Chapter 13: Accounting for Inflation & Changing Prices

Inflation

Price indexes

Inflation accounting

Income measurement systems

SFAS No. 33

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 problemsMany historical numbers are not economically

relevantHistorical numbers are not additive

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 stockholdersMany dividends are really liquidating in nature

Price Indexes

Is a weighted average of the current prices of goods and servicesAverages are related to prices in a base periodPurpose is to determine how much change has

occurred

Types of price indexesSpecific price indexGeneral price index

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

Inflation Accounting

General purchasing power adjustment translates historical dollars into dollars having equivalent purchasing powerCurrent valuation, also called current cost, attempts to derive the specific value or worth for a particular point ...Entry valuesExit values

Entry vs. Exit Values

Entry valuesValue in use is best represented by replacement

costsStrong argument in support of use

Exit values Are a form of opportunity costsThe balance sheet becomes the principal

financial statement

Purchasing Power Gains & Losses

Arise as a result of holding net monetary assets or liabilities during a period when the price level changes

Monetary assets and liabilities include cash itself and other assets and liabilities that are receivable or payable in a fixed number of dollars

Purchasing Power Gains & Losses

State of the Enterprise

Inflation Deflation

Net Monetary Asset Position

Purchasing Power Loss

Purchasing Power Gain

Net Monetary Liability Position

Purchasing Power Gain

Purchasing Power Loss

Holding Gains & Losses

Holding gains and losses on 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

The Gearing Adjustment

Somewhat related to the holding gainWas 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

Income Measurement Systems

Current Value ApproachesDistributable 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

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

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. .

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

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

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

Chapter 13: Accounting for Inflation & Changing Prices

Inflation

Price indexes

Inflation accounting

Income measurement systems

SFAS No. 33