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Chapter 13: Accounting for Inflation & Changing Prices. Inflation Price indexes Inflation accounting Income measurement systems SFAS No. 33. Inflation. The rise in the average price level for all goods and services produced in an economy

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chapter 13 accounting for inflation changing prices
Chapter 13: Accounting for Inflation & Changing Prices
  • Inflation
  • Price indexes
  • Inflation accounting
  • Income measurement systems
  • SFAS No. 33
inflation
Inflation
  • The rise in the average price level for all goods and services produced in an economy
  • Under a historical cost-based system of accounting inflation leads to two basic problems
    • Many historical numbers are not economically relevant
    • Historical numbers are not additive
inflation and historical costing
Inflation and Historical Costing
  • Likely predictive value is diminished
  • Comparability among financial statements of different firms is restricted
  • Capital maintenance
    • Income usually overstated relative to amounts that can be distributed to stockholders
    • Many dividends are really liquidating in nature
price indexes
Price Indexes
  • Is a weighted average of the current prices of goods and services
    • Averages are related to prices in a base period
    • Purpose is to determine how much change has occurred
  • Types of price indexes
    • Specific price index
    • General price index
price indexes5
Price Indexes
  • Paasche-type indexes
    • Uses current-year quantities
    • Wholesale Price Index
    • Consumer price Index
  • Laspeyres-type indexes
    • Uses base-year quantities
    • Less costly to construct
inflation accounting
Inflation Accounting
  • General purchasing power adjustment translates historical dollars into dollars having equivalent purchasing power
  • Current valuation, also called current cost, attempts to derive the specific value or worth for a particular point ...
    • Entry values
    • Exit values
entry vs exit values
Entry vs. Exit Values
  • Entry values
    • Value in use is best represented by replacement costs
    • Strong argument in support of use
  • Exit values
    • Are a form of opportunity costs
    • The balance sheet becomes the principal financial statement
purchasing power gains losses
Purchasing Power Gains & Losses
  • Arise as a result of holding net monetary assets or liabilities during a period when the price level changes
  • Monetaryassets and liabilities include cash itself and other assets and liabilities that are receivable or payable in a fixed number of dollars
holding gains losses
Holding Gains & Losses
  • Holding gains and losseson real (nonmonetary) assets can be divided into two parts
    • monetary holding gains and losses, which arise purely because of the change in the general price level during the period; and
    • real holding gains and losses, which are the difference between general price-level-adjusted amounts and current values.
  • Are capital adjustments only; they are not a component of income
the gearing adjustment
The Gearing Adjustment
  • Somewhat related to the holding gain
  • Was used in Great Britain as part of that country’s inflation accounting mechanism
  • Results in gains to equity capital during inflation because debt capital does not have any claim on holding gains
  • proved to be an extremely confusing concept
income measurement systems
Income Measurement Systems
  • Current Value Approaches
    • Distributable Income (DI)
    • Realized Income (RI)
    • Earning Power Income (EPI)
  • Methods differ in terms of disposition of real holding gains and the resulting type of capital maintenance measure
sfas no 33
SFAS No. 33
  • FASB decided to keep nominal historical costs as the basis of primary financial statements
  • Specified that the effects of changing prices should be presented as supplementary information in annual reports
  • FASB realized that a consensus could not be obtained on which method of accounting should be adopted
sfas no 3314
SFAS No. 33
  • Not all enterprises had to comply with SFAS No. 33
  • For constant dollar reporting, the SFAS required disclosure of
    • Information on income from continuing operations for the current fiscal year on a historical cost/constant dollar basis . . .
    • The purchasing power gain or loss on net monetary items for the current fiscal year. .
sfas no 33 s failure
SFAS No. 33’s Failure
  • There was a dramatic decline of inflation during the early 1980s
  • Measurement problems were present
  • Questions of understandability and usefulness for predictive purposes
sfas no 82 issued in 1984
SFAS No. 82 issued in 1984
  • Eliminated the constant dollar income disclosures that had previously been required by SFAS No. 33
  • SFAS No. 33
    • information confused users
    • may have caused “information overload” because of the presence of similar current cost income disclosures
sfas no 89
SFAS No. 89
  • Two parts of SFAS No. 33 remained in effect; were “encouraged” but not required
    • current cost income measurement, purchasing power gain or loss, and
    • holding gain information
  • FASB beat a hasty retreat from the problem of accounting for changing prices
chapter 13 accounting for inflation changing prices18
Chapter 13: Accounting for Inflation & Changing Prices
  • Inflation
  • Price indexes
  • Inflation accounting
  • Income measurement systems
  • SFAS No. 33