1. Chapter 13 General price-level accounting

2. The dollar’s purchasing power General purchasing power, which refers to the monetary unit’s ability to purchase goods or services, is inversely related to the price of goods or services for which it may be exchanged When the price of goods or services decreases, the movement is referred to as deflation, which is also an increase in money’s general purchasing power Because historical-cost accounting does not recognise these changes in the general purchasing power of money, the balance sheet contains diverse kinds of assets and liabilities that refer to different dates and that are expressed in changes in the purchasing power of the dollar

3. The dollar’s purchasing power (cont’d) General price-level accounting corrects this situation by completely restating the historical-cost financial statements in a way that reflects changes in the dollar’s purchasing Changes in the purchasing power of the dollar are measured by means of index numbers A price index is the ratio of a similar group of goods or services on another given date, known as the base year Price indices that measure changes in prices on a general basis reflect the purchasing power of the dollar

4. Chambers’ model Assume that a firm’s balance sheet may be divided into monetary items and non-monetary items Monetary items may be defined as items for which amounts are fixed in terms of number of dollars by contract or otherwise, regardless of changes in price levels For the period t0, the balance sheet equation, expressed in dollars at time 0, is: M 0 + N 0 =R 0 where: M 0 = net monetary items N 0 = net non-monetary items R 0 = residual equity

5. Chambers’ model (cont’d) Let us also assume there is a change in the general price level p. By definition, p = (P 1 /P 0 ) – 1, where P 0 is the price index at time 0 and P 1 is the price index at time 1. The balance sheet equation at t2, restated for the changes in the general price level, is: M 0 (1 + p) + N 0 (1 + p) = R 0 (1 + p) which is equivalent to: M 0 + M 0p + N 0 + N 0p = R 0 + R 0p

6. Chambers’ model (cont’d) Given that, by definition, net monetary assets are expressed in fixed amounts of dollars, it is appropriate to remove M 0p from each side of the equation and to replace M 0 from each side of the equation and to replace M 0 with M 1, meaning that: M 0 + M 0p + N 0 + N 0P = R 0 + R 0p The last equation may be interpreted as follows: 1. M 1 represents the net monetary assets at t1 2. N 0 + N 0 represents the general price-level restated monetary assets at t1

7. Chambers’ model (cont’d) 3. R 0 + R 0 represents the general price-level restated residual equity at t1 4. M 0 represents the gains or losses on monetary items: by definition, M 0 is equal to net monetary assets C 0 less monetary liabilities L 0 The balance sheet equation at t2 may be restated: C 1 + (N 0 + N 0p ) – L 1 = (R 0 + R 0p ) – (C 0p – L 0p ) or C 1 + (N 0 + N 0p ) – L 1 = (R 0 + R 0p ) – C 0p + L 0p

8. Chambers’ model (cont’d) Consequently, L 0p represents the gain from the outstanding liabilities during the period, and C 0p represents the loss resulting from holding monetary assets from t0 to t1 From this simplified model, we can develop the methodology required for the restatement of historical-cost amounts in traditional financial statements into units of general purchasing power.

9. Chambers’ model (cont’d) The following steps are necessary: 1.obtain the complete set of historical-cost financial statements 2.determine and obtain an acceptable general price-level index on which data on the index numbers are available to cover the life of the oldest item on the balance sheet, and classify each item on the balance sheet as a monetary or non-monetary item 3.adjust the non-monetary items by a conversion factor to reflect the current general purchasing power 4.calculate the general purchasing power (general price-level) gains or losses arising from holding monetary items

10. General price-level gains and losses Holders of monetary items gain or lose purchasing power because the general level of price changes Such gains and losses are called general purchasing-power gains or losses, or general price-level gains or losses on monetary items When prices are rising: –monetary assets lose purchasing power, which is recognised by a general price-level loss –monetary liabilities gain purchasing power, which is recognised by a general price-level gain

11. General price-level gains and losses (cont’d) During periods of decreasing prices: –monetary assets gain purchasing power, which is recognised by a general price-level gain –monetary liabilities lose purchasing power, which is recognised by a general price-level loss

