How to Improve Operating Margins

Chapter 10

Accounting For Inflation

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Learning Objectives

•  Discuss the major methods of asset valuation. •  Describe the alternative units of measurement in

financial reporting. •  Describe the uses of financial report information. •  Describe the difference between monetary and

nonmonetary accounts.

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Complaints About Historical Cost •  In the late 1970s, the FASB issued a statement that

required the disclosure of the effects of inflation to be shown in supplementary schedules to the financial statements. –  As inflation slowed in the 1980s, the disclosures

were no longer required. –  However, the basic knowledge about reporting the

effects of changing prices (inflation) is still important and useful.

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Two Dimensions of Financial Reporting

•  Asset Valuation •  Measurement Unit

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Asset Valuation •  Cost Valuation is a primary principle of

accounting •  Two major alternative methods of cost valuation

exist –  Acquisition or historical cost –  Current or replacement cost

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Measurement Unit Alternatives •  Values will be reported in currency units (dollars) •  Two major alternative measurement units are

possible –  Nominal (unadjusted) dollars

•  No recognition of changes in purchasing power

– Constant Dollars •  Purchasing power changes are recognized

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Monetary VS. Non Monetary

•  Monetary Items –  Cash or claims to cash that are fixed –  Changes in purchasing power will not affect

reported value •  A mortgage for $1,000,000 still requires payment of

$1,000,000

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•  Non Monetary items –  Changes in purchasing power will impact reported

amounts

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Monetary VS. Non Monetary

Adjusting for Purchasing Power Changes – Monetary Items Example Purchasing Power Index Unadj. Hist. Cost Purchasing Power Adj. Cost

100.0 $1,000 $1,000 110.0 1,000 1,000 121.0 1,000 1,000 133.1 1,000 1,000

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Monetary items are fixed in dollars and reported values do not change.

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Adjusting for Purchasing Power Changes – Non Monetary Items Example

Purchasing Power Index Unadj. Hist. Cost Purchasing Power Adj. Cost 100.0 $1,000 $1,000 110.0 1,000 1,100 121.0 1,000 1,210 133.1 1,000 1,331

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PP Adj Cost =

Current PP Index Acquisition PP Index Unadj Hist Cost x

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Four Alternative Financial Reporting Methods

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

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Historical Cost/Nominal Dollars (HC)

•  The historical cost/nominal dollar method is the most popular approach to income measurement and is the primary method under GAAP. –  This method measures invested capital in nominal

dollars. –  No income appears until an asset is sold, and price

fluctuations are ignored.

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Current Cost/Nominal Dollars (CV)

•  The focus of the current cost/nominal dollar method is on income from continuing operations. –  The current cost method reports only the profit available

after replacing any physical capital expended in operations for the period.

–  This method requires subjective assessments of cost valuation.

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Historical Cost/Constant Dollars (HC-GPL) •  With this method, the income measurements in each year

are restated in terms of constant dollars, which have the same purchasing power of the current year, instead of nominal dollars, which have different purchasing powers of various years. –  Because of inflation, dollars spent or received in a

subsequent year have a different value than dollars spent or received in the base year.

–  Constant-dollar accounting measures all items on the financial statements (including items from previous years) in current dollars using a general price index.

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•  General price index - an index that compares the average price of a group of goods and services at one date with the average price of a similar group at another date

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General Price Index

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Current Cost/Constant Dollars (CV-GPL) •  With this method gains and losses from charges in

prices are recognized prior to sale. •  The gains and losses are adjusted for charges in

general purchasing power.

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Impact of Reporting Methods on Net- Income

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

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Recognizing Purchasing Power Gains/ Losses

•  Only done in Financial Reporting Methods that report transactions in constant (general price level adjusted) dollars

•  Holding debt during a period of inflation produces a purchasing power gain

•  Holding cash during a period of inflation produces a purchasing power loss

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Purchasing Power Gain Example Unadjusted 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

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-Ending PI = 315.5 -Beginning PI = 303.5 -Midpoint PI = 309.5 19

Purchasing Power Loss Example Unadjusted Conversion

Factor Constant Dollars

Beg. Accounts Receivable $217 315.5/303.5 $226

+ Additions 32 315.5/309.5 33

Ending Accounts Receivable $249 $259

-Actual Ending A/R $249

Purchasing Power Loss $10

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Depreciation Expense Impact-Example Facts •  Acquisition Cost $10,000 (PI = 100.0) •  Est. Life 5 Years •  PI (at Year End) 110 •  Replacement Cost $12,000 (at Year End) Depreciation Expense under Alt. Reporting HC - $10,000/5 = $2,000 HC-GPL - [$10,000 x 110/100] / 5 = $2,200 CV-GPL - $12,000 / 5 = $2,400

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Unrealized Gains in Replacement Value- Example

HC HC-GPL CV CV-GPL

Beg. Cost Valuation $10,000 $10,000 $10,000 $10,000

End Cost Valuation 10,000 11,000 12,000 12,000

Deprec. Exp. 2,000 2,200 2,400 2,400

End Reported Cost Net of

Depreciation $8,000 8,800 9,600 9,600

Ending Cost Basis After

Depreciation 8,000 8,800 8,000 8,800

Gain/Loss 0 0 1,600 800

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Summary •  In periods of inflation or deflation unadjusted

historical cost accounting measured in nominal dollars can be seriously flawed.

•  Using unadjusted historical cost accounting but reporting in constant dollars (HC-GPL) can remove most of the distortions with no sacrifice in objectivity.

•  Methods that rely on current values (CV and CV- GPL) may introduce subjectivity in asset valuation.

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