International Accounting, 6/e

1. International Accounting, 6/e Frederick D.S. Choi Gary K. Meek Chapter 8: Financial Reporting and Changing Prices

2. Learning Objectives • What do we mean by the term, changing prices? • Why are financial statements misleading during periods of changing prices? • What are the various ways of adjusting financial statements for changing prices? • Do adjustments for changing prices vary internationally? • What does IAS 21 have to say about inflation adjustments in hyperinflationary countries? • What is the restate-translate controversy争议 all about? • Is it possible to double-count for the effects of foreign inflation?

3. CHANGING PRICES DEFINED • To understand what changing prices means, we must distinguish between general and specific price movements价格变动, both of which are embraced by the term. • A general price level change occurs when, on average, the prices of all goods and services in an economy change. The monetary unit gains or loses purchasing power. An overall increase in prices is called inflation: a decrease, deflation. • What causes inflation? Evidence suggests that aggressive monetary and fiscal policies designed to achieve high economic growth targets, excessive spending associated with national elections, and the international transmission 国际传播of inflation are causal explanations.

4. A specific price change, on the other hand, refers to a change in the price of a specific good or service caused by changes in demand and supply. Thus, the annual rate of inflation in a country may average 5 percent, while the specific price of one-bedroom apartments may rise by 50 percent during the same period. • Exhibit 7-2 defines additional terminology used in this chapter.

5. Attribute特性. The quantifiable可以量化的 characteristic of an item that is measured for accounting purposes.For example, historical cost and replacement cost are attributes of an asset. • current-cost adjustments. Adjusting asset values for changes in specific prices. • disposable wealth可支配财富. The amount of a firm's net assets that could be withdrawn without reducing its beginning level of net assets. • gearing adjustment杠杆调整. The benefit to shareholders' purchasing power gain from debt financing and signals that the firm need not recognize the additional replacement cost of operating assets to the extent they are financed by debt. The U.S. expression for gearing is leverage.

6. general purchasing power equivalents一般购买力平价. Currency amounts货币金额 that have been adjusted for changes in the general level of prices. • general purchasing gains and losses. See monetary gains and losses. • historical cost-constant currency历史固定成本货币. See general purchasing power equivalents. • holding gain置存收益. Increase in the current cost of a nonmonetary asset. • Hyperinflation恶性通货膨胀. An excessive rate of inflation, as when the general level of prices in an economy increases by more than 25 percent per annum年利率. • inflation. Increase in the general level of prices of all goods and services in an economy.

7. monetary asset货币性资产. A claim to a fixed amount of currency in the future, like cash or accounts receivable. • monetary gains货币性利得. Increases in general purchasing power that occur when monetary liabilities are held during a period of inflation. • monetary liability货币性负债. An obligation to pay a fixed amount of currency in the future, such as an account payable or debt that bears a fixed rate of interest. • monetary losses货币性损失. Decreases in general purchasing power that occur when monetary assets are held during a period of inflation. • monetary working capital adjustment货币性流动资金调整额. The effect of specific price changes on the total amount of working capital used by the business in its operations.

8. nominal amounts面额. Currency amounts that have not been adjusted for changing prices. • nonmonetary asset. An asset that does not represent a fixed claim to cash, such as inventory or plant and equipment. • nonmonetary liability. A debt that does not require the payment of a fixed sum of cash in the future, such as a customer advance. Here the obligation is to provide the customer a good or service whose value may change because of inflation. • parity adjustment平价调整. An adjustment that reflects the difference in inflation between the parent and host countries东道国.

9. permanent assets永久性资产. A Brazilian term for fixed assets, buildings, investments, deferred charges递延费用 and their respective depreciation, and depletion损耗 or amortization amounts. • price index物价指数. A cost ratio where the numerator分子 is the cost of a representative “basket” of goods and services in the current year and the denominator分母 is the cost of the same basket of goods and services in a benchmark year基年. • purchasing power购买力. The general ability of a monetary unit to command goods and services. • real profit实际利润. Net income that has been adjusted for changing prices. • replacement cost. The current cost of replacing the service potential of an asset in the normal course of business.

10. reporting currency报表币种. The currency in which an entity prepares its financial statements. • restate-translate method重申翻译法. Used when a parent company consolidates the accounts of a foreign subsidiary located in an inflationary environment. With this method, the subsidiary's accounts are first restated for local inflation and then translated to the parent currency. • specific price change. The change in the price of a specific commodity, such as inventory or equipment. • translate-restate method翻译重申法. A consolidation method that first translates a foreign subsidiary's accounts to parent currency and then restates the translated amounts for parent-country inflation.

