain monetary asset (liability) holding loss (gain) because of the decrease in purchasing power of money. These gains and losses are shown on income statement as “net monetary position gain (loss)”. Briefly, companies whose monetary assets are more/less than monetary liabilities, purchasing power loss/gain (net monetary position loss/gain) would be calculated. • Non-monetary items in the current balance sheet date adjusted by multiplying these items with coefficients calculated through Wholesale Price Indexes announced by the Turkish Statistical Institute. So balance sheet items will present the figures which have current purchasing power. Appendix B presents a simple illustration of the inflation adjustment regulation of the CMB and emphasizes the difference between the Ministry of Finance and CMB regulations.

9. Conclusions The application of inflation adjustment was a turning point for the financial statements of the companies in Turkey. The financial statements were heavily distorted by the high inflation rates of inflation for years. The incentives in the Turkish Tax Regulations could not bring permanent solutions to negate the effect of inflation on financial statements. The permanent solution for removing the effect of inflation is adjustment of financial statements through recalculating the figures of the balance sheets and income statements by multiplying them with the calculated adjustment coefficients. By means of inflation adjustment the real taxable income can be found. Consequently in Turkey the adjustments of the balance sheets of December 31st, 2003 according to the Regulations of Ministry of Finance and the following adjustments are referred as inflation adjustments. The adjustment of the balance sheets of December

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31st, 2003 was only the adjustment of balance sheet items hence this adjustment removed the distortions of inflation on balance sheets only. The resultant profit or loss did not take into account for tax purposes.17 After the year 2004, when the cumulative inflation exceed 100% in the last three annual fiscal periods and the inflation exceed 10% in the current period, the inflation adjustment were made subject to the Regulations of Ministry of Finance and the resultant inflation profit/loss were taken into account for the determination of taxable income. The inflation adjustment would terminate if both of these conditions are not realized simultaneously. At the end of 2003 the inflation rates cumulatively and annually matched the conditions stated in the Regulations and the Ministry of Finance announced that the tax payers whose asset totals are higher than 7,500,000 TL and gross sales amounts higher than 15,000,000 TL on their December 31st, 2003 financial statements should adjust their balance sheets in line with the provisions set forth in the Law Numbered 5024. If taxpayers adjusted their balance sheets as of December 31st, 2003, they will continue to adjust their balance sheets as of the second and subsequent advance tax periods of the year 2004, even if their asset total and/or gross sales stay below the limits. Consequently, inflation adjustment was firstly applied at the end of 2003 in Turkey. At last the financial statements of the companies began to give correct, reliable and comparable information. At the year 2004, the annual and cumulative inflation rates met the criteria which was mentioned in the Regulations of Ministry of Finance only for the first two advance tax periods. The inflation rates decreased and did not meet the criteria for the last two advance tax periods of 2004. However the companies adjusted their financial statements in all of the advance tax periods in the year 2004 hence they applied inflation adjustment for the two advance tax periods, so they are required to continue for the following advance tax periods till the end of the year according to the Regulations of Ministry of Finance. For all of the advance tax periods of the year 2005, inflation adjustment was not made on the financial statements, because the conditions stated in the Law Numbered 5024 were not realized. Consequently, it can be said that in Turkey inflation adjustment was applied at the years 2003 and 2004. In Turkey companies were looking forward to apply inflation adjustment for years in order to reduce their taxable income and taxes. But unfortunately the Turkish companies were not happy with the inflation adjustment regulation of the Ministry of Finance. The results of the research by Acar and Tugay (2005) showed that 53.3% of the 148 accountants referred the inflation adjustment regulation of the Ministry of Finance as “insufficient”. 70.2% of them think that inflation adjustment should become effective earlier. The companies could not really present their real financial information hence the inflation adjustment regulation of the Ministry of Finance only required to the adjustment of balance sheets. Also by means of inflation adjustment, most of the incentives negating the effect of inflation in the Turkish Tax Regulation were abolished. Also the depreciation rates that were announced by the Ministry of Finance were decreased. The companies in Turkey recently do not apply inflation adjustment and also do not benefit from the incentives which provide tax 17 The adjustment of the Decembet 31st 2003 balance sheets in Turkey was an application to make the companies familiar to the inflation accounting. This regulation did not effect the taxable incomes, only removed the distortions of the inflation on balance sheets. Fully inflation adjustment was applied after the year 2004.

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advantage. The results of the research by Karapinar and Ayanoglu (2005) shows that majority of the 325 accountants agree that incentives negating the effects of inflation should not be abolished. It can be said that the communiqu´es of the Capital Market Board considering inflation adjustment are more satisfactory for the companies hence they are compatible with international accounting standards. According to these communiqu´es both the balance sheet and income statement figures of the companies are adjusted and the net monetary position profit or loss is calculated. However in Turkey only publicly traded and/or listed companies are subject to the Regulations of the Capital Market Board. One more problem behind the application of inflation adjustment was the education of accountants. The importance of education on inflation adjustment is supported by the studies of Karapinar and Ayanoglu (2005), Acar and Tugay (2005) and Civan and Yildiz (2002). The results of all of the studies imply that the majority of respondents (accountants) believe that the education opportunities on inflation adjustment are insufficient in Turkey and they need further education. Turkey, as a developing country, is in the process of convergence to international accounting standards. The application of inflation adjustment can be referred as a part of this process. As the financial statements of the companies become more reliable and comparable by means of inflation adjustment, they will be able to give correct information to the managers, public and foreign investors in the frame of globalization.

