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Accounting for Changes prices (Inflation Accounting)
Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved.
Additional Financial Reporting Issues
Inflation accounting – general purchasing power and current cost accounting approaches. Inflation accounting – differences in standards worldwide.
Additional Financial Reporting Issues
1. 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.
Short-term investments are reported either cost or current market value . Property. Inventory is carried at the lower of cost or market value.Introduction conventional accounting results in a mix of attributes being reflected in the asset section of the balance sheet . plant and equipment is reported at cost less accumulated depreciation 8-4 . Accounts receivable are reported at the net amount expected to receive in the future.
Introduction Price of most assets fluctuate. often increasing . For example. reporting land was purchased in 1940 in the historical cost at $1000 (irrelevant) 8-5 . Reporting assets on the balance sheet at their historical cost during a period of price changes can make the balance sheet information irrelevant.
Inflation inflation is a rise in the general level of prices of goods and services in an economy over a period of time. the annualized percentage change in a general price index 8-6 . inflation is also an erosion in the purchasing power of money . A chief measure of price inflation is the inflation rate.
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.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. 8-7 .
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. 8-8 .Measure of Inflation Inflation is usually estimated by calculating the inflation rate of a price index. usually the general price level .
and in January 2008 it was 211. general price level was 202.416.28% The resulting inflation rate for the general price level in this one year period is 4.080 – 202. consumers rose by approximately four percent in 2007 8-9 . the U.416 202. The formula for calculating the annual percentage rate inflation in the general price level over the course of 2007 is: ( 211.080.28%.S. meaning the general level of prices for typical U. in January 2007.S.Measure of Inflation For instance.416 ) = 4.
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 8-10 .Inflation Accounting – Conceptual Issues Impact of inflation on financial statements 1. Understated asset values.
That may result in high cash outflows so lead to liquidity problems Learning Objective 1 8-11 . Understated assets result in understated expenses (depreciation and COGS) This lead to overstated income.Inflation Accounting – Conceptual Issues 2. thus more taxes paid and stockholders demand a higher level of dividends. Overstated income and overpayment of taxes.
Differing impacts across companies resulting in lack of comparability.Inflation Accounting – Conceptual Issues 3. Because inflation rates tend to vary across countries. comparison made by parent company across its subsidiaries located in different countries can be distorted Learning Objective 1 8-12 . A company with older fixed assets will report a higher return on assets than a company with newer fixed assets.
For example $202 can purchases one basket of good and service. so you need to $211 to buy the same basket .5% percent of the basket. Historical cost also ignores purchasing power gains and losses during the period of inflation. only year later when general price level stated at $211. The difference between $211 needed to maintain the purchasing power and 202 result in $9 purchasing power loss . the same $202 can purchases 95.Inflation Accounting – Conceptual Issues purchasing power gains and losses. Learning Objective 1 8-13 .
such as accounts payable. Purchasing power gains result from holding monetary liabilities. such as cash and accounts receivable. Learning Objective 1 8-14 . The two most common approaches to inflation accounting are general purchasing power accounting and current cost accounting.Inflation Accounting – Conceptual Issues Purchasing power losses result from holding monetary assets.
By updating the values of assets from historical cost to the current cost to replace these assets. 8-15 . Account for in the general price level.Methods of accounting for changing prices Tow solution have been developed to deal with distortions caused by historical cost 1. this is known as current replacement cost (CRC) or simply. Account for specific price changes. 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. current cost (CC) accounting . more simply general purchasing power accounting 2.
Learning Objective 1 8-16 .Inflation Accounting – Conceptual Issues 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.
General purchasing power net income maintains the purchasing power of contributed capital. Current cost net income maintains the productive capacity of physical capital. Learning Objective 1 8-17 .Inflation Accounting – Conceptual Issues Net Income and Capital Maintenance Historical cost net income maintains a nominal. amount of contributed capital. not adjusted for inflation.
The general price index (GPI) on that date is 100.Year 1 . HIE company’s balance sheet on January 1.Example Assume that HIE company is formed in January 1. Cash 200 Contributed capital 200 8-18 . by investors contributing 200 in cash .Year 1 as follows.
one unit of inventory is purchased on January 2.Example With the initial equity investment. Cash Inventory 100 100 200 Contributed capital 200 200 8-19 . resulting in the following position 1.Year 1 as follows.Year 1 at a cost of $100 and $100 remains in cash.
Year 1 at which time the inventory is sold for $150 in cash. at December 31. the managers of HIE company go on vocation.Year 1. returning on December 31.Example on January 2. 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 Cost of sales Income 150 (100) 50 8-20 .
prior to any distribution of dividends is as follow Cash 250 Contributed capital Retained earning 200 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.Example The balance sheet at December 31. Year 1. 8-21 .
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 .