11. What Does “ChangingPrices” Mean and How are Price Changes Measured? • General price level changes are measured by use of a general price level index (GPL). • GPL is a cost ratio that compares the cost of a basket of goods in the current period with the cost of that same basket in a prior or base period. • The reciprocal of the GPL is a measure of the general purchasing power of the monetary unit. • Specific price changes are measured by a specific price index (SPL). • SPL is a cost ratio that compares the cost of a specific item with its cost in a prior or base period.

12. Why are Financial Statement Potentially Misleading During Periods of Changing Prices? • During periods of inflation, revenues are based on the general purchasing power of the current period. • Expenses, such as depreciation and amortization, may be based on currency of higher general purchasing power because their related assets were typically acquired in the past when GPLs were lower. • Deducting扣除 expenses based on historical purchasing power from revenues that expressed in currency of current purchasing power yields a nonsensical无意义的 index of performance.

13. During a period of specific price changes, assets recorded at their original acquisition costs seldom reflect the assets’ current (higher) value resulting in an overstatement in reported income. This, in turn, may lead to: • Higher taxes • Higher dividends • Higher wages • From a managerial perspective, accounting numbers unadjusted for changing prices distort: • Financial projections • Budget comparisons • Performance data

14. Types of Adjustments for Changing Prices • Objective of conventional historical cost accounting: maintain a firm’s original investment. • Assume a firm begins operations with an initial cash investment of $1,000. Cash is immediately converted to saleable inventory which is all sold at 50% mark-up by the end of the year for $1,500. There are no price changes during the period. • Revenues would be $1,500 received uniformly over the period, expenses would be $1,000, and net income would be $500. • Net income of $500 represents the amount that could be withdrawn from the firm and leave the owners with their original investment intact完整的.

15. General Price Level Adjustments • Objective: to measure income such that it represents an amount that could be withdrawn from the business while preserving the general purchasing power of the firm’s original investment. • Assume the same facts as previously except that the GPL advances from a level of 100 at the beginning of the period to 121 at period’s end and averaged 110 during the year. • To keep up with inflation, owners’ equity should grow by at least $210; i.e., beginning equity = $1,000 x 121/100 = ending owners’ equity of $1,210.

16. To accomplish this, revenues are expressed in end of period purchasing power by multiplying $1,500 by 121/110 =$1,650 (110 is used as an expedient to reflect the fact that revenues are received uniformly over the year). • Expenses (cost of sales in this example) would also be expressed in end of period purchasing power by multiplying $1,000 (incurred at the beginning of the year) by 121/100 =$1,210. • This produces an adjusted operating income of $440 (=$1,650 - $1,210).

17. During inflation, an additional consideration must be accounted for. These are the gains and/or losses attributed to holding monetary items. • Monetary asset = cash or a claim to a fixed number of currency in the future; e.g. cash or accounts receivable. • Monetary liability = obligations to pay a fixed number of currency in the future; e.g., most payables excluding customer advances. • During inflation, a firm holding monetary assets experiences a purchasing power loss as cash or receivables are not adjusted for inflation; a firm holding monetary liabilities experiences a purchasing power gain, as monetary liabilities are not adjusted for inflation.

18. In the foregoing example, the firm received $1,500 in cash from sales uniformly均匀地 during the year. If this monetary asset were adjusted for inflation its ending balance should be $1,650 (= $1,500 x 121/100). Its actual ending cash balance is only $1,500, giving rise to a purchasing power loss (monetary loss) of $150. • Price level adjusted net income would be $290 (= $440 - $150). • Withdrawing $290 from the business would leave the firm with $1,210, the amount necessary to keep up with inflation. • For balance sheet purposes, all non-monetary assets and liabilities would be adjusted to their end of period purchasing power equivalents by multiplying them by the end of period index over the index that prevailed when these items were acquired.

20. Adjustments for Specific Price Changes • Objective: to measure income such that it represents an amount that could be withdrawn from the business while preserving the firm’s productive capacity; i.e., ability to replace specific assets whose prices have risen during the period. • Continuing the previous example, assume that in addition to general inflation, specific prices of inventory have increased by 30%. • As the replacement cost of inventories have increased by 30%, owners’ equity should grow by at least $300; i.e., beginning equity = $1,000 x 130/100 = $1,300. Failing this, the company will not be able to maintain its productive capacity; replace all of its inventory. • To accomplish this, assets and their related expenses are restated to their current cost equivalents.