Appendix A At January 1st, 2003 X Company was established with 100,000 TL cash. In January X Company purchased 10 merchandises unit price 10,000 TL. 8 of these goods were sold with 15,000 unit price. A.1. Term end financial statements before adjustment: Company X Balance Sheet December 31st, 2003 Cash and cash equivalents Inventory Total assets Capital Income before taxes Total liabilities

120,000 20,000 140,000 100,000 40,000 140,000

Company × Period 2003 Income Statement Gross Sales Cost of Goods Sold Gross Sales Margin

Adjustment coefficients are as follows: January 2003 = 1.079 December 2003 = 1.0

120,000 (80,000) 40,000

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Inflation adjustment: Inventory Capital

20,000 × 1.079 = 21,580 100,000 × 1.079 = 107,900

Difference 1,580 7,900

Determination of adjusted figure of cost of goods sold: (+) Adjusted figure of existing goods at January, 1st, 2003 (+) Adjusted figure of purchased goods in the period 100,000 × 1.079 = 107,900 (−) Adjusted figure of existing goods at December, 31st, 2003 20,000 × 1.079 = 21,580 Adjusted figure of cost of goods sold

– 107,900 21,580 86,320

The following journal entries should be made for the inflation adjustment: Inventory Inflation Adjustment Inflation Adjustment Capital Adjustment Differences Inflation Adjustment Losses Inflation Adjustment Income Summary Inflation Adjustment Losses

Debit 1,580 Debit 7,900 Debit 6,320 Debit 6,320

Credit 1,580 Credit 7,900 Credit 1,580 Credit 6,320

After these adjustments, the balance of income summary account (33,680) shows the adjusted profit figure.

A.2. Term end financial statements after adjustment: Company X Balance Sheet December 31st, 2003 Cash and cash equivalents Inventory Total assets Capital Income before taxes Total liabilities

120,000 21,580 141,580 107,900 33,680 141,580

Company × Period 2003 Income Statement: Gross Sales Cost of Goods Sold Gross Sales Margin

120,000 (86,320) 33,680

With the application of inflation adjustment, the income before taxes of Company X (40,000 TL) reduced to 33,680 TL. The difference between the adjusted and unadjusted income before taxes figure can be referred as the inflation profit of the term.

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Appendix B At January, 1st, 2003 X Company was established with 100,000 TL cash. In January X Company purchased 10 merchandises unit price 10,000 TL. 8 of these goods were sold with 15,000 unit price. B.1. Term end financial statements before adjustment: Company X Balance Sheet December, 31st, 2003 Cash and cash equivalents Inventory Total assets Capital Income before taxes Total liabilities

120,000 20,000 140,000 100,000 40,000 140,000

Company × Period 2003 Income Statement Gross Sales Cost of Goods Sold Gross Sales Margin

120,000 (80,000) 40,000

The Wholesale Price Indexes: December 2003 index January 2003 index Average index

7,382.1 6,840.7 (7,382.1 + 6,840.7)/2 = 7,111.4

Adjustment coefficients: January index adjustment coefficient Average index adjustment coefficient

7,382.1/6,840.7 = 1.079 7,382.1/7,111.4 = 1.038

Adjusted figures: Inventory Capital Sales Costs of goods sold

20,000 × 1.079 = 21,580 100,000 × 1.079 = 107,900 120,000 × 1.038 = 124,56018 80,000 × 1.079 = 86,320

The Statement of Net Monetary Position Gain or Loss: Adjusted figure of net monetary items at January, 1st, 2003 Adjusted figure of increase in net monetary items 120,000 × 1.038 Net monetary item which should exist at the end of the term Net monetary item at December, 31st, 2003 Net monetary position loss

– 124,560 124,560 120,000 4,560

Company × Period 2003 Adjusted Income Statement: Gross Sales Cost of Goods Sold Gross Sales Margin Net monetary position loss Income before taxes

124,560 (86,320) 38,240 (4,560) 33,680

18 Sales are adjusted by average index, because they are realized widespread. Widespread realized transactions are adjusted by average index according to the CMB communiqu´e.

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The Income before taxes of the Company X is calculated 33,680 TL according to the regulations of CMB. Recall that, this is the same income figure which was adjusted according to the regulations of Ministry of Finance. The two of the regulations give the same result. However, under the regulations of the Ministry of Finance, The Statement of Net Monetary Position Gain or Loss is not prepared and the income statement items are not adjusted.

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