The Government of Ethiopia is in the process of privatizing its breweries. Heineken’s bid for the two breweries came at a time when there is intense debate about the prices at which the government is disposing state assets. At the heart of the debate is valuation. The deal is worth a total of $163 million, and Heineken is reportedly the highest bidder. By the end of 2010 Heineken’s consolidated revenues were 14 133 million Euros while its total assets were 26 549 million Euros.
The bid price is less than 0.5% of Heineken’s total assets. Heineken is a global company with operations in various parts of the world. In recent years the company has been growing through acquisition. It is engaged in global branding. This global branding is important to the company in the light of the observed geographical shift in beer consumption. From a financial management perspective how global companies such as Heineken are managing the risk of investing in countries that are located in volatile regions of the world is interesting. The effects of the privatization are evidently important to Ethiopian beer consumers and other stakeholders like employees who will be affected by the restructuring.
In its 2011 edition Foreign Policy downgraded Ethiopia from its “warning” list to its “alert” list. It ranked Ethiopia 17th out of 177 countries in its global list of failed states. The failed states index incorporates economic, political and social indicators. If Foreign Policy experts are to be taken seriously, capital must shun a failing state. If it does not shun, then the rate of return must be high enough to reflect the risk. The interesting question then is whether Heineken is likely to get enough rate of return to compensate for the increased risk. This commentary is therefore aimed at sparking a debate that is useful for both the investor and host country stakeholders.
Inflation and valuation of Investments
The association between investment and risk is well documented in the finance literature. As risk level increases cost of capital also increases. Furthermore, as cost of capital increases aggregate level of investment in an economy declines. At firm level, high cost of capital makes the net present value of a project unattractive. Managing inflation risk is thus the primary function of the board of directors of any business organization. There are a number of other factors that affect cost of capital. Industry, ownership structure, control, extent of influence on operating and financing decisions, dividends, and exchange rate and devaluations are among the host of factors that affect cost of capital. These factors need to be incorporated in the valuation of assets. When market prices are not revealed or when pricing efficiency is a problem, determination of the values of assets gets tricky.
One approach to overcoming valuation problems is to examine the financial statements of the target company. This is important when market prices are not readily available. Fair value accounting can provide useful pointers for both the bargain hunter and the seller. It is important to note that historical cost financial statements understate non monetary assets and overstate revenues during times of inflation. Net income and taxes are also overstated. As fair value financial statements provide base values, one can quickly observe whether bid prices are reasonable. The Netherlands is the source of knowledge for replacement cost accounting, and hence Heineken knows fair value accounting well.
In 2008 official statistics showed that Ethiopia’s inflation (consumer price index) was 17.2%. It was next to Zimbabwe (12563%), Burma (35%), Guinea (23.4%), Venezuela (18.7%) and Sao Tome and Principe (18%)2. By the end of 2010 the inflation situation in Ethiopia deteriorated further partly due of the unexpected devaluation of the Birr by about 17% and partly due to shortage and an unsuccessful price cap on basic commodities. Hence, both official inflation and expected inflation were higher than 17.2% in 2010. In 2011, there are no indications which suggest that inflation is coming under control. Furthermore, the government has increased the salaries of the civil servants significantly. It is in the middle of this inflationary situation that the government is talking about its ambitious Growth and Transformation Plan. Finance is a major bottleneck in the plan, and at present the government is trying to entice the Ethiopian Diaspora to invest. In sum, except for some anomalous empirical results, there is consensus among economists that inflation is bad for any economy.
Accounting for Inflation
Reliable and relevant accounting information is critical for making investment decisions. As a result of fair value accounting, the value relevance of financial statement numbers in emerging markets has improved in recent years. The gap between market value and book value has narrowed over time. The International Accounting Standards Board’s (IASB) conceptual statement also raises key issues that relate to accountability, capital maintenance, measurement reliability and valuation. By the end of 2009 International Financial Reporting Standards (IFRS) has been in use in more than 100 countries.
