Financial Ratios Analysis and Comparison Paper
Chapter 10 Accounting for Inflation LEARNING OBJECTIVES After studying this chapter, you should be able to do the following: 1. Discuss the major types of asset valuation. 2. Describe the alternative units of measurement in financial reporting. 3. Define the major financial reporting alternatives. 4. Describe the uses of financial report information. 5. Describe the difference between monetary and nonmonetary accounts. REAL-WORLD SCENARIO Lydia Renee is the CEO of a large metropolitan hospital that has come under recent attacks from the local press regarding profit levels at her hospital. Last year Lydia’s hospital earned more than $10 million, which was described in the local press as “obscene” because the hospital is tax exempt. Lydia tried to explain that all the earnings for the hospital were earmarked for future investment and replacement of physical facilities, but the local reporter was adamant about profiteering at Lydia’s hospital. Lydia’s CFO, William Olin, has told her that the need for profit is directly related to the existence of inflation in the cost of plant and equipment that the hospital needs to purchase. For example, a new digital mammography unit was recently acquired for $750,000 to replace an older unit acquired 5 years ago for $350,000. The hospital recognized historical cost depreciation on this older mammography unit of $70,000 per year ($350,000/5), but the real replacement cost of the equipment was much larger. Mr. Olin showed Lydia that firms with heavy investments in plant and equipment such as hospitals must make positive profits because the historical accounting costs of depreciation grossly understate true replacement costs. Mr. Olin then recast the hospital’s financial statements using the principles of “constant purchasing power accounting” to demonstrate that the hospital actually incurred a modest loss of $1,000,000 in the most recent year. Lydia understands the nature of the purchasing power adjustments that Mr. Olin has made but is seeking a way to communicate this in a clear manner to the local press. To adjust for the effects of changing price levels, the Financial Accounting Standards Board (FASB) has issued a number of pronouncements over the last 35 years. In September 1979 the FASB issued Statement 33, which required large public enterprises to provide supplemental information on the effects of changing price levels in their annual financial reports. In particular, Statement 33 required firms to disclose primarily current cost and constant dollar earnings; certain other income statement items; and current cost of inventory, property, plant, and equipment in notes to the financial statements. This was a major step for the FASB and represented for the first time that firms were required to report price-level effects in their financial reports. In 1986, when the inflation rate had subsided to less than 5%, the FASB substantially modified its initial position set forth in Statement 33 with the publication of Statement 89. This pronouncement left much of Statement 33 intact, except that it designated the reporting as voluntary. Consequently, most publicly traded companies stopped disclosing inflation-adjusted earnings. In Statement 89 business enterprises were encouraged, but not required, to report supplementary information on the effects of changing prices in the following areas for the most recent 5 years: • Net sales and operating revenues, using constant purchasing power • Income from continuing operations on a current cost basis • Purchasing power gains or losses from holding monetary items • Increases in specific prices of net plant, property, and equipment net of inflation • Foreign currency translation adjustments on a current cost basis • Net assets (assets less liabilities) on a current cost basis • Income per common share from continuing operations on a current cost basis • Cash dividends per common share • Market price per common share at year end The rationale for these changes in financial reporting stems from the inaccuracy and inability of present historical cost reporting to measure financial position accurately in an inflation-riddled economy. Although the U.S. inflation rate has been low in recent years, inflationary pressures can increase at any time and will never be removed entirely. Many countries around the world still experience high inflation. Mexico and Brazil have required some accounting inflationary adjustments for over 20 years. Furthermore, some analysts expect a worldwide shortage of energy sources by 2020, which might lead to a long-term increase in inflation rates. Thus, inflation accounting will continue to be relevant. Most people understand the effects that general inflation has on their purchasing power, and they realize that a dollar of 1997 