inflation accounting

McGraw-Hill/Irwin Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved.

Accounting for

Changes prices

(Inflation Accounting)

Upload by Bishwajit Rout.

FMU

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Additional Financial Reporting Issues

Chapter Topics Inflation accounting – general purchasing power and

current cost accounting approaches. Inflation accounting – differences in standards

worldwide.

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Additional Financial Reporting Issues

Learning Objectives1. Explain the concepts underlying two methods of

accounting for changing prices (inflation)—general purchasing power accounting and current cost accounting.

2. Describe attempts to account for inflation in different countries, as well as the rules found in International Financial Reporting Standards (IFRSs) related to this issue.

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Introduction conventional accounting results in a mix of

attributes being reflected in the asset section of the balance sheet . Accounts receivable are reported at the net

amount expected to receive in the future. Inventory is carried at the lower of cost or

market value. Short-term investments are reported either

cost or current market value . Property, plant and equipment is reported at

cost less accumulated depreciation

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Introduction

Price of most assets fluctuate, often increasing .

Reporting assets on the balance sheet at their historical cost during a period of price changes can make the balance sheet information irrelevant.

For example, reporting land was purchased in 1940 in the historical cost at $1000 (irrelevant)

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Inflation inflation is a rise in the general level of

prices of goods and services in an economy over a period of time.

inflation is also an erosion in the purchasing power of money .

A chief measure of price inflation is the inflation rate, the annualized percentage change in a general price index

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Effects of Inflation Inflation can have positive and negative effects

on an economy negative effects :

A decrease in the real value of money and other monetary items over time

Uncertainty about future inflation may discourage investment and saving.

and high inflation may lead to shortages of goods if consumers begin hoarding out of concern that prices will increase in the future

Positive effects A mitigation of economic recessions. debt relief by reducing the real level of debt.

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Measure of Inflation

Inflation is usually estimated by calculating the inflation rate of a price index, usually the general price level .

The General price level (Consumer Price Index) measures prices of a selection of goods and services (basket) purchased by a "typical consumer".

The inflation rate is the percentage rate of change of a price index over time.

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Measure of Inflation For instance, in January 2007, the U.S. general

price level was 202.416, and in January 2008 it was 211.080. The formula for calculating the

annual percentage rate inflation in the general price level over the course of 2007 is:

The resulting inflation rate for the general price level in this one year period is 4.28%, meaning

the general level of prices for typical U.S. consumers rose by approximately four percent in

2007

211.080 – 202.416 202.416 = 4.28%)(

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Inflation Accounting – Conceptual Issues

Impact of inflation on financial statements

1. Understated asset values. Negative impact on ability to borrow. Can invite hostile takeover to the extent that

the current market price of a company's stock does not reflect the current value of assets

Learning Objective 1

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2. Overstated income and overpayment of taxes. Understated assets result in

understated expenses (depreciation and COGS)

This lead to overstated income, thus more taxes paid and stockholders demand a higher level of dividends.

That may result in high cash outflows so lead to liquidity problems


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3. Differing impacts across companies resulting in lack of comparability. A company with older fixed assets will

report a higher return on assets than a company with newer fixed assets.

Because inflation rates tend to vary across countries, comparison made by parent company across its subsidiaries located in different countries can be distorted


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purchasing power gains and losses. Historical cost also ignores purchasing power

gains and losses during the period of inflation. For example $202 can purchases one basket of

good and service, only year later when general price level stated at $211, the same $202 can purchases 95.5% percent of the basket, so you need to $211 to buy the same basket .

The difference between $211 needed to maintain the purchasing power and 202 result in $9 purchasing power loss .


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Purchasing power losses result from holding monetary assets, such as cash and accounts receivable.

Purchasing power gains result from holding monetary liabilities, such as accounts payable.

The two most common approaches to inflation accounting are general purchasing power accounting and current cost accounting.


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Methods of accounting for changing prices

Tow solution have been developed to deal with distortions caused by historical cost

1. Account for in the general price level.This approach makes adjustments to the historical cost of assets to update for changes in purchasing power of the currency and therefore is referred to as general price level adjusted historical cost (GPLAHC) accounting or, more simply general purchasing power accounting

2. Account for specific price changes.By updating the values of assets from historical cost to the current cost to replace these assets, this is known as current replacement cost (CRC) or simply, current cost (CC) accounting .

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Net Income and Capital Maintenance

Historical cost, general purchasing power and current cost accounting all flow from different concepts of capital maintenance.

