Chapter 8 Accounting for Changes prices (Inflation Accounting)
Additional Financial Reporting Issues Chapter Topics • Inflation accounting – general purchasing power and current cost accounting approaches. • Inflation accounting – differences in standards worldwide.
Additional Financial Reporting Issues Learning Objectives 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.
Introduction • conventional accounting results in a mix of attributes being reflected in the asset section of the balance sheet . • Accounts receivable are reported at the net amount expected to receive in the future. • Inventory is carried at the lower of cost or market value. • Short-term investments are reported either cost or current market value . • Property, plant and equipment is reported at cost less accumulated depreciation
Introduction • Price of most assets fluctuate, often increasing . • Reporting assets on the balance sheet at their historical cost during a period of price changes can make the balance sheet information irrelevant. • For example, reporting land was purchased in 1940 in the historical cost at $1000 (irrelevant)
Inflation • inflation is a rise in the general level of prices of goods and services in an economy over a period of time. • inflation is also an erosion in the purchasing power of money . • A chief measure of price inflation is the inflation rate, the annualized percentage change in a general price index
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. • 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.
Measure of Inflation • Inflation is usually estimated by calculating the inflation rate of a price index, usually the general price level . • 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.
Measure of Inflation • For instance, in January 2007, the U.S. general price level was 202.416, and in January 2008 it was 211.080. The formula for calculating the annual percentage rate inflation in the general price level over the course of 2007 is: • The resulting inflation rate for the general price level in this one year period is 4.28%, meaning the general level of prices for typical U.S. consumers rose by approximately four percent in 2007 ) ( 211.080 – 202.416 = 4.28% 202.416
Inflation Accounting – Conceptual Issues Impact of inflation on financial statements • Understated asset values. • 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
Inflation Accounting – Conceptual Issues • Overstated income and overpayment of taxes. • Understated assets result in understated expenses (depreciation and COGS) • This lead to overstated income, thus more taxes paid and stockholders demand a higher level of dividends. • That may result in high cash outflows so lead to liquidity problems Learning Objective 1
Inflation Accounting – Conceptual Issues • Differing impacts across companies resulting in lack of comparability. • A company with older fixed assets will report a higher return on assets than a company with newer fixed assets. • 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
Inflation Accounting – Conceptual Issues purchasing power gains and losses. • Historical cost also ignores purchasing power gains and losses during the period of inflation. • For example $202 can purchases one basket of good and service, only year later when general price level stated at $211, the same $202 can purchases 95.5% percent of the basket, so you need to $211 to buy the same basket . • The difference between $211 needed to maintain the purchasing power and 202 result in $9 purchasing power loss . Learning Objective 1
Inflation Accounting – Conceptual Issues • Purchasing power losses result from holding monetary assets, such as cash and accounts receivable. • Purchasing power gains result from holding monetary liabilities, such as accounts payable. • The two most common approaches to inflation accounting are general purchasing power accounting and current cost accounting. Learning Objective 1
Methods of accounting for changing prices • Tow solution have been developed to deal with distortions caused by historical cost • Account for in the general price level. 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, more simply general purchasing power accounting • Account for specific price changes. By updating the values of assets from historical cost to the current cost to replace these assets, this is known as current replacement cost (CRC) or simply, current cost (CC) accounting .
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. Learning Objective 1
Inflation Accounting – Conceptual Issues Net Income and Capital Maintenance • Historical cost net income maintains a nominal, not adjusted for inflation, amount of contributed capital. • 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
Example • Assume that HIE company is formed in January 1,Year 1 , by investors contributing 200 in cash . The general price index (GPI) on that date is 100. HIE company’s balance sheet on January 1,Year 1 as follows. Cash 200 Contributed capital 200
Example • With the initial equity investment, one unit of inventory is purchased on January 2,Year 1 at a cost of $100 and $100 remains in cash, resulting in the following position 1,Year 1 as follows. Cash 100 Contributed capital 200 Inventory 100 200200
Example • on January 2,Year 1, the managers of HIE company go on vocation, returning on December 31, Year 1 at which time the inventory is sold for $150 in cash, at December 31, 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 150 Cost of sales (100) Income 50
Example • The balance sheet at December 31, Year 1, prior to any distribution of dividends is as follow Cash 250 Contributed capital 200 Retained earning 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 • 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 .
Capital MaintenanceIASB 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.
Capital MaintenanceIASB 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.
Inflation Accounting -- Methods General Purchasing Power (GPP) Accounting • Under (GPP) Accounting, nonmonetary assets, liabilities, stockholders equity, 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. • Also referred to as General Price-Level-Adjusted Historical Cost Accounting (GPLAHC). • Requires purchasing power gains and losses to be included in net income. Learning Objective 1
Inflation Accounting -- Methods General Purchasing Power (GPP) Accounting • Because inventory was acquired on January 1, Year 1, when the GPI was 100, and GPI at December 31, Year 1, is 120, the cost of sales (inventory) is restated using the 120/100 . • Because the sales occurred on December 31, Year 1, when the GPI was 120, 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
Follow the Example • At January 1, Year 1, HIE company has monetary assets 100 and no monetary liabilities, yielding a net monetary asset position of $100. • BecauseHIE holding this cash for entire year, a net purchasing power loss (PPL) of $20 arises. • In addition HIE receiving $150 cash on December 31, Year 1 from the sales of the inventory, because this cash on December 31, Year 1 there is no loss on purchasing power by the end of the year .