is not equivalent to a dollar in 2007. Most of us will intuitively make price-level adjustments to account for differences. A person who had a salary of $50,000 in 1997 and a salary of $50,000 in 2007 knows that their overall financial position has eroded because of increases in the Consumer Price Index (CPI). The accounting profession’s task is to make its financial statement adjustments easy to understand by most people who use and rely on these statements as scorecards of business success. The major purpose of this chapter is to discuss and describe the major alternatives for reflecting the effects of inflation in financial statements. Specific methods are described, and the adjustments that need to be made to convert historical cost statements are illustrated. This discussion should provide a basis for understanding and using financial statements that have been adjusted for inflation. LEARNING OBJECTIVE 1 Discuss the major types of asset valuation. REPORTING ALTERNATIVES Methods of financial reporting can be categorized using two dimensions: the method of asset valuation and the unit of measurement. In Chapter 8 we discussed five major principles of accounting, two of which are cost valuation and a stable monetary unit. When historical cost values do not change and inflation or deflation does not exist, accountants can feel very comfortable using unadjusted historical cost as the method for valuing assets acquired by the firm. If asset values do change or the monetary unit is not stable, then alternative asset valuation rules may be needed. Two alternative methods of asset valuation are acquisition (or historical) cost and current (or replacement) value. Asset valuation at acquisition cost means that the value of the asset is not changed over time to reflect changing market values. Amortization of the value may take place, but the basis is the acquisition cost. Depreciation is recorded, using the acquisition (historical) cost of the asset. Use of an acquisition cost valuation method postpones the recognition of gains or losses from holding assets until the point of sale or retirement. Current valuation of assets revalues the assets in each reporting period. The assets are stated at their current value rather than their acquisition cost. Likewise, depreciation expense is based on the current value, not the historical cost. Current valuation recognizes gains or losses from holding assets before sale or retirement. If it was easy to obtain objective measures of current asset values, all assets would be restated to current value, but in many cases objective measures of current value may not be obtainable. LEARNING OBJECTIVE 2 Describe the alternative units of measurement in financial reporting. There are also two major alternative units of measurement in financial reporting: nominal (unadjusted) dollars and constant dollars measured in units of general purchasing power. Use of a nominal dollar unit of measurement simply means that the attribute being measured is the number of dollars. From an accounting perspective, a dollar of one year is no different from a dollar of another year. No recognition is given to changes in the purchasing power of the dollar because purchasing power is not measured. The major outcome associated with the use of this measure unit is that gains or losses, regardless of when they are recognized, are not adjusted for changes in purchasing power. For example, if a piece of land that was acquired for $1 million in 1987 sold for $3 million in 2007, it would have generated a $2 million gain, regardless of changes in the purchasing power of the dollar during the 20-year period. A constant dollar measuring unit reports the effects of all financial transactions in terms of constant purchasing power. The unit that is usually used is the purchasing power of the dollar at the end of the reporting period or the average during the fiscal year. The measurement is made by multiplying the unadjusted, or nominal, dollars by a price index to convert to a measure of constant purchasing power. During periods of inflation, when using a constant dollar measuring unit, gains from holding assets are reduced, whereas losses are increased. Thus, in the previous land sale example, the initial acquisition cost would be restated to 2007 purchasing power units to reduce the gain in Exhibit 10-1. Because the CPI increased from 114.4 in 1987 to 202.4 in 2007, we restate the 1987 cost by the conversion factor (202.4/114.4, or 1.769). Exhibit 10-1 Restatement of Land Cost Unadjusted historical cost Sale of land in 2007 (CPI = 202.4) $3,000,000 Purchase of land 1987 (CPI = 114.4) $1,000,000 Unadjusted gain on sale $2,000,000 Purchasing power cost Sale of land in 2007 (CPI = 202.4) $3,000,000 Conversion factor (CPI 2007/CPI 1987) 1.769 Restated cost of land $1,769,000 Adjusted gain