Net income represents the amount of dividends that can be paid out while still maintaining the company’s capital balance.


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Net Income and Capital Maintenance

Historical cost net income maintains a nominal, not adjusted for inflation, amount of contributed capital.

General purchasing power net income maintains the purchasing power of contributed capital.

Current cost net income maintains the productive capacity of physical capital.


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Example

Assume that HIE company is formed in January 1,Year 1 , by investors contributing 200 in cash . The general price index (GPI) on that date is 100. HIE company’s balance sheet on January 1,Year 1 as follows.

Cash 200 Contributed capital 200

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Example With the initial equity investment, one unit of

inventory is purchased on January 2,Year 1 at a cost of $100 and $100 remains in cash, resulting in the following position 1,Year 1 as follows.

Cash 100 Contributed capital200

Inventory 100200

200

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Example on January 2,Year 1, the managers of HIE

company go on vocation, returning on December 31, Year 1 at which time the inventory is sold for $150 in cash, at December 31, Year 1 the general price index is 120 (20% annual inflation during the year 1) and the inventory has current replacement cost of $150 .

The income statement for year 1 appear as follows:Sales 150Cost of sales (100)Income 50

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Example The balance sheet at December 31, Year 1, prior to any

distribution of dividends is as follow

Cash 250 Contributed capital200

Retained earning 50

250

The economic definition of income is the amount that can be distributed to owners after making sure that the company is as well at the end of a year as it was at the beginning of the year.

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Example

If the company were to distribute a dividend of $50 equal to year 1 net income, the resulting balance sheet would be exactly the same as it was at the beginning of the year

Cash 200 Contributed capital 200 HC income is the amount that can be distributed

to owners while maintaining the nominal amounts of contributed capital at the beginning of the year .

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Capital Maintenance IASB Framework

Concepts of Capital maintenanceFinancial capital maintenance One approach to income measurement. Net income represents the increase in net

financial assets, excluding owner transactions.

The approach in U.S. GAAP.

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Capital Maintenance IASB Framework

Concepts of Capital maintenancePhysical capital maintenance Another approach to income measurement. Net income represents increase in physical

productive capacity excluding owner transactions.

Requires current costs for measurement of certain physical assets.

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Inflation Accounting -- Methods

General Purchasing Power (GPP) Accounting Under (GPP) Accounting, nonmonetary assets, liabilities,

stockholders equity, and all income statement items are restated from the GPI at the transaction date to the GPI at the at the end of current period.

Fixed assets and intangible assets and the related depreciation and amortization would also be restated for changes in general Purchasing Power .

Updates historical cost accounting for changes in the general purchasing power of the monetary unit.

Also referred to as General Price-Level-Adjusted Historical Cost Accounting (GPLAHC).

Requires purchasing power gains and losses to be included in net income.


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General Purchasing Power (GPP) Accounting Because inventory was acquired on January 1, Year 1,

when the GPI was 100, and GPI at December 31, Year 1, is 120, the cost of sales (inventory) is restated using the 120/100 .

Because the sales occurred on December 31, Year 1, when the GPI was 120, there is no need to restate sales (or the restatement ratio can be expressed as 120/120).

In addition to restating sales and cost of sales GPP accounting also requires a net purchasing power gains and losses to be included in net income

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Follow the Example At January 1, Year 1, HIE company has

monetary assets 100 and no monetary liabilities, yielding a net monetary asset position of $100.

Because HIE holding this cash for entire year, a net purchasing power loss (PPL) of $20 arises.

In addition HIE receiving $150 cash on December 31, Year 1 from the sales of the inventory, because this cash on December 31, Year 1 there is no loss on purchasing power by the end of the year .

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Follow the ExampleThe PPl calculated as follow:Cash 1/1/Y1 ……….…… $100 x (120/100) = $120 (need to maintain pp)

+ increase in cash,Year1 $150 x (120/120) = $150ٍ�Subtotal …………………………………………$270Less : cash 12/31/Y1…………………………. ($250)purchasing power loss……………………….. $ 20

Combining the restatement with PPL, GPP income is calculated as follows:

HC Restatement ratio GPP Sales ……… $150 x (120/120) $150Cost of sales 100 x (120/100) 120Subtotal ………………… $ 50 $ 30purchasing power loss……………………….. ................. 20Income……………………………………………………….. $ 10

To calculated the purchasing power loss

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Follow the Example Contributed capital must also be restated for year 1

inflation as follow: HC Restatement ratio GPP

Contributed capital 200 x(120/100) $240The journal entry needed to account for GPP adjustment is as follow:

Dr. Inventory (cost of sales) 20 Purchasing power loss 20

Cr. Contributed capital 40GPP income represent the amount that can be distributed to owners while marinating the purchasing power of capital at the beginning of the year.

