International Financial Accounting Chapter 8: Changing Prices Accounting Choi/Meek, 7/e

Learning Objectives What do we mean by the term, changing prices? Why are financial statements misleading during periods of changing prices? What are the various ways of adjusting financial statements for changing prices? Do adjustments for changing prices vary internationally? What does IAS 21 have to say about inflation adjustments in hyperinflationary countries? What is the restate-translate controversy all about? Is it possible to double-count for the effects of foreign inflation?

Price change General price level change: refers to a movement in the prices of all goods and services in an economy on average. Positive price movement is termed inflation. A negative price movement is called deflation.

Price change Specific price change: refers to the movement in the price of a specific asset; e.g., a change in the price of inventory, plant, or equipment. 4 4

Price change General price level changes are measured by use of a general price level index (GPL). GPL is a cost ratio that compares the cost of a basket of goods in the current period with the cost of that same basket in a prior or base period. The reciprocal of the GPL is a measure of the general purchasing power of the monetary unit. Specific price changes are measured by a specific price index (SPL). SPL is a cost ratio that compares the cost of a specific item with its cost in a prior or base period. 5 5

Why are Financial Statement Potentially Misleading During Periods of Changing Prices? During periods of inflation, revenues are based on the general purchasing power of the current period. Expenses, such as depreciation and amortization, may be based on currency of higher general purchasing power because their related assets were typically acquired in the past when GPLs were lower. Deducting expenses based on historical purchasing power from revenues that expressed in currency of current purchasing power yields a nonsensical index of performance.

Why are Financial Statements Potentially Misleading During Periods of Changing Prices? During a period of specific price changes, assets recorded at their original acquisition costs seldom reflect the assets’ current (higher) value resulting in an overstatement in reported income. This, in turn, may lead to: Higher taxes Higher dividends Higher wages

Why are Financial Statements Potentially Misleading During Periods of Changing Prices? From a managerial perspective, accounting numbers unadjusted for changing prices distort: Financial projections Budget comparisons Performance data 8 8

Types of Adjustments for Changing Prices Objective of conventional historical cost accounting: maintain a firm’s original investment. Assume a firm begins operations with an initial cash investment of $1,000. Cash is immediately converted to saleable inventory which is all sold at 50% mark-up by the end of the year for $1,500. There are no price changes during the period.

Types of Adjustments for Changing Prices Revenues would be $1,500 received uniformly over the period, expenses would be $1,000, and net income would be $500. Net income of $500 represents the amount that could be withdrawn from the firm and leave the owners with their original investment intact. 10 10

General Price Level Adjustments Objective: to measure income such that it represents an amount that could be withdrawn from the business while preserving the general purchasing power of the firm’s original investment. Assume the same facts as previously except that the GPL advances from a level of 100 at the beginning of the period to 121 at period’s end and averaged 110 during the year. To keep up with inflation, owners’ equity should grow by at least $210; i.e., beginning equity = $1,000 x 121/100 = ending owners’ equity of $1,210.

General Price Level Adjustments To accomplish this, revenues are expressed in end of period purchasing power by multiplying $1,500 by 121/110=1,650 (110 is used as an expedient to reflect the fact that revenues are received uniformly over the year). Expenses (cost of sales in this example) would also be expressed in end of period purchasing power by multiplying $1,000 (incurred at the beginning of the year) by 121/100=1,210. This produces an adjusted operating income of $440 (=$1,650 - $1,210). 12 12

General Price Level Adjustments During inflation, an additional consideration must be accounted for. These are the gains and/or losses attributed to holding monetary items. Monetary asset = cash or a claim to a fixed number of currency in the future; e.g. cash or accounts receivable. Monetary liability = obligations to pay a fixed number of currency in the future; e.g., most payables excluding customer advances.

General Price Level Adjustments During inflation, a firm holding monetary assets experiences a purchasing power loss as cash or receivables are not adjusted for inflation; a firm holding monetary liabilities experiences a purchasing power gain, as monetary liabilities are not adjusted for inflation. 14 14

General Price Level Adjustments In the foregoing example, the firm received $1,500 in cash from sales uniformly during the year. If this monetary asset were adjusted for inflation its ending balance should be $1,650 (= $1,500 x 121/110). Its actual ending cash balance is only $1,500, giving rise to a purchasing power loss (monetary loss) of $150. Price level adjusted net income would be $290 (= $440 - $150).

General Price Level Adjustments Withdrawing $290 from the business would leave the firm with $1,210, the amount necessary to keep up with inflation. For balance sheet purposes, all non-monetary assets and liabilities would be adjusted to their end of period purchasing power equivalents by multiplying them by the end of period index over the index that prevailed when these items were acquired. 16 16

Adjustments for Specific Price Changes Objective: to measure income such that it represents an amount that could be withdrawn from the business while preserving the firm’s productive capacity; i.e., ability to replace specific assets whose prices have risen during the period. Continuing the previous example, assume that in addition to general inflation, specific prices of inventory have increased by 30%.