12. Calculating general price-level gain or loss General price-level gain or loss is calculated by: 1.computing the net monetary asset position at the beginning of the period 2.restating the net monetary asset position at the beginning of the period in terms of the purchasing power of the dollar at the end of the period 3.restating all of the monetary receipts for the year on a year-end basis and adding the result to the restated net monetary position at the beginning of the period

13. Calculating general price-level gain or loss (cont’d) 4.restating all of the monetary payments of the year on a year-end basis and deducting the result from the total restated net increase in monetary items 5.Deducting the actual net monetary assets at the end of the period from the computed net monetary assets at the end of the period

14. Using our example, these five steps may be summarised as follows: Monetary Items UnadjustedAdjusted Steps 1 and 2$10,000$15,000 Step 3 20,00024,000 Total$30,000$39,000 Step 4$15,000$18,000 Total$15,000$21,000 Step 5$15,000 Purchasing power gain (or loss)$ 6,000 Calculating general price-level gain or loss (cont’d)

15. Calculating general price-level gain or loss (cont’d) To summarise: general price-level gains or losses are computed by restating the net monetary position at the beginning of the period and the net monetary transactions during the period as units of general purchasing power at the end of the period the result is compared with the actual net monetary position, and the difference is the general price-level gain or loss

16. Treatment of the general price-level gain or loss A lack of agreement exists on the nature of the general price-level gain or loss and its relevant accounting treatment. The following approaches have been suggested: 1.Accounting Research Study No. 6, APB Statement No. 3, and the FASB and the CICA Exposure Drafts on general price-level accounting take the position that the general price-level gain or loss should be included in current income 2.only the general price-level gain and loss should be treated as capital items 3.both the general price-level gain and loss should be treated as capital items

17. Treatment of the general price-level gain or loss (cont’d) 4.both the general price-level gain and loss should be included in current income, with the exception of gains and losses related to long-term debt, which should not appear until they are realised through the redemption of the bonds 5.all price-level gains and losses should be included in current income, with the exception of gains and losses that arise from including monetary items in shareholders’ equity (for example, preferred shares having monetary characteristics) As a general rule, all price-level gains or losses are recognised in the general price-level income statement

18. Non-monetary items Non-monetary items are restated in terms of the current general purchasing power by multiplying the cost of the item reported on the historical-cost- based financial statements by the following conversion factor:

19. Shareholder’s equity The restatement of shareholders’ equity, with the exception of retained earnings, is similar to the restatement of non-monetary items. The original invested capital is multiplied by the following conversion factor:

20. Retained earnings Retained earnings, which cannot be adjusted by a single conversion factor, represent net income after dividends accumulated since the creation of the going concern. Retained earnings may be stated as follows: 1.The first time historical-cost financial statements are restated in terms of units of current general purchasing power; retained earnings may be determined simply as the residual after all other items in the balance sheet have been restated

21. Retained earnings (cont’d) 2.In the following periods, the end-of-period retained earnings in units of current general purchasing power may be determined by: –net income in units of current general purchasing power, report-level gains or losses on non-monetary shareholders’ equity items in the general price-level statement (including general price-level gains or losses on monetary items) –adjustments resulting from general price-level gains or losses on monetary shareholders’ equity items

22. General price-level accounting versus current- value accounting Under current-value accounting, an increase in the price of a non-monetary item results in a holding gain Under general price-level accounting, the adjustment of historical cost is simply a restatement of a non- monetary item in terms of the current general purchasing power, and no gain or loss is recognised

23. The monetary–non-monetary distinction It is important to distinguish between monetary and non-monetary items, because different treatments are applied to the two types of items Non-monetary items must be translated into dollars of the same purchasing power at the end of the current period Monetary items, on the other hand, are already stated in end-of-current-period dollars and gain or lose purchasing power as a result of changes in the general price level Monetary items gain or lose purchasing power: non-monetary items do not