on sale $1,231,000 Constant dollar measurement has a further significant effect on financial reporting: The gains or losses created by holding monetary liabilities or monetary assets during periods of purchasing power changes are recognized in the financial reporting. Monetary assets and liabilities are defined as those items that reflect cash or claims to cash that are fixed in terms of the number of dollars, regardless of changes in prices. Almost all liabilities are monetary items, whereas monetary assets consist primarily of cash, marketable securities, and receivables. Purchasing power gains or losses are recognized on monetary items because there is an assumption that the gains or losses are already realized, because repayments or receipts are fixed. For example, an entity that owed $25 million during a year when the purchasing power of the dollar decreased by 10% would report a $2.5 million (0.10 × $25 million) purchasing power gain. All gains or losses would be recognized, regardless of the asset valuation basis used. LEARNING OBJECTIVE 3 Define the major financial reporting alternatives. The interfacing of the valuation basis and the unit of measurement basis produces four alternative financial reporting methods (Table 10–1). Each of the four methods is a possible basis for financial reporting. The unadjusted historical cost (HC) method represents the present method used by accountants; the other three methods are alternatives that provide some degree of inflationary adjustment not present in the HC method. The HC-general price level adjusted (HC-gPL) method is often referred to as constant dollar accounting, whereas the current value-general price level adjusted (Cv-gPL) method is referred to as current cost accounting. Table 10-1 Alternative Financial Reporting Bases Asset Valuation Method Unit of Measurement Acquisition Cost Current Value Nominal dollars Unadjusted historical cost (HC) Current value (CV) Constant dollars Historical cost-general price level adjusted (HC–GPL) Constant dollar accounting Current value-general price level adjusted (CV–GPL) Current cost accounting Table 10–2 summarizes the effects the four reporting methods would have on the three critical income statement items: depreciation expense, purchasing power gains or losses, and unrealized gains in replacement values. Table 10-2 Major Effect of Alternative Reporting Methods on Net Income Measurement Impact Variables Reporting Methods Depreciation Expense Purchasing Power Gains/Losses Unrealized Gains in Replacement Value HC No change No change/not recognized No change/not recognized HC-GPL Increase/GPL depreciation recognized Gain or loss/depends on the net monetary asset position No change/not recognized CV Increase/will recognize replacement cost No change/not recognized Gain/will recognize increase in replacement cost CV-GPL Increase/will recognize current replacement cost Gain or loss/depends on the net monetary asset position Gain/will recognize increase in replacement cost but will reduce amount by changes in the GPL LEARNING OBJECTIVE 4 Describe the uses of financial report information. USES OF FINANCIAL REPORT INFORMATION The measurement of financial position is an important function, and its results are useful to a great variety of decision makers, both internal and external to the organization. Changes in financial reporting methods unquestionably alter the resulting measures of financial position reported in financial statements. These changes are likely to produce changes in the decisions that are based on the financial reports (Figure 10–1). Figure 10-1 Financial Data in Decision Making Lenders represent an important category of financial statement users who may change their decisions on the basis of a new financial reporting method. The lender’s major concern is the relative financial position of both the individual firm and the industry. A decrease in the relative financial position of the industry could seriously affect both the availability and the cost of credit. If, for a variety of reasons, new measurements of financial position make the healthcare industry appear weaker than other industries, financing terms could change. Particularly for the healthcare industry, which is increasingly dependent on debt financing, the importance of changes in financial reporting methods cannot be overstated. Research on the results of changing to an HC-GPL or constant dollar accounting method has shown that the relative financial positions of individual firms and industries are also likely to change. Changes in financial reporting methods also could have an effect on decisions reached by regulatory and rate-setting organizations. As a result of such changes, comparisons of costs across institutions may be more meaningful than they were previously. For example, depreciation in firms