IASB Framework Concepts of Capital maintenance
Financial 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.
IASB Framework Concepts of Capital maintenance
Physical 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.
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. Learning Objective 1 8-25 . stockholders equity. Also referred to as General Price-Level-Adjusted Historical Cost Accounting (GPLAHC).Inflation Accounting -. liabilities.Methods General Purchasing Power (GPP) Accounting Under (GPP) Accounting. Requires purchasing power gains and losses to be included in net income. nonmonetary assets.
and GPI at December 31.Inflation Accounting -. 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 8-26 . Year 1. when the GPI was 120. the cost of sales (inventory) is restated using the 120/100 .Methods General Purchasing Power (GPP) Accounting Because inventory was acquired on January 1. Year 1. Because the sales occurred on December 31. is 120. when the GPI was 100. Year 1.
Year 1 from the sales of the inventory. Because HIE holding this cash for entire year. Year 1. In addition HIE receiving $150 cash on December 31. Year 1 there is no loss on purchasing power by the end of the year . a net purchasing power loss (PPL) of $20 arises. HIE company has monetary assets 100 and no monetary liabilities.Follow the Example At January 1. yielding a net monetary asset position of $100. because this cash on December 31. 8-27 .
.. $ 20 Combining the restatement with PPL.... $ 10 8-28 . 20 Income……………………………………………………….........Year1 $150 x (120/120) = $150 ٍSubtotal …………………………………………$270 To calculated the purchasing Less : cash 12/31/Y1………………………….Follow the Example The PPl calculated as follow: Cash 1/1/Y1 ………. ($250) power loss purchasing power loss………………………. GPP income is calculated as follows: HC Restatement ratio GPP Sales ……… $150 x (120/120) $150 Cost of sales 100 x (120/100) 120 Subtotal ………………… $ 50 $ 30 purchasing power loss……………………….....…… $100 x (120/100) = $120 (need to maintain pp) + increase in cash....
Inventory (cost of sales) 20 Purchasing power loss 20 Cr.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) $240 The journal entry needed to account for GPP adjustment is as follow: Dr. Contributed capital 40 GPP income represent the amount that can be distributed to owners while marinating the purchasing power of capital at the beginning of the year. 8-29 .
Year1. Year 1. is as follow: Cash 240 Contributed capital 240 8-30 .Follow the Example The balance sheet at December 31. Year 1. the balance sheet at December 31. prior to any distribution of dividends at (GPP) model is as Cash 240 Contributed capital 240 Retained earning 10 250 After paying dividends at $10. prior to any distribution of dividends at historical cost model is as follow: Cash 250 Contributed capital 200 Retained earning 50 250 After adjusting the accounts for GPP the balance sheet at December 31.
Nonmonetary assets are restated to current replacement costs and expense items are based on these restated costs.historical cost of nonmonetary assets are replaced with current replacement . Holding gains and losses included in equity.Inflation Accounting -. 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.Methods 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. Learning Objective 1 8-31 . Under Current Cost (CC) Accounting . Also referred to as Current Replacement Cost Accounting.
Learning Objective 2 8-32 .S.Inflation Accounting Internationally United States and United Kingdom SFAS 33. companies to provide GP and CC accounting disclosures. Both countries have experienced low rates of inflation since the 1980s. Financial Reporting and Changing Prices briefly required large U. this was also was only briefly required. This information is now optional and few companies provide it. In the UK. SSAP 16 required current cost information.
Brazil. Recognition of the Effects of Inflation in Financial Information. Chile.S. and Mexico have developed sophisticated inflation accounting standards over time. Learning Objective 2 8-33 . Mexico’s Bulletin B-10. Like the U. and UK.Inflation Accounting Internationally Latin America Latin America has a long history of significant inflation. is a well-known example. Brazil has abandoned inflation accounting.
An exception is the option to use replacement cost for inventory and related cost of goods sold. 8-34 Learning Objective 2 .Inflation Accounting Internationally Mexico – Bulletin B-10 Requires restatement of nonmonetary assets and liabilities using the central bank’s general price level index. This exception allows a combination of country of origin price index and the exchange rate between Mexico and country of origin. Another exception is imported machinery and equipment.
Cost of sales and depreciation were also based on replacement costs.Inflation Accounting Internationally Netherlands – Replacement Cost Accounting Prior to the required use of IFRSs in 2005. In 2003 only Heineken used this approach. Dutch companies could use replacement cost accounting. Heineken presented inventories and fixed assets at replacement cost. The entry accompanying the asset revaluation was reported in stockholders’ equity. Learning Objective 2 8-35 .