In September 2010 the Financial Accounting Standards Board (FASB) issued the Statement of Financial Accounting Concepts # 8. The statement replaces FASB’s Concept Statement #2 of 1980. The IASB is also in the process of reviewing its conceptual framework. Statement # 8 of FASB defines the objectives of General Purpose Financial Statements. Objective # 4 states that the primary aim of financial statements is “to assess an entity’s prospects for future net cash inflows, [for] existing and potential investors, lenders, and other creditors that need information about the resources of the entity, claims against the entity and how efficiently and effectively the entity’s management and governing board have discharged their responsibilities to use the entity’s resources”. Similarly, Objective # 7 states that general purpose financial statements are not designed to show the value of the reporting entity but they provide information to existing and potential investors, lenders and other creditors to estimate the value of the reporting entity”.
Furthermore, IAS 29, Financial Reporting in Hyperinflationary Economies, provides for companies located in environments where high inflation is a norm. The main idea behind IAS 29 is that the financial statements of an entity that reports in the currency of a hyperinflationary economy should be restated using general price index or replacement costs, and gains or losses on net monetary position should be recognized in the comprehensive income statement. The Standard allows management to use its judgment as to when restatement of financial statements becomes necessary. Paragraph 3 of IAS 29 (see also www.iasplus.com) outlines the characteristics of a hyperinflation economy. They are:-
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; and
The cumulative inflation rate over three years approaches, or exceeds, 100%.
IAS 29 is relevant to Ethiopia. There is consensus which indicates that between 2006 and 2011 Ethiopia’s inflation has steadily increased, and much of the reported earnings growth figures are disillusioned by inflation. Hence, it is prudent to designate Ethiopia as a hyperinflationary country. The implication of this for corporate reporting is that accountants need to consider preparing financial statements in accordance with IAS 29.
IAS 21, The Effects of Changes in Foreign Exchange Rates, is another relevant standard. Its aim is to provide for foreign currency transactions, foreign operations and translation of financial statements into parent company currency. It separates transaction risk from translation risk. It prompts management to disclose the method(s) used for hedging each type of risk. The consolidating entity is also required to define its functional currency. IAS 21 requires that companies first restate the financial statements using general price level indices or replacement costs, and then translate the local currency into parent company (presentation) currency. This requirement has the potential to make global companies double count the effects of inflation. This matter is relevant for both foreign investors like Heineken and Diaspora investors who want to hedge the risk of investing in their home countries.
Concluding Remarks
The news of privatization has a number of implications for various types of stakeholders. From a financial perspective, the immediate attention is on (i) whether Heineken’s offer price reflects the fair value of the assets that are being disposed off, and (ii) whether the time is right for privatization. The second issue is about the liberalization of the Ethiopian economy. The so called developmental state rhetoric that is advanced by the Prime Minister is incompatible with liberalization. The third issue relates to the development of accounting policy. With regard tot the latter, there are a number of gains that stem from adopting IFRS in countries like Ethiopia. First, financial statements can be easily compared with international financial statements. Furthermore, IFRS improves accountability, risk management, recognition, measurement and disclosures.
The political economy of privatization requires a separate work. Notwithstanding this, it is important to note that there is a widely entrenched view which suggests that ownership concentration, inequality, corruption and opacity problems were exacerbated by the type of political leadership that emerged in Ethiopia during the last 20 years. Three groups of enterprises control the Ethiopia economy. The first group is the State Owned Enterprises (SOEs) sector, and except for public utilities most of them attribute their origin to the nationalization of 1975. The alcohol and beverages sector was one of the most profitable industries among the nationalized industries.
The privatization of the 1990s transferred State assets to the balance sheets of MIDROC and EFFORT in questionable ways. MIDROC companies are owned by one person, and hence most of the financial statements are not available to the general public. The law also does not require the publication of the financial statements of public interest companies. The Endowment Fund for the Rehabilitation of Tigrai (EFFORT) is strangely owned by the core group of the ruling regime, the Tigrai People Liberation Front. The conglomerate is managed by ex-combatants and the Prime Minister’s spouse who is also a member of the House of Peoples Representatives and the Executive Committee of the ruling party. Hence, politics and business appear to be merged together. EFFORT does not publish its financial statements, and no one really knows its financial strength. The implication of this institutional structure for liberalization, ownership structure and corporate governance is complex. Hence, the impacts of adopting IFRS in Ethiopia are many, and include improvement in corporate governance and the valuation of assets. The message here is that though accounting in the West is often criticized for producing “dead numbers”, it serves as an instrument of good governance, provides fair values, and facilitates a country’s integration to global finance.
