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Inflation accounting

Inflation accounting. All countries have inflation in their currencies. Even if relatively modest, this inflation will eventually distort historical values. A 5% inflation rate will halve the value of a currency in 15 years.

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Inflation accounting

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  1. Inflation accounting

  2. All countries have inflation in their currencies. Even if relatively modest, this inflation will eventually distort historical values. • A 5% inflation rate will halve the value of a currency in 15 years. • This means the historic values of items will be distorted over a long term. • Using the historic rates of items acquired over time implies the false assumptions of homogeneous currency and additivity.

  3. This problem was addressed in the 1970’s in the US. • Inflation soared to higher than 12%. • Inflation adjusted financial statements were required as a supplement to the financial statements. • No longer required in 1985. • Currently only countries that have high historic inflation rates use these.

  4. Types of inflation adjusted models • General Price Level Adjusted (GPLA) • Current Cost Adjusted (CCA)

  5. General Price Level Adjusted (GPLA) • Changes in General purchasing power over time • Uses index measures of inflation • Procedures • start with historical cost financial statements • designate all items monetary or non monetary • adjust non monetary items for inflation • numerator CPI at the financial statement date • denominator is CPI on purchase date • for income statement most income and expense items average CPI • compute net monetary gain or loss on income statement p. 89 • Retained Earnings is plug

  6. Problems with this model • a general index does not take into account specific price changes • companies have baskets of items that differ from the CPI basket

  7. Current Cost Adjusted (CCA) • Here money has no inherent value, it is a medium of exchange only • Physical assets are the measure of income and wealth • (S)he who dies with the most toys wins! • This is very intuitive and reasonable • It will, however, drive you insane!!

  8. The Republic of ScortiaConsumer Price Index

  9. The Cudo CompanyIncome StatementFor the year ended December 30, 1999

  10. The Cudo CompanyCost of Goods Sold ScheduleFor the year ended December 31, 1999

  11. The Cudo CompanyBalance sheetDec. 31, 2001

  12. Loss on Cash and Cash Equivalents PPLME = ΔCPI(bCCE + eCCE)/2 Where PPLME = purchasing power loss on cash and cash equlivalents ΔCPI = Change in the consumer price index for the year. bCCE = the beginning cash and cash equlivalents eCCE = Ending cash and cash equlivalents. Therefore: PPLME = [(584/450)-1] * ($135,000 + $105,000)/2 = $35,733

  13. Purchasing Power Gain on Monetary Liabilities PPGML = ΔCPI(bML + eML)/2 Where PPLML = purchasing power gain on monetary liabilities ΔCPI = Change in the consumer price index for the year. bML = the beginning monetary liabilities eML = Ending monetary liabilities.  PPGML = [(584/450)-1] * ($375,000 + $385,000)/2 = $56,578

  14. Purchasing Power Gain <Loss> Putting these two equations together we have: PPG = PPGML - PPLMC = $56,578 – 35,733 = $20,845

  15. Real Interest Paid Interest expense $84,720 Less PPG 20,285 Risk adjusted Real interest expense $64,435

  16. The Cudo CompanyBalance Sheet12/31/1999

  17. The Cudo CompanyBalance Sheet

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