Information Reflecting the Effects of Changing Prices was issued in 1981. IAS 29 is required for some companies located in environments experiencing very high levels of inflation. Learning Objective 2 8-36 .Inflation Accounting Internationally International Financial Reporting Standards IAS 15. This standard has been withdrawn due to lack of support. Financial Reporting in Hyperinflationary Economies. The relevant standard now is IAS 29.
of any entity whose functional currency is the currency of a hyperinflationary economy. 8-37 . including the consolidated financial statements.IAS 29 Financial Reporting in Hyperinflationary Economies This Standard shall be applied to the financial statements.
even if the period is short Interest rates. 3. wages and prices are linked to a price index. the following: The general population prefers to keep its wealth in non-monetary assets or in a relatively stable foreign currency.100%. 5. Prices may be quoted in that currency. but are not limited to. and The cumulative inflation rate over three years is approaching. 1. or exceeds.Hyperinflationary Economies Hyperinflation is indicated by characteristics of the economic environment of a country which include. 2. Sales and purchases on credit take place at prices that compensate for the expected loss of purchasing power during the credit period. Amounts of local currency held are immediately invested to maintain purchasing power. The general population regards monetary amounts not in terms of the local currency but in terms of a relatively stable foreign currency. 8-38 . 4.
Inflation Accounting Internationally International Financial Reporting Standards IAS 29 includes guidelines for determining the environments where it must be used. Learning Objective 2 8-39 . Purchasing power gains and losses are included in net income. Income statement items are restated using a general price index from the time of the transaction. Nonmonetary assets and liabilities and stockholders’ equity are restated using 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. Other items in the statement of financial position are restated 8-40 . 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.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 money held and items to be received or paid in money.
generally reports costs current at the time at which the underlying transactions or events occurred.Statement of comprehensive income The current cost statement of comprehensive income. before restatement. 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. 8-41 . 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.
Where such a subsidiary is a foreign subsidiary. 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.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. 8-42 . its restated financial statements are translated at closing rates.
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: 8-43 .
1989 Opening Closing Assets Monetary assets Inventories Shares Depreciable assets Land Total Liabilities and Equities Liabilities Capital stock Retained earnings Total $100 80 50 200 50 480 $350 50 80 480 $110 100 50 180 50 490 310 50 130 490 8-44 . January 1. and December 31. Conventional Balance Sheet.Conventional Balance Sheet.
1989 Sales ………………………………. opening ………. For the year ended December 31. (20) interest on loans ……………(50) (270) Net income ……………………………. (500) Inventory. $800 Inventory. (80) Purchases ……………….50 8-45 ..... Conventional Income statement. (200) Depreciation………………. closing ………… 100 Cost of sales………………………… (480) Expenses………………….Conventional Income statement...
All the item in the statement are recorded at historical values . The opening inventory value and depreciation represent cost incurred before 1989. Sales. Therefore.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. The recorded value of the depreciable assets declined only by the nominal depreciation of $20. given that the company does not pay income tax. The retained earnings increased by $50 as determined by the conventional income statement. The net income of $50 is retained. purchases. land and capital stock did not change during the year. expenses and interest incurred during the year. the recorded nominal value of the shares. 8-46 .
1989 Conventional Assets Monetary assets Inventories Shares Depreciable assets Land Total Liabilities and Equities Liabilities Capital stock Retained earnings Total $100 80 50 200 50 480 $350 50 80 480 Restated 100 100 70 300 100 670 (Net (depreciated) value. January 1.) 350 200 120 (To balance) 670 8-47 .1.Restating the opening balance sheet Conventional and restated Balance Sheet.
inventories. The nonmonetary assets . do not require any restatement. receivables. which are stated in nominal money units. Assets: The monetary assets (cash.1. investment in bonds. etc. depreciable assets. shares. 1988) should be restated to December 1988 prices.Restating the opening balance sheet The individual items in the conventional opening balance sheet (December 31. 8-48 .). Because the nominal value represents the real value of the asset concerned. 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.
respective historical values) to $570 (100 + 70 + 300 + 100. Restatement Factor = Price index at end of analyzed period Price index at 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 restated values). 8-49 .Restatement Factor Restatement factor is used to inflate a given value in proportion to the inflation that has occurred since the recording date.
Therefore.Restating the opening balance sheet The liabilities and Equities The liabilities (payables. received loans. is restated. (670 .). do not require any restatement as the nominal value represents the real value of the liability concerned.1. The retained earnings item is not restated. that is.200 = $120) 8-50 .350 . which are monetary items and stated in nominal money units. The restatement is carried out by applying the corresponding restatement factor to each recorded capital stock transaction (equity addition) over the company's history. which has been issued in the past. it is derived by subtracting the liabilities and capital stock from the total restated assets. etc. the restated value equals the recorded value in the conventional statement. The capital stock.
