Chapter 10. Accounting For Inflation. 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.
Accounting For Inflation
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.
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.
Cost Valuation is a primary principle of accounting
Two major alternative methods of cost valuation exist
Values will be reported in currency units (dollars)
Two major alternative measurement units are possible
Non Monetary items
Monetary items are fixed in dollars and reported values do not change.
PP Adj Cost =
Current PP Index
Acquisition PP Index
Unadj Hist Cost x
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.
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.
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.
General price index Items Example- 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
General Price Index
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.
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
-Ending PI = 315.5
-Beginning PI = 303.5
-Midpoint PI = 309.5
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
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.