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Follow the Example The balance sheet at December 31, Year 1, prior to any distribution of

dividends at historical cost model is as follow:


Retained earning 50250

After adjusting the accounts for GPP the balance sheet at December 31, Year1, prior to any distribution of dividends at (GPP) model is as


Retained earning 10250

After paying dividends at $10, the balance sheet at December 31, Year 1, is as follow:


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Current Cost (CC) Accounting Maintaining the purchasing power of equity does not

necessarily ensure that the company is able to continue to operate at its existing level of capacity.

To determine the amount of income that can be distributed to owners while maintaining the company productive capacity or physical capital , Current Cost (CC) Accounting must be used.

Under Current Cost (CC) Accounting ,historical cost of nonmonetary assets are replaced with current replacement .

Also referred to as Current Replacement Cost Accounting. Nonmonetary assets are restated to current replacement

costs and expense items are based on these restated costs.

Holding gains and losses included in equity.Learning Objective 1

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Inflation Accounting Internationally

United States and United Kingdom SFAS 33, Financial Reporting and Changing Prices

briefly required large U.S. companies to provide GP and CC accounting disclosures.

This information is now optional and few companies provide it.

In the UK, SSAP 16 required current cost information, this was also was only briefly required.

Both countries have experienced low rates of inflation since the 1980s.


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Latin America Latin America has a long history of significant inflation. Brazil, Chile, and Mexico have developed sophisticated

inflation accounting standards over time. Like the U.S. and UK, Brazil has abandoned inflation

accounting. Mexico’s Bulletin B-10, Recognition of the Effects of

Inflation in Financial Information, is a well-known example.


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Mexico – Bulletin B-10 Requires restatement of nonmonetary assets and

liabilities using the central bank’s general price level index.

An exception is the option to use replacement cost for inventory and related cost of goods sold.

Another exception is imported machinery and equipment.

This exception allows a combination of country of origin price index and the exchange rate between Mexico and country of origin.


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Netherlands – Replacement Cost Accounting Prior to the required use of IFRSs in 2005, Dutch

companies could use replacement cost accounting. In 2003 only Heineken used this approach. Heineken presented inventories and fixed assets at

replacement cost. Cost of sales and depreciation were also based on

replacement costs. The entry accompanying the asset revaluation was

reported in stockholders’ equity.


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International Financial Reporting Standards IAS 15, Information Reflecting the Effects of Changing

Prices was issued in 1981. This standard has been withdrawn due to lack of

support. The relevant standard now is IAS 29, Financial Reporting

in Hyperinflationary Economies. IAS 29 is required for some companies located in

environments experiencing very high levels of inflation.


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IAS 29 Financial Reporting in Hyperinflationary Economies

This Standard shall be applied to the financial statements, including the consolidated financial statements, of any entity whose functional currency is the currency of a hyperinflationary economy.

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Hyperinflationary Economies

Hyperinflation is indicated by characteristics of the economic environment of a country which include, but are not limited to, the following:

1. 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;

2. 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;

3. 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

4. Interest rates, wages and prices are linked to a price index; and5. The cumulative inflation rate over three years is approaching, or

exceeds,100%.

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International Financial Reporting Standards IAS 29 includes guidelines for determining the

environments where it must be used. Nonmonetary assets and liabilities and stockholders’

equity are restated using a general price index. Income statement items are restated using a general

price index from the time of the transaction. Purchasing power gains and losses are included in net

income.


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Statement of financial position

Statement of financial position amounts not already expressed in terms of the measuring unit current at the end of the reporting period are restated by applying a general price index.

Monetary items are not restated because they are already expressed in terms of the monetary unit current at the end of the reporting period.

Monetary items are money held and items to be received or paid in money.

Items stated at current cost are not restated because they are already expressed in terms of the measuring unit current at the end of the reporting period. Other items in the statement of financial position are restated

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Statement of comprehensive income

The current cost statement of comprehensive income, before restatement, generally reports costs current at the time at which the underlying transactions or events occurred.

Cost of sales and depreciation are recorded at current costs at the time of consumption; sales and other expenses are recorded at their money amounts when they occurred.

