Transcript Chapter 13: Accounting for Inflation & Changing Prices

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
problems
Many historical numbers are not economically
relevant
Historical 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 stockholders
Many dividends are really liquidating in nature
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
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 power
Current valuation, also called current cost,
attempts to derive the specific value or
worth for a particular point ...
Entry values
Exit values
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
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 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
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
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