that operate in relatively new physical plants cannot be compared with the unadjusted historical depreciation costs of older facilities. Without financial reporting adjustments, new facilities may appear to have higher costs and thus be less efficient, whereas, in fact, the opposite may be true. The actions of interested community leaders who have access to and make decisions based on financial statements also might be affected by reporting method changes. For example, suppose that individual, corporate, and public agency giving is in part affected by reported income. Many, in fact, regard reported income as a basic index of need, and the relationship between income and giving seems logical. Thus, because each of the alternative financial reporting methods we discussed produces a different measure of income, total giving in each case could be affected. Internal management decisions also might change with a new financial reporting method. Perhaps the most obvious example of such a change is rate setting. Organizations that have control over pricing decisions and are not reacting to market-determined prices should set prices at levels at least high enough to recover their costs. The use of any of the three alternative methods of reporting increases reported cost levels and therefore increases rates. CASE EXAMPLE: WILLIAMS CONVALESCENT CENTER In the remainder of this chapter we show how adjustments are made in the income statement and balance sheet of Williams Convalescent Center, a 120-bed skilled and intermediate care facility, to take into account the effects of inflation. The center’s two financial statements are shown in Table 10–3 and 4. Note that values are reported for each of the following three reporting methods: HC, HC-GPL, and CV-GPL. In this discussion we do not describe or apply the CV method. The accounting profession presently is not seriously considering this method, and it is not likely to be considered in the future. The CV method suffers from a serious flaw: It does not recognize the effects of changing price levels on equity. In short, the CV method treats increases in the replacement cost of assets as a gain and does not restate them for changes in purchasing power. Table 10-3 Statement of Income for Williams Convalescent Center (000s Omitted) HC 20Y4 Constant Dollar (HC-GPL) 20Y4 Current Cost (CV-GPL) 20Y4 Operating revenue $3,556 $3,625 $3,625 Operating expenses 3,253 3,316 3,316 Depreciation 74 164 185 Interest 102 104 104 Net income $127 $41 $20 Purchasing power gain from holding net monetary liabilities during the year — $43 $43 Increase in specific prices of property, plant, and equipment during the year — — $136 Less effect of increase in general price level — — $144 Increase in specific prices over (under) increase in the general price level — — ($8) Change in equity due to income transactions $127 $84 $55 Table 10–5 presents values for the CPI, the price index presently used by the accounting profession to adjust financial statements for the effects of inflation. Price Index Conversion Both methods we selected to adjust the financial statements of the Williams Convalescent Center (CV-GPL and HC-GPL) use purchasing power as the unit of measurement. This means that unadjusted dollars are not the measurement unit for reporting accounting transactions and that all reported values in the financial statements are expressed in dollars of a specified purchasing power. Usually, the purchasing power used is the period end value. In our case example Williams Convalescent Center uses purchasing power as of December 31, 20Y4, as its unit of measurement. This means we restate all accounts to a purchasing power of 315.5, the CPI value at 20Y4. Table 10-5 Consumer Price Index, Year-End Values Year CPI 19X0 119.1 19X1 123.1 19X2 127.3 19X3 138.5 19X4 155.4 19X5 166.3 19X6 174.3 19X7 186.1 19X8 202.9 19X9 229.9 20Y0 258.4 20Y1 283.4 20Y2 292.4 20Y3 303.5 20Y4 315.5 Restatement of nominal or unadjusted dollars to constant dollars is a relatively simple process, at least conceptually. All that is required are the following three pieces of information: 1. The unadjusted value of the account in historical or nominal dollars 2. A price index that reflects the purchasing power in which the unadjusted value is currently expressed 3. A price index that reflects the purchasing power at the date the account is to be restated For example, Williams Convalescent Center’s long-term debt at December 31, 20Y3, is $1,203 (see Table 10–4). To express that amount in constant dollars as of December 31, 20Y4, the following adjustment would be made: Table 10-4 Balance Sheet for Williams Convalescent Center (000s Omitted) HC 20Y3 20Y4 Constant Dollar (HC-GPL) 20Y4 Current Cost (CV-GPL) 20Y4 Current assets Cash $98 $21 $21 $21 Accounts receivable 217 249 249 249 Supplies 22 27 27 27 