Therefore all amounts need to be restated into the measuring unit current at the end of the reporting period by applying a general price index.

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Consolidated financial statements

parent that reports in the currency of a hyperinflationary economy may have subsidiaries that also report in the currencies of hyperinflationary economies.

The financial statements of any such subsidiary need to be restated by applying a general price index of the country in whose currency it reports before they are included in the consolidated financial statements issued by its parent.

Where such a subsidiary is a foreign subsidiary, its restated financial statements are translated at closing rates.

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Illustration example ABC corporation work in a highly inflation

country and prepare its financial statements in general purchasing power in accordance with IAS29 .

The financial statements of ABC corporation is as follow:

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Conventional Balance Sheet. Conventional Balance Sheet.

January 1. and December 31. 1989 Opening Closing

Assets Monetary assets $100 $110 Inventories 80 100 Shares 50 50 Depreciable assets 200 180 Land 50 50 Total 480 490 Liabilities and Equities Liabilities $350 310 Capital stock 50 50 Retained earnings 80 130 Total 480 490

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Conventional Income statement. Conventional Income statement. For the year ended December 31. 1989

Sales ……………………………….. $800 Inventory, opening ……….. (80) Purchases ……………….... (500) Inventory, closing ………… 100 Cost of sales………………………… (480) Expenses………………….. (200) Depreciation………………. (20) interest on loans ……………(50) (270) Net income …………………………….50

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Other data Given 20% inflation during 1989 During 1989 the company neither invested nor disposed of shares

or fixed assets, also no equity additions or withdrawals occurred. Therefore, the recorded nominal value of the shares, land and

capital stock did not change during the year. The recorded value of the depreciable assets declined only by the

nominal depreciation of $20. The retained earnings increased by $50 as determined by the

conventional income statement. All the item in the statement are recorded at historical values . Sales, purchases, expenses and interest incurred during the year. The opening inventory value and depreciation represent cost

incurred before 1989. The net income of $50 is retained, given that the company does not

pay income tax.

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1- Restating the opening balance sheet

Conventional and restated Balance Sheet. January 1. 1989

Conventional Restated

Assets Monetary assets $100 100 Inventories 80 100 Shares 50 70 Depreciable assets 200 300 (Net (depreciated) value.) Land 50 100 Total 480 670 Liabilities and Equities Liabilities $350 350 Capital stock 50 200 Retained earnings 80 120 (To balance) Total 480 670

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The individual items in the conventional opening balance sheet (December 31, 1988) should be restated to December 1988 prices.

Assets: The monetary assets (cash, receivables, investment in

bonds, etc.), which are stated in nominal money units, do not require any restatement. Because the nominal value represents the real value of the asset concerned.

The nonmonetary assets - inventories, shares, depreciable assets, and land are restated. The restatement can be carried out by applying the corresponding restatement factor to each recorded transaction in these assets over the company's history.

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Restatement Factor Restatement factor is used to inflate a given

value in proportion to the inflation that has occurred since the recording date.

Given That the restatement process of the nonmonetary assets inflated the values of the four categories of assets from $380 (80 + 50 + 200 + 50, respective historical values) to $570 (100 + 70 + 300 + 100, respective restated values).

Restatement Factor = Price index at end of analyzed period

Price index at recording date

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The liabilities and Equities The liabilities (payables, received loans, etc.), which are

monetary items and stated in nominal money units, do not require any restatement as the nominal value represents the real value of the liability concerned, Therefore, the restated value equals the recorded value in the conventional statement.

The capital stock, which has been issued in the past, is restated. The restatement is carried out by applying the corresponding restatement factor to each recorded capital stock transaction (equity addition) over the company's history.

The retained earnings item is not restated; it is derived by subtracting the liabilities and capital stock from the total restated assets, that is, (670 - 350 - 200 = $120)

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2- Restating Intra-Year Capital Transactions

Intra-year capital transactions are those transactions incurred during the year which directly affect the level of balance-sheet items, such as investments or disinvestments in shares, fixed assets, and equity additions or withdrawals.

These transactions should be restated to year-end prices.

The restatement of these items can be carried out in two ways :

1. Applying the corresponding restatement factor to each recorded transaction, or.

2. Using the average price index for the restatement factor, assuming that the transactions incurred more-or-less evenly during the year

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2- Restating Intra-Year Capital Transactions

Restatement Factor =

In our example there are no Intra-year capital transactions.

Price index Dec. 1989 Average price index Dec. 1988 - Dec. 1989

The restatement of these items can be carried out in two ways :

1.Applying the corresponding restatement factor to each recorded transaction, or.

