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.  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.

 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  Currently only countries that have high historic inflation rates use these.

Types of inflation adjusted models  General Price Level Adjusted (GPLA)  Current Cost Adjusted (CCA)

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

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

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!!

The Republic of Scortia Consumer Price Index YearIndex

The Cudo Company Income Statement For the year ended December 30, 1999 Historical CostAdjustmentConstant Cost Revenue from sales Cost of Goods sold Salary expense Advertising expense Depreciation expense Interest expense Utilities Taxes Net operating income Add: Net monetary gain Net Income $605,000 (400,000) (35,000) (10,000) (40,000) (75,000) (5,000) (3,000) $37,000 N/A $37, /517 Table 3 584/ / /517 $683,404 (481,454) (39,536) (11,296) (61,474) (84,720) (5,648) (3,389) ($4,113) 20,845 $16,732

The Cudo Company Cost of Goods Sold Schedule For the year ended December 31, 1999 Item Beginning Inventory Purchase 1/1/00 Purchase 4/1/00 Purchase 7/1/00 Purchase 10/1/00 Ending Inventory Cost of goods sold Historic Cost, 73,793 units purchased ,000 $5 per unit $150,000 17,007 $5.88 per unit 100,000 14,286 $7 per unit 100,000 12,500 $8 per unit ,250 $8 per unit $50,000 $400, / / / /550.5 Current Cost $194, , , ,085 (53,043) $481,454

The Cudo Company Balance sheet Dec. 31, /31/9812/31/99 ASSETS Cash Accounts Receivable Prepaid Rent Inventory Supplies Equipment Accum.Depreciation Total LIABILITIES Accounts Payable Bank Loan Payable Bonds Payable OWNERS EQUITY Contributed Capital Retained Earnings Total $100,000 35,000 20, , ,000 (40,000) $525,000 $25, ,000 50,000 $50, ,000 $525,000 $75,000 30,000 25,000 50,000 15, ,000 80,000 $515,000 $35, ,000 50,000 $50,000 80,000 $515,000

Loss on Cash and Cash Equivalents PPL ME = ΔCPI(bCCE + eCCE)/2 Where PPL ME = 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: PPL ME = [(584/450)-1] * ($135,000 + $105,000)/2 = $35,733

Purchasing Power Gain on Monetary Liabilities PPG ML = ΔCPI(bML + eML)/2 Where PPL ML = 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. PPG ML = [(584/450)-1] * ($375,000 + $385,000)/2 = $56,578

Purchasing Power Gain Putting these two equations together we have: PPG = PPG ML - PPL MC = $56,578 – 35,733 = $20,845

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

The Cudo Company Balance Sheet 12/31/1999 Assets Cash Accounts Rec. Prepaid Rent Inventory Supplies Equipment Accum.Depr. Total Liabilities Accounts Payable Bank Loan Payable Bonds Payable Owner’s Equity Contributed Capital Retained Earnings Total $75,000 30,000 25,000 50,000 15, ,000 (80,000) $515,000 $35, ,000 50,000 $50,000 80,000 $515,000 N/A 584/517 Table 3 584/ /380 N/A 584/380 Reconciliation $75,000 30,000 28,240 53,043 16, ,737 (122,947) $695,017 $35, ,000 50,000 $76, ,175 $695,017

The Cudo Company Balance Sheet Restated 12/31/98Restated 12/31/99 ASSETS Cash Accounts Receivable Prepaid Rent Inventory Supplies Equipment Accum.Depreciation Total LIABILITIES Accounts Payable Bank Loan Payable Bonds Payable OWNERS EQUITY Contributed Capital Retained Earnings Total $129,778 45,422 25, , ,737 (51,911) $776,960 $32, ,333 64,889 $64, ,405 $776,960 $75,000 30,000 28,240 53,043 16, ,737 (122,947) $695,017 $35, ,000 50,000 $76, ,175 $695,017