1. Chapter 10 Accounting For Inflation

2. 9–2 Learning Objectives Discuss the major methods of asset valuation. Describe the alternative units of measurement in financial reporting. Describe the uses of financial report information. Describe the difference between monetary and nonmonetary accounts. 2

3. 9–3 Complaints About Historical Cost In the late 1970s, the FASB issued a statement that required the disclosure of the effects of inflation to be shown in supplementary schedules to the financial statements. –As inflation slowed in the 1980s, the disclosures were no longer required. –However, the basic knowledge about reporting the effects of changing prices (inflation) is still important and useful. 3

4. Two Dimensions of Financial Reporting Asset Valuation Measurement Unit 9–4 4

5. Asset Valuation Cost Valuation is a primary principle of accounting Two major alternative methods of cost valuation exist –Acquisition or historical cost –Current or replacement cost 9–5 5

6. Measurement Unit Alternatives Values will be reported in currency units (dollars) Two major alternative measurement units are possible –Nominal (unadjusted) dollars No recognition of changes in purchasing power –Constant Dollars Purchasing power changes are recognized 9–6 6

7. Monetary VS. Non Monetary Monetary Items –Cash or claims to cash that are fixed –Changes in purchasing power will not affect reported value A mortgage for $1,000,000 still requires payment of $1,000,000 9–7 7

8. Non Monetary items –Changes in purchasing power will impact reported amounts 9–8 8 Monetary VS. Non Monetary

9. Adjusting for Purchasing Power Changes – Monetary Items Example Purchasing Power IndexUnadj. Hist. CostPurchasing Power Adj. Cost 100.0$1,000 110.01,000 121.01,000 133.11,000 9–9 Monetary items are fixed in dollars and reported values do not change. 9

10. Adjusting for Purchasing Power Changes – Non Monetary Items Example Purchasing Power IndexUnadj. Hist. CostPurchasing Power Adj. Cost 100.0$1,000 110.01,0001,100 121.01,0001,210 133.11,0001,331 9–10 PP Adj Cost = Current PP Index Acquisition PP Index Unadj Hist Cost x 10

11. Four Alternative Financial Reporting Methods Asset Valuation Method Unit of Measurement Acquisition CostCurrent Value Nominal dollarsUnadjusted historical cost (HC) Current Value (CV) Constant dollarsHistorical cost-general price level adjusted (HC-GPL) Constant dollar accounting Current value-general price level adjusted (CV-GPL) Current cost accounting 9–11 11

12. 9–12 Historical Cost/Nominal Dollars (HC) The historical cost/nominal dollar method is the most popular approach to income measurement and is the primary method under GAAP. –This method measures invested capital in nominal dollars. –No income appears until an asset is sold, and price fluctuations are ignored. 12

13. 9–13 Current Cost/Nominal Dollars (CV) The focus of the current cost/nominal dollar method is on income from continuing operations. –The current cost method reports only the profit available after replacing any physical capital expended in operations for the period. –This method requires subjective assessments of cost valuation. 13

14. 9–14 Historical Cost/Constant Dollars (HC-GPL) With this method, the income measurements in each year are restated in terms of constant dollars, which have the same purchasing power of the current year, instead of nominal dollars, which have different purchasing powers of various years. –Because of inflation, dollars spent or received in a subsequent year have a different value than dollars spent or received in the base year. –Constant-dollar accounting measures all items on the financial statements (including items from previous years) in current dollars using a general price index. 14

15. 9–15 General price index - an index that compares the average price of a group of goods and services at one date with the average price of a similar group at another date 15 General Price Index

16. 9–16 Current Cost/Constant Dollars (CV-GPL) With this method gains and losses from charges in prices are recognized prior to sale. The gains and losses are adjusted for charges in general purchasing power. 16

17. Impact of Reporting Methods on Net- Income Impact Variables Reporting MethodsDepreciation Expense Purchasing Power Gains/Losses Unrealized Gains in Replacement Value HCNo change No change/not recognized HC-GPL Increase/GPL depreciation recognized Gain or loss/depends on the net monetary asset position No change/not recognized CV Increase/will recognize replacement cost No change/not recognized Gain/will recognize increase in replacement cost CV-GPL Increase/will recognize current replacement cost Gain or loss/depends on the net monetary asset position Gain/will recognize increase in replacement cost but will reduce amount by changes in the GPL 9–17 17

18. Recognizing Purchasing Power Gains/Losses Only done in Financial Reporting Methods that report transactions in constant (general price level adjusted) dollars Holding debt during a period of inflation produces a purchasing power gain Holding cash during a period of inflation produces a purchasing power loss 9–18 18

19. Purchasing Power Gain Example UnadjustedConversion Factor Constant Dollars Beginning long-term debt (12/31/Y3) $1,203315.5/303.5$1,251 -Repayment (6/30/Y4)152315.5/309.5155 +New debt (6/30/Y4)427315.5/309.5435 Ending long-term debt (12/31/Y4) $1,478$1,531 -Actual ending long-term debt (12/31/Y4) $1,478 Purchasing power gain$53 9–19 -Ending PI = 315.5 -Beginning PI = 303.5 -Midpoint PI = 309.5 19

20. Purchasing Power Loss Example Unadjusted Conversion Factor Constant Dollars Beg. Accounts Receivable$217315.5/303.5$226 + Additions32315.5/309.533 Ending Accounts Receivable $249$259 -Actual Ending A/R$249 Purchasing Power Loss$10 9–20 20

21. Depreciation Expense Impact-Example Facts Acquisition Cost$10,000 (PI = 100.0) Est. Life5 Years PI (at Year End)110 Replacement Cost $12,000 (at Year End) Depreciation Expense under Alt. Reporting HC-$10,000/5 = $2,000 HC-GPL-[$10,000 x 110/100] / 5 = $2,200 CV-GPL -$12,000 / 5 = $2,400 9–21 21

22. Unrealized Gains in Replacement Value- Example HCHC-GPLCVCV-GPL Beg. Cost Valuation $10,000 End Cost Valuation 10,00011,00012,000 Deprec. Exp.2,0002,2002,400 End Reported Cost Net of Depreciation $8,0008,8009,600 Ending Cost Basis After Depreciation 8,0008,8008,0008,800 Gain/Loss001,600800 9–22 22

23. Summary In periods of inflation or deflation unadjusted historical cost accounting measured in nominal dollars can be seriously flawed. Using unadjusted historical cost accounting but reporting in constant dollars (HC-GPL) can remove most of the distortions with no sacrifice in objectivity. Methods that rely on current values (CV and CV-GPL) may introduce subjectivity in asset valuation. 9–23 23