Prepaid expenses 36 36 36 36 Total current assets $373 $333 $333 $333 Property and equipment Land 200 200 530 525 Building and equipment 2,102 2,228 4,948 5,570 2,302 2,428 5,478 6,095 Less accumulated depreciation 783 844 1,874 2,186 Investments 161 596 596 596 Total assets $2,053 $2,513 $4,533 $4,838 Current liabilities 412 493 493 493 Long-term debt 1,203 1,478 1,478 1,478 Partner’s equity 438 542 2,562 2,867 $2,053 $2,513 $4,533 $4,838 Unadjusted amount × 20Y4 CPI/20Y3 CPI or $ 1 , 203 × 315.5 303.5 = $ 1 , 251 The value of the beginning long-term debt for the center would be $1,251, expressed in purchasing power as of December 31, 20Y4. The previously described adjusted method is the same for all other accounts. The price index to which the conversion is made is usually the price index at the ending balance sheet date (December 31, 20Y4, in our example). The price index from which the conversion is made represents the purchasing power in which the account is currently expressed. This value varies depending on the classification of the account as either monetary or nonmonetary. LEARNING OBJECTIVE 5 Describe the difference between monetary and nonmonetary accounts. Monetary Versus Nonmonetary Accounts When restating financial statements from one based on an HC method to one based on a constant dollar method, it is critical to distinguish between monetary accounts and nonmonetary accounts. Monetary accounts are automatically stated in current dollars and therefore require no price-level adjustments. Monetary items, discussed earlier in this chapter, consist of cash, claims to cash, or promises to pay cash that are fixed in terms of dollars, regardless of price-level changes. Nonmonetary accounts require price-level adjustments to be stated in current dollars. Because of the fixed nature of monetary items, holding them during a period of changing price levels creates a gain or loss. For example, if a firm holds cash during a period of inflation, the firm will experience a monetary loss because the purchasing power of the cash has eroded over the holding period. Conversely, if a firm has a monetary liability during a period of inflation, it will experience a gain because it will repay the liability with dollars of a lower purchasing power; n constant dollar accounting purchasing power is the unit of measurement, not unadjusted dollars. This can be seen in Table 10–6, which includes data from the Williams Convalescent Center. The data in Table 10–6 assume that a repayment of long-term debt and new issue occurred at the midpoint of the year, June 30, 20Y4. The price index at that point would have been approximately 309.5. This resulted from taking the average of the beginning and ending values (303.5 + 315.5) ÷ 2. In constant dollars the Williams Convalescent Center would have reported $1,531 of long-term debt as of December 31, 20Y4. However, the actual value of the long-term debt at that date was $1,478. The difference of $53 represents a purchasing power gain to the center during the year. Because the price level increased during 20Y4, the value of the long-term debt actually owed by the center declined when measured in constant purchasing power. Nonmonetary asset accounts must be restated to purchasing power as of the current date. The price index at the time of acquisition represents the price index from which the conversion is made. The price index at the current date represents the index to which the conversion is made. To illustrate the adjustment, assume that the building and equipment account of the Williams Convalescent Center has the age distribution presented in Table 10–7. Table 10-6 Computation Purchasing Power Gains and Losses (000s Omitted) Unadjusted Historical Dollars Conversion Factor Constant Dollars Beginning long-term debt (12/31/Y3) $1,203 315.5/303.5 $1,251 –Repayment (6/30/Y4) 152 315.5/309.5 155 +New debt (6/30/Y4) 427 315.5/309.5 435 Ending long-term debt (12/31/Y4) $1,478 $1,531 –Actual ending long-term debt (12/31/Y4) $1,478 Purchasing power gain $53 The data in Table 10–7 show that assets with a historical cost of $2,228 represent $4,948 of cost when stated in dollars as of December 31, 20Y4. The latter value is much more meaningful than the former as a measure of actual asset cost in 20Y4. It provides the center with a measure of cost that is expressed in dollars as of the current date and thus better represents its actual investment. Depreciation expense also should be restated in 20Y4 dollars to accurately portray the center’s actual cost of using its building and equipment in the generation of current revenues. Table 10-7 Restatement of Nonmonetary Assets Year Acquired Cost Conversion Factor Constant Dollar Cost (12/31/Y4) 19X0 $1,500 315.5/119.1 $3,974 19X8 401 315.5/202.9 624 20Y1 201 315.5/283.4 224 20Y4 126 315.5/315.5 126 $2,228 $4,948 Adjusting the Income statement Operating Revenues If one assumes that revenues are realized equally throughout the year, the restatement is significantly simplified. If the assumption is valid––and in most cases it is––it means that the revenues can be considered realized at the midpoint of the year, in our case June 30, 20Y4. As already noted, the price index at June 30, 20Y4, can be assumed to be the average of the beginning and ending price index, or 309.5. The restated operating revenue is calculated as follows: Operating revenues × 20Y4 CPI ÷ 20Y4 mid-year CPI or $3,556 × 315.5 ÷ 309.5 = $3,625 Operating Expenses Based on the same assumption that we used with operating revenues, the adjustment for operating expenses is as follows: $3,253 × 315.5 ÷ 309.5 = $3,316 Operating expenses do not include depreciation or interest. Separate adjustments for these two items may be required. Depreciation The depreciation expense adjustment is different from the earlier adjustments in two ways. First, depreciation expense represents an amortization of assets purchased over a long period, usually many years. This means that the midpoint conversion method used for operating revenues and operating expenses is clearly not appropriate. Second, the adjustment methods for the HC-GPL or constant dollar and CV-GPL or current cost methods diverge. Depreciation expense may vary considerably because the current cost of the assets may differ dramatically from the constant dollar cost. Remember, a price index represents price changes for a large number of goods and services; specific price changes of individual assets may vary significantly from that index. For example, the general price level may have increased 20% in the last 5 years, but the cost of a specific piece of equipment may have increased 50% during the same period. Constant Dollar Adjustment We estimate the depreciation expense value for Williams Convalescent Center under the constant dollar method by using the relationship of constant dollar buildings and equipment cost in Table 10–7 to historical cost. This gives us a multiplier of restated cost to historical cost that we can then apply to historical cost depreciation. The multiplier from Table 10–7 is calculated as follows: Constant dollar cost Historical cost = $ 4 , 948 / $ 2 , 228 = 2.221 We then multiply this factor times the historical depreciation expense of $74 to yield a constant dollar depreciation expense of $164. Current Cost Adjustment The identification of the current cost of existing physical assets is a subjective and complex process. To many individuals the current cost method provides little additional value compared with the constant dollar method. Whether it will be eventually eliminated and replaced by the constant dollar method is not clear at this time. The first issue to address is the definition of current cost. By and large, current cost can be equated to the replacement cost of the assets. In short, we must determine what the cost of replacing assets in today’s dollars would be. This could be estimated through a variety of techniques using, for example, insurance appraisals or specific price indexes. In the case of Williams Convalescent Center, we assume that a recent insurance appraisal indicated a replacement cost of $5,570 for buildings and equipment. With this estimate, depreciation expense could be adjusted as follows: Appraisal cost Historical cost × Depreciation expense = Restated depreciation expense or $ 5 , 570 $ 2 , 228 × $ 74 = $ 185 Interest Expense We again assume that interest expense is paid equally throughout the year. This assumption produces the following interest expense adjustment: $102 × 315.5 ÷ 309.5 = $104 Purchasing Power Gains or Losses A purchasing power gain results if one is a net debtor during a period of increasing prices, whereas a purchasing power loss results if one is a net creditor during such a period. In most healthcare firms, purchasing power gains result because liabilities exceed monetary assets. A firm is thus paying its debts with dollars that are of less value than the ones it received. To calculate purchasing power gains or losses, net monetary asset positions must first be calculated. The net monetary position for Williams Convalescent Center is presented in Table 10–8. The actual calculation of the purchasing power gain for Williams Convalescent Center is presented in Table 10–9. Because the center was in a net monetary liability position during the year, it experienced a purchasing power gain of $43. This value is not an element of net income; rather, it is shown below the net income line in Table 10–3. It thus affects the change in equity. Table 10-8 Net Monetary Asset Schedule Beginning (12/31/Y3) Ending (12/31/Y4) Monetary assets Cash $98 $21 Accounts receivable 217 249 Prepaid expenses 36 36 