Adjustments for Specific Price Changes As the replacement cost of inventories have increased by 30%, owners’ equity should grow by at least $300; i.e., beginning equity = $1,000 x 130/100 = $1,300. Failing this, the company will not be able to maintain its productive capacity; replace all of its inventory. To accomplish this, assets and their related expenses are restated to their current cost equivalents. 18 18

Adjustments for Specific Price Changes Inventory and hence cost of sales (all inventory was sold) would be restated to $1,300 (= $1,000 x 130/100). This produces a replacement cost based adjusted operating income of $200 (= $1,500 - $1,300). Withdrawing $200 from the business would leave the firm with $1,300, the amount necessary to enable it to preserve its productive capacity.

Adjustments for Specific Price Changes Objective: to measure income such that it represents an amount that could be withdrawn from the business while preserving the firm’s general purchasing power and allowing it to maintain its productive capacity in real terms. Same facts as before. General price levels have advanced by 21% and specific prices have increased by 30%. A distinctive feature of this measurement framework is that it reports changes in the current costs of a firm’s nonmonetary assets, net of inflation.

General Price Level Adjusted Current Costs The increase in the inventory’s cost due to general inflation was $210 (= $1,000 x 121/100). The real change in the inventory’s current cost was $90 [= ($1,000 x 121/100) – ($1,000 x 130/100)]. Net income is $200 (= $1,650 revenues - $1,300 cost of sales - $150 monetary loss). It represents the amount that could be paid out as a dividend and yet allow the firm to keep up with general inflation and allow it to replace specific assets (inventory) whose prices have advanced by $90 in real terms.

National Variations – U.S. U.S. SFAS 89 encourages but does not mandate the following disclosures for each of the five most recent years: Net sales Income from continuing operations on a current-cost basis. Monetary gains or losses on net monetary items. Increases or decreases in the current cost or lower recoverable amount of inventory or plant, property and equipment, net of inflation. Aggregate foreign currency translation adjustment, on a current cost basis. Net assets at year-end on a current cost basis.

National Variations – U.S. Earnings per share on a current cost basis. Dividends per share of common stock. Level of the Consumer Price Index used to measure income from continuing operations. For foreign operations included in the consolidated statements: Translate foreign accounts to dollars, then restate for U.S. inflation, if the dollar is the functional currency. Restate for foreign inflation, then translate to U.S. dollars if the local currency is functional. 23 23

Choi/Meek, 7/e

National Variations – United Kingdom In the U.K., SSAP 16 recommends one of three reporting options: Present current-cost accounts as the basic financial statements with supplementary historical cost accounts. Present historical-cost accounts as the basic statements with supplementary current-cost accounts. Present current-cost accounts as the only accounts accompanied by adequate historical-cost information.

National Variations – United Kingdom The foregoing options must include a monetary working capital adjustment that captures the monetary gains or losses from holding net monetary assets. This adjustment, however, employs specific price indexes as opposed to general price level indexes. Also required is a gearing adjustment that offsets inflation-adjusted cost of sales, depreciation, and the monetary working capital adjustment for monetary gains resulting from the use of debt. 26 26

National Variations – Brazil Permanent assets (i.e., fixed assets, buildings, investments, deferred charges, and their respective depreciation, as well as their amortization or depletion accounts) are adjusted for general price level changes. Stockholders’ equity accounts (i.e., capital, revenue reserves, retained earnings, and capital reserve accounts) are also adjusted by GPL changes. Permanent asset adjustments are offset against stockholders’ equity adjustments. A permanent asset adjustment < equity adjustment produces a purchasing power loss. A permanent asset adjustment > equity adjustment produces a purchasing power gain.

IAS 21 Requires the restatement of primary financial statement information for operations located in hyperinflationary environments. Historical cost or current cost statements must be expressed in constant purchasing power as of the balance sheet date. Purchasing power gains or losses on net monetary items must be included in current income.

IAS 21 Firms must disclose: that restatement for inflation has been made. which asset valuation framework is being used in the primary statements. which price index is used and its level at the balance sheet date and movement during the period. 29 29

Restate/Translate Controversy When consolidating the accounts of subsidiaries located in inflationary environments, should management first restate these accounts for foreign inflation, then translate to parent currency? Or, should they first translate unadjusted accounts to parent currency, then restate for parent country inflation? Our solution, based on a dividend discount valuation framework: Restate statements to be consolidated for specific price changes. Translate to parent currency using the current rate. Use specific price indexes to calculate monetary gains and losses.

Double-counting for Inflation Local inflation affects exchange rates used to translate inflation-adjusted foreign currency balances to parent currency. Result: Inflation is accounted for twice. To eliminate the double-dip, back out the period’s translation gain or loss from the inflation adjustment.