Chapter 13: Accounting for Inflation & Changing Prices

1. Chapter 13: Accounting for Inflation & Changing Prices • Inflation • Price indexes • Inflation accounting • Income measurement systems • SFAS No. 33

2. Inflation • The rise in the average price level for all goods and services produced in an economy • Under a historical cost-based system of accounting inflation leads to two basic problems • Many historical numbers are not economically relevant • Historical numbers are not additive

3. Inflation and Historical Costing • Likely predictive value is diminished • Comparability among financial statements of different firms is restricted • Capital maintenance • Income usually overstated relative to amounts that can be distributed to stockholders • Many dividends are really liquidating in nature

4. Price Indexes • Is a weighted average of the current prices of goods and services • Averages are related to prices in a base period • Purpose is to determine how much change has occurred • Types of price indexes • Specific price index • General price index

5. Price Indexes • Paasche-type indexes • Uses current-year quantities • Wholesale Price Index • Consumer price Index • Laspeyres-type indexes • Uses base-year quantities • Less costly to construct

6. Inflation Accounting • General purchasing power adjustment translates historical dollars into dollars having equivalent purchasing power • Current valuation, also called current cost, attempts to derive the specific value or worth for a particular point ... • Entry values • Exit values

7. Entry vs. Exit Values • Entry values • Value in use is best represented by replacement costs • Strong argument in support of use • Exit values • Are a form of opportunity costs • The balance sheet becomes the principal financial statement

8. Purchasing Power Gains & Losses • Arise as a result of holding net monetary assets or liabilities during a period when the price level changes • Monetaryassets and liabilities include cash itself and other assets and liabilities that are receivable or payable in a fixed number of dollars

9. Purchasing Power Gains & Losses

10. Holding Gains & Losses • Holding gains and losseson real (nonmonetary) assets can be divided into two parts • monetary holding gains and losses, which arise purely because of the change in the general price level during the period; and • real holding gains and losses, which are the difference between general price-level-adjusted amounts and current values. • Are capital adjustments only; they are not a component of income

11. The Gearing Adjustment • Somewhat related to the holding gain • Was used in Great Britain as part of that country’s inflation accounting mechanism • Results in gains to equity capital during inflation because debt capital does not have any claim on holding gains • proved to be an extremely confusing concept

12. Income Measurement Systems • Current Value Approaches • Distributable Income (DI) • Realized Income (RI) • Earning Power Income (EPI) • Methods differ in terms of disposition of real holding gains and the resulting type of capital maintenance measure

13. SFAS No. 33 • FASB decided to keep nominal historical costs as the basis of primary financial statements • Specified that the effects of changing prices should be presented as supplementary information in annual reports • FASB realized that a consensus could not be obtained on which method of accounting should be adopted

14. SFAS No. 33 • Not all enterprises had to comply with SFAS No. 33 • For constant dollar reporting, the SFAS required disclosure of • Information on income from continuing operations for the current fiscal year on a historical cost/constant dollar basis . . . • The purchasing power gain or loss on net monetary items for the current fiscal year. .

15. SFAS No. 33’s Failure • There was a dramatic decline of inflation during the early 1980s • Measurement problems were present • Questions of understandability and usefulness for predictive purposes

16. SFAS No. 82 issued in 1984 • Eliminated the constant dollar income disclosures that had previously been required by SFAS No. 33 • SFAS No. 33 • information confused users • may have caused “information overload” because of the presence of similar current cost income disclosures

17. SFAS No. 89 • Two parts of SFAS No. 33 remained in effect; were “encouraged” but not required • current cost income measurement, purchasing power gain or loss, and • holding gain information • FASB beat a hasty retreat from the problem of accounting for changing prices

18. Chapter 13: Accounting for Inflation & Changing Prices • Inflation • Price indexes • Inflation accounting • Income measurement systems • SFAS No. 33