21. Inventory and hence cost of sales (all inventory was sold) would be restated to $1,300 (= $1,000 x 130/100). • This produces a replacement cost based adjusted operating income of $200 (= $1.500 - $1,300). • Withdrawing $200 from the business would leave the firm with $1,300, the amount necessary to enable it to preserve its productive capacity. • See pp. 143-144 of Infosys’ annual report at www.infosys.com/investor/reports-filings and select annual report for 2007.

22. General Price Level Adjusted Current Costs • Objective: to measure income such that it represents an amount that could be withdrawn from the business while preserving the firm’s general purchasing power and allowing it to maintain its productive capacity in real terms. • Same facts as before. General price levels have advanced by 21% and specific prices have increased by 30%. • A distinctive feature of this measurement framework is that it reports changes in the current costs of a firm’s nonmonetary assets, net of inflation.

23. The increase in the inventory’s cost due to general inflation was $210 (= $1,000 x 121/100). • The real change in the inventory’s current cost was $90 [= ($1,000 x 121/100) – ($1,000 x 130/100)]. • Net income is $200 (= $1,650 revenues - $1,300 cost of sales - $150 monetary loss). It represents the amount that could be paid out as a dividend and yet allow the firm to keep up with general inflation and allow it to replace specific assets (inventory) whose prices have advanced by $90 in real terms.

27. National Variations – U.S. • U.S. SFAS 89 encourages but does not mandate要求 the following disclosures for each of the five most recent years: • Net sales • Income from continuing operations on a current-cost basis. • Monetary gains or losses on net monetary items. • Increases or decreases in the current cost or lower recoverable amount of inventory or plant, property and equipment, net of inflation. • Aggregate foreign currency translation adjustment, on a current cost basis. • Net assets at year-end on a current cost basis. • Earnings per share on a current cost basis. • Dividends per share of common stock.

28. Level of the Consumer Price Index used to measure income from continuing operations. • For foreign operations included in the consolidated statements: • Translate foreign accounts to dollars, then restate for U.S. inflation, if the dollar is the functional currency. • Restate for foreign inflation, then translate to U.S. dollars if the local currency is functional.

30. National Variations – United Kingdom • In the U.K., SSAP 16 recommends one of three reporting options: • Present current-cost accounts as the basic financial statements with supplementary historical cost accounts. • Present historical-cost accounts as the basic statements with supplementary current-cost accounts. • Present current-cost accounts as the only accounts accompanied by adequate historical-cost information.

31. The foregoing options must include a monetary working capital adjustmentthat captures the monetary gains or losses from holding net monetary assets. This adjustment, however, employs specific price indexes as opposed to general price level indexes. • Also required is a gearing adjustmentthat offsets inflation-adjusted cost of sales, depreciation, and the monetary working capital adjustment for monetary gains resulting from the use of debt.

32. National Variations – Brazil • Permanent assets (i.e., fixed assets, buildings, investments, deferred charges, and their respective depreciation, as well as their amortization or depletion accounts) are adjusted for general price level changes. • Stockholders’ equity accounts (i.e., capital, revenue reserves, retained earnings, and capital reserve accounts) are also adjusted by GPL changes. • Permanent asset adjustments are offset against stockholders’ equity adjustments. • A permanent asset adjustment < equity adjustment produces a purchasing power loss. • A permanent asset adjustment > equity adjustment produces a purchasing power gain.

34. IAS 21 • Requires the restatement of primary financial statement information for operations located in hyperinflationary environments. • Historical cost or current cost statements must be expressed in constant purchasing power as of the balance sheet date. • Purchasing power gains or losses on net monetary items must be included in current income. • Firms must disclose: • that restatement for inflation has been made. • which asset valuation framework is being used in the primary statements. • which price index is used and its level at the balance sheet date and movement during the period.

35. Restate/Translate Controversy争论 • When consolidating the accounts of subsidiaries located in inflationary environments, should management first restate these accounts for foreign inflation, then translate to parent currency? • Or, should they first translate unadjusted accounts to parent currency, then restate for parent country inflation? • Our solution, based on a dividend discount valuation framework: • Restate statements to be consolidated for specific price changes. • Translate to parent currency using the current rate. • Use specific price indexes to calculate monetary gains and losses.

36. Double-counting for Inflation • Local inflation affects exchange rates used to translate inflation-adjusted foreign currency balances to parent currency. • Result: Inflation is accounted for twice. • To eliminate the double-dip, back out the period’s translation gain or loss from the inflation adjustment. • See example for inventory on page 268 of text. • See Appendix 7-1 for cost of sales example.