Investments 161 596 Total monetary assets $512 $902 Monetary liabilities Current liabilities $412 $493 Long-term 1,203 1,478 Total monetary liabilities $1,615 $1,971 Net monetary assets ($1,103) ($1,069) Increase in Specific Prices Over General Prices The adjustment to consider—an increase in specific prices over general prices––is made only in the current cost method. The constant dollar method does not recognize any increases (or reductions) in prices that are different from the general price level. In short, no gains or losses from holding assets are permitted in the constant dollar method. The calculations involved in this adjustment can be complex. In our Williams Convalescent Center example, we make some assumptions to simplify the arithmetic without impairing the reader’s conceptual understanding of the adjustment. We assume the following data: Insurance appraisal of buildings and equipment, 12/31/Y3: $5,015 Insurance appraisal of buildings and equipment, 12/31/Y4: $5,570 Appraised value of land, 12/31/Y3: $500 Appraised value of land, 12/31/Y4: $525 New equipment bought on 12/31/Y4: $126 Table 10–10 shows the increase in specific prices over general prices. These data show that, during 20Y4, the value of physical assets held by Williams Convalescent Center did not increase more than the general price level. In fact, there was an $8,000 decline in the specific prices of assets held by the firm when compared with the increase in general price level during the year. This may be a positive sign for the center if it is not contemplating a sale. The replacement cost for its assets is increasing less than the general price level. Therefore, revenues could increase less than the general price level and replacement could still be ensured. Adjusting the balance sheet Monetary Items None of the monetary items—cash, accounts receivable, prepaid expenses, investments, current liabilities, or long-term debt––requires adjustment. The values of these items already reflect current dollars. Land In our discussion of the increase in specific prices over the general price level in the Williams Convalescent Center’s income statement, we assumed an appraisal value for land of $525. That value is used here with the current cost method. With the constant dollar method, we assume that the land was acquired in 19X0 for $200. To restate that amount to purchasing power as of December 31, 20Y4, the following calculation is made: $200 × 315.5 ÷ 119.1 = $530 Buildings and Equipment Values for the center’s buildings and equipment and the related accumulated depreciation already have been cited for the current cost method. We assume those same values here. This produces a value for buildings and equipment of $5,570 (000s omitted) based on an appraisal. The value for accumulated depreciation was derived as follows: = Adjusted accumulated depreciation Unadjusted accumulated depreciation × Appraisal value − Current year acquisitions Historical cost − Current year acquisitions = or $ 2 , 186 = $ 844 × ( $ 5 , 570 − $ 126 ) ( $ 2 , 228 − $ 126 ) Table 10-9 Purchasing Power Gain (Loss) Schedule Actual Dollars Factor Conversion Constant Dollars Beginning net monetary liabilities $1,103 315.5/303.5 $1,147 –Decrease 34 315.5/309.5 35 Ending net monetary liabilities $1,069 $1,112 –Actual $1,069 Purchasing power gain $43 Table 10-10 Increase in Specific over General Prices Schedule Building and Equipment Land Total Ending appraised value less acquisitions of $126 $5,444 $525 $5,969 –Accumulated depreciation on appraised value 2,186 0 2,186 Ending net appraised value $3,258 $525 $3,783 Beginning appraised value $5,015 $500 $5,515 –Accumulated depreciation on appraised value 1,868 — 1,868 Beginning net appraised value $3,147 $500 $3,647 Beginning net appraised value restated for general price level (315.5/303.5) $3,791 Increase in specific prices over general price level ($3,783 less $3,791) ($8) Equity Equity calculations are not discussed in any detail here. It is enough for our purposes to recognize that equity is a derived figure. Equity must equal total assets less liabilities. In our Williams Convalescent Center example, this generates values of $2,562 for the constant dollar method and $2,867 for the current cost method. SUMMARY Financial reporting suffers from its current reliance on the HC valuation concept. Inflation has made many of the reported values in current financial reports meaningless to decision makers. The example used in this chapter illustrates this point. The total asset investment of Williams Convalescent Center is approximately 100% larger when adjusted for inflation under the current cost or constant dollar method. Net income, however, decreased. The result is a dramatic deterioration in return on investment––the single most important test of business success.
Table 10–11 summarizes