24. Monetary items The official definition adopted in the various pronouncements of the accounting bodies considers monetary items to be items the amounts of which are fixed by contracts or otherwise fixed in terms of dollars (or whatever is the domestic currency), regardless of changes in specific prices or in the general price level

25. Problems with distinguishing between monetary and non- monetary items Problem areas exist because some assets and liabilities may exhibit characteristics of both monetary and non-monetary items Various degrees of fixity are therefore possible, as implied by the word ‘fixed’ in the definition of a monetary item Because conditions change, the price of a monetary item need not be fixed permanently

26. Examples of monetary and non-monetary classifications Preferred shares are classified as non- monetary items in APB Statement No. 3 The FASB Exposure Draft states that, ‘preferred stock carried at an amount equal to its fixed liquidation or redemption price is monetary because the claim of the preferred stockholders on the assets of the enterprise is in a fixed number of dollars’ Deferred income taxes are classified as non- monetary items on the basis that they are a cost saving and are deferred as reductions of expenses in future periods

27. Examples of monetary and non- monetary classifications (cont’d) Foreign currency on hand, claims to foreign currency, and obligations payable in foreign currency may be interpreted as either monetary or non-monetary items, as follows: –if they are perceived as commodities, they are non-monetary items, because the prices of commodities may fluctuate –if they are perceived as similar to domestic- currency items, they are monetary items

28. Examples of monetary and non- monetary classifications (cont’d) A more logical viewpoint would be to classify foreign-currency items as: –monetary if they are stated at the closing rate of exchange in the historical-cost financial statements –non-monetary if they are stated at the historical rate of exchange in the historical-cost financial statements Long-term debts in foreign currency may be interpreted as either monetary or non-monetary: –the debt will be interpreted as monetary if it is stated at the closing rate of exchange –the debt will be seen as non-monetary if it is stated at the historical rate of exchange

29. Examples of monetary and non- monetary classifications (cont’d) Convertible debt is perceived to have monetary and non-monetary characteristics Accounting Research Study No. 6 proposes that convertible debt be treated as: –monetary when the market price of its shares is below the conversion price –non-monetary when the market price of shares is at or above the conversion price Another position is that convertible bonds should be treated as monetary debts – obligations to pay a fixed number of dollars – until they are converted

30. Price-level indices A price-level index compares general or specific changes in price from one period to another A general price-level index can be defined as a series of measurements, expressed as percentages, of the relationship between the average price of a group of goods and services on a succession of dates and the average price of a similar group of goods and services on a common date The components of the series are called price- index numbers The general price-level index is based on a large range of goods and services The specific price-level index refers to a particular good or industry

31. Index formulas We will use the following symbols to represent the four basic formulas:

32. The Laspeyres formula The Lasperyres formula assumes that the price index is a weighted sum of current- period prices divided by a weighted sum of base-period prices, where the weights are base-period quantities of commodities Such an index, called a Lasperyres index, is computed thus:

33. The Paasche formula The Paasche formula assumes that the price index is a weighted sum of current-period prices divided by a weighted sum of base- period prices, where the weights are current- period quantities of commodities Such an index, called a Paasche index, is computed thus:

34. The fixed-weighted formula The fixed-weighted formula assumes that the price index is a weighted sum of current-period prices divided by a weighted sum of base-period prices, where the weights are average period quantities of commodities Such an index, called a fixed-weighted index, is computed thus:

35. The Fisher formula The Fisher formula assumes that the price index is a geometric average of Laspeyres and Paasche formulas. The Fisher index is computed thus:

36. Price-level accounting and purchasing power General price-level accounting employs a conversion factor based on changes in the general price-level index to convert dollars on one date to the number of dollars having the same purchasing power on another date An appropriate concept of purchasing power and an appropriate general price- level index must be chosen

37. Price-level accounting and purchasing power (cont’d) Hendriksen presents different concepts of purchasing power, these being: –general purchasing power –purchasing power of the firm –specific replacement purchasing power General purchasing power measured by a general price-level index reflects changes in the value of money and, consequently, is deemed most relevant for general price- level accounting

38. Choice of a general price-level index