2.Using the average price index for the restatement factor, assuming that the transactions incurred more-or-less evenly during the year

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3- Restating the Closing Balance Sheet

Conventional and restated Balance Sheet. January 1. 1989 December 31. 1989

Restated 1/1 Conventional Restated Assets Monetary assets 100 $110 110 Inventories 100 100 110 Shares 70 50 84 Depreciable assets 300 180 328 Land 100 50 120 Total 670 490 752 Liabilities and Equities Liabilities 350 $310 310 Capital stock 200 50 240 Retained earnings 120 130 202 (To balance) Total 670 490 752

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The restated closing balance sheet la the result of adjusting data from three sources

Monetary assets and liabilities - derived from the conventional closing balance sheet. These items are treated according to the procedures outlined in restating the monetary assets in restating the opening Balance Sheet.

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The restatement of Inventories can be carried out by applying the corresponding restatement factor to each recorded transaction in these Inventories over the Year, The restatement process inflated the value of the closing inventories from $100 to $110. .

Shares, land, (Nondepreciable Assets) and capital stock derived from the opening restated balance sheet. These items are updated to year-end prices (we given that Inflation rate is 20%) .

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Updating means translating figures from restated dollars for a given

date in the past to dollars of purchasing power at a later date, using a

restatement factor.

Ill. Example: Adjusted financial figures for December 31, 1988 and

December 31, 1989 are compared, as follows.

December 31, 1988 December 31, 1989

Price Index 100 120

Restatement factor 120/100 = 1.2 120/120 = 1

Shares 70 84

Land 100 120

Capital stock 200 240

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Depreciable assets: The treatment of depreciable assets, such as

plant and equipment, involves the restatement of both assets value and depreciation expenses, to December 1989 prices. .

Given that there was neither investment nor disinvestment in these assets during 1989 and that the inflation rate was 20% during the year, the corresponding restated values are as follow :

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Opening Closing

$400 Acquisition cost $480

(100) Less: Accumulated depreciation (120)

1989's depreciation (32)

300 Net (depreciated) value 328

The restated opening acquisition cost of $400 is updated to $480

in December 1989 prices (restatement factor of 1.2).

The $32 depreciation for 1989 is derived from the restated

acquisition cost, and stated in December 1989 prices.

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4- Deriving the Year's Adjusted Net Income

The simplest way to derive the inflation-adjusted net income of a

company is by measuring the change in equity between the closing and

opening balance sheets, where the figures are stated in year-end prices.

The adjusted net income for the illustrative company in 1989 is

calculated as follow :-

Opening Closing

Dec. 1988 Prices Dec. 1989 Prices*

Assets $670 $804 $752

Less: Liabilities (350) (420) (310)

Equity 320 384 442

Less: Opening equity (384)

Adjusted net income 58

*December 1988 prices times 1.2 restatement factor (given 20% inflation during 1989.

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5- Adjusting the Income Statement

Adjustment of the conventional income statement can be carried out by restating all the items to year-end prices. This procedure provides improved information for planning and control purposes, but it is more cumbersome to apply and difficult to comprehend.

The conventional income statement for 1989 and the adjusted statement, following the above mentioned procedure, are presented as follow:

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Income Statement for the year ended December 31, 1989 Conventional and fully Restated

Conventional Restated * Sales $ 800 $880** Inventory, opening $(80) $(120) Purchases (500) (550) Inventory, closing 100 110 Cost of sales (480) (560) Expenses (200) (220)** Depreciation (20) (32) Interest on loans (50) (50)

(270) (302) Net income, retained 50 18 Gain on net monetary position 40 Adjusted net income 58

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Sales, Purchases, closing Inventory, and Expenses are restated by using restatement factor 1.1, based on average price indexes for Dec. 1989 .

Average Price Index An average price index for a given period should be used for restating values that are incurred evenly throughout the period. Example: Consider the following price indexes

Inventory, opening carried from the opening restated balance sheet

and then Restated using the restatement factor 1.2 (given 20% inflation in 1989).

Oct. 1989 – 307 Nov. 1989 – 320 Dec. 1989 - 330

The average price index is : (310+320+330)/3 = 320 The corresponding restatement factor is 330/320 = 1.03125

inflation accounting

Business

methodsgeneral purchasing power

average price index

closing balance sheet

generalpurchasing power accounting

net income represents

conventional income statement

opening balance sheet

general price level