Using the average price index for the restatement factor. such as investments or disinvestments in shares. or. The restatement of these items can be carried out in two ways : 1.2.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. These transactions should be restated to year-end prices. assuming that the transactions incurred more-orless evenly during the year 8-51 . and equity additions or withdrawals. 2. Applying the corresponding restatement factor to each recorded transaction. fixed assets.
assuming that the transactions incurred more-or-less evenly during the year Restatement Factor = Price index Dec.2.Dec. 1989 Average price index Dec.Restating Intra-Year Capital Transactions The restatement of these items can be carried out in two ways : 1. Applying the corresponding restatement factor to each recorded transaction. 1988 . 2. or. 8-52 . 1989 In our example there are no Intra-year capital transactions. Using the average price index for the restatement factor.
3. January 1. 1989 December 31.Restating the Closing Balance Sheet Conventional and restated Balance Sheet. 1989 Restated 1/1 Conventional Restated Assets Monetary assets Inventories Shares Depreciable assets Land Total Liabilities and Equities Liabilities Capital stock Retained earnings Total 100 100 70 300 100 670 350 200 120 670 $110 100 50 180 50 490 $310 50 130 490 110 110 84 328 120 752 310 240 202 (To balance) 752 8-53 .
derived from the conventional closing balance sheet.3. These items are treated according to the procedures outlined in restating the monetary assets in restating the opening Balance Sheet.Restating the Closing Balance Sheet The restated closing balance sheet la the result of adjusting data from three sources Monetary assets and liabilities . 8-54 .
. The restatement process inflated the value of the closing inventories from $100 to $110. These items are updated to yearend prices (we given that Inflation rate is 20%) .Restating the Closing Balance Sheet The restatement of Inventories can be carried out by applying the corresponding restatement factor to each recorded transaction in these Inventories over the Year.3. (Nondepreciable Assets) and capital stock derived from the opening restated balance sheet. land. Shares. 8-55 .
1988 Price Index Restatement factor Shares Land Capital stock 100 120/100 = 1. December 31. Example: Adjusted financial figures for December 31. as follows. Ill.2 70 100 200 December 31.Restating the Closing Balance Sheet Updating means translating figures from restated dollars for a given date in the past to dollars of purchasing power at a later date. 1989 are compared.3. 1989 120 120/120 = 1 84 120 240 8-56 . 1988 and December 31. using a restatement factor.
. the corresponding restated values are as follow : 8-57 . Given that there was neither investment nor disinvestment in these assets during 1989 and that the inflation rate was 20% during the year. involves the restatement of both assets value and depreciation expenses.3. to December 1989 prices.Restating the Closing Balance Sheet Depreciable assets: The treatment of depreciable assets. such as plant and equipment.
3.Restating the Closing Balance Sheet Opening $400 (100) Acquisition cost Less: Accumulated depreciation 1989's depreciation 300 Net (depreciated) value Closing $480 (120) (32) 328 The restated opening acquisition cost of $400 is updated to $480 in December 1989 prices (restatement factor of 1.2). 8-58 . and stated in December 1989 prices. The $32 depreciation for 1989 is derived from the restated acquisition cost.
. where the figures are stated in year-end prices.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. 1988 Prices Assets Less: Liabilities Equity Less: Opening equity Adjusted net income $670 (350) 320 Dec.2 restatement factor (given 20% inflation during 1989. The adjusted net income for the illustrative company in 1989 is calculated as follow :Opening Dec.4. 1989 Prices* $804 (420) 384 $752 (310) 442 (384) 58 8-59 Closing *December 1988 prices times 1.
This procedure provides improved information for planning and control purposes. but it is more cumbersome to apply and difficult to comprehend. following the above mentioned procedure. are presented as follow: 8-60 .5.Adjusting the Income Statement Adjustment of the conventional income statement can be carried out by restating all the items to year-end prices. The conventional income statement for 1989 and the adjusted statement.
opening Purchases Inventory. 1989 Conventional and fully Restated Sales Inventory. closing Cost of sales Expenses Depreciation Interest on loans Net income. retained Gain on net monetary position Adjusted net income Conventional $ 800 $(80) (500) 100 (480) (200) (20) (50) (270) 50 Restated * $880** $(120) (550) 110 (560) (220)** (32) (50) (302) 18 40 58 8-61 .Income Statement for the year ended December 31.
and Expenses are restated by using restatement factor 1. 1989 – 307 Nov. based on average price indexes for Dec. 1989 . Purchases.1. opening carried from the opening restated balance sheet and then Restated using the restatement factor 1. closing Inventory. 1989 – 320 Dec. Average Price Index An average price index for a given period should be used for restating values that are incurred evenly throughout the period.330 The average price index is : (310+320+330)/3 = 320 The corresponding restatement factor is 330/320 = 1. Sales. Example: Consider the following price indexes Oct. 8-62 . 1989 .2 (given 20% inflation in 1989).03125 Inventory.