Follow the Example The PPl calculated as follow: Cash 1/1/Y1 ……….…… $100 x (120/100) = $120 (need to maintain pp) + increase in cash,Year1 $150 x (120/120) = $150 ٍSubtotal …………………………………………$270 Less : cash 12/31/Y1…………………………. ($250) purchasing power loss………………………..$ 20 Combining the restatement with PPL, 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……………………….. .................20 Income……………………………………………………….. $ 10 To calculated the purchasing power loss
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. Inventory (cost of sales) 20 Purchasing power loss 20 Cr. 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.
Follow the Example • The balance sheet at December 31, Year 1, 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, Year1, 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, the balance sheet at December 31, Year 1, is as follow: Cash 240 Contributed capital 240
Inflation Accounting -- 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. • 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. • Under Current Cost (CC) Accounting ,historical cost of nonmonetary assets are replaced with current replacement . • Also referred to as Current Replacement Cost Accounting. • Nonmonetary assets are restated to current replacement costs and expense items are based on these restated costs. • Holding gains and losses included in equity. Learning Objective 1
Inflation Accounting Internationally United States and United Kingdom • SFAS 33, Financial Reporting and Changing Prices briefly required large U.S. companies to provide GP and CC accounting disclosures. • This information is now optional and few companies provide it. • In the UK, SSAP 16 required current cost information, this was also was only briefly required. • Both countries have experienced low rates of inflation since the 1980s. Learning Objective 2
Inflation Accounting Internationally Latin America • Latin America has a long history of significant inflation. • Brazil, Chile, and Mexico have developed sophisticated inflation accounting standards over time. • Like the U.S. and UK, Brazil has abandoned inflation accounting. • Mexico’s Bulletin B-10, Recognition of the Effects of Inflation in Financial Information, is a well-known example. 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. • An exception is the option to use replacement cost for inventory and related cost of goods sold. • Another exception is imported machinery and equipment. • This exception allows a combination of country of origin price index and the exchange rate between Mexico and country of origin. Learning Objective 2
Inflation Accounting Internationally Netherlands – Replacement Cost Accounting • Prior to the required use of IFRSs in 2005, Dutch companies could use replacement cost accounting. • In 2003 only Heineken used this approach. • Heineken presented inventories and fixed assets at replacement cost. • Cost of sales and depreciation were also based on replacement costs. • The entry accompanying the asset revaluation was reported in stockholders’ equity. Learning Objective 2
Inflation Accounting Internationally International Financial Reporting Standards • IAS 15, Information Reflecting the Effects of Changing Prices was issued in 1981. • This standard has been withdrawn due to lack of support. • The relevant standard now is IAS 29, Financial Reporting in Hyperinflationary Economies. • IAS 29 is required for some companies located in environments experiencing very high levels of inflation. Learning Objective 2
IAS 29 Financial Reporting in Hyperinflationary Economies • This Standard shall be applied to the financial statements, including the consolidated financial statements, of any entity whose functional currency is the currency of a hyperinflationary economy.
Hyperinflationary Economies • Hyperinflation is indicated by characteristics of the economic environment of a country which include, but are not limited to, the following: • The general population prefers to keep its wealth in non-monetary assets or in a relatively stable foreign currency. 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. Prices may be quoted in that currency; • Sales and purchases on credit take place at prices that compensate for the expected loss of purchasing power during the credit period, even if the period is short • Interest rates, wages and prices are linked to a price index; and • The cumulative inflation rate over three years is approaching, or exceeds,100%.
Inflation Accounting Internationally International Financial Reporting Standards • IAS 29 includes guidelines for determining the environments where it must be used. • Nonmonetary assets and liabilities and stockholders’ equity are restated using a general price index. • Income statement items are restated using a general price index from the time of the transaction. • Purchasing power gains and losses are included in net income. Learning Objective 2
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 not restated because they are already expressed in terms of the monetary unit current at the end of the reporting period. • Monetary items are money held and items to be received or paid in money. • 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. Other items in the statement of financial position are restated
Statement of comprehensive income • The current cost statement of comprehensive income, before restatement, generally reports costs current at the time at which the underlying transactions or events occurred. • 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. • 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.
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. • 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. • Where such a subsidiary is a foreign subsidiary, 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:
1- Restating the opening balance sheet • The individual items in the conventional opening balance sheet (December 31, 1988) should be restated to December 1988 prices. • Assets: • The monetary assets (cash, receivables, investment in bonds, etc.), which are stated in nominal money units, do not require any restatement. Because the nominal value represents the real value of the asset concerned. • The nonmonetary assets - inventories, shares, depreciable assets, 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.
Restatement Factor • Restatement factor is used to inflate a given value in proportion to the inflation that has occurred since the 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 historical values) to $570 (100 + 70 + 300 + 100, respective restated values).
1- Restating the opening balance sheet • The liabilities and Equities • The liabilities (payables, received loans, etc.), which are monetary items and stated in nominal money units, do not require any restatement as the nominal value represents the real value of the liability concerned, Therefore, the restated value equals the recorded value in the conventional statement. • The capital stock, which has been issued in the past, is restated. The restatement is carried out by applying the corresponding restatement factor to each recorded capital stock transaction (equity addition) over the company's history. • The retained earnings item is not restated; it is derived by subtracting the liabilities and capital stock from the total restated assets, that is, (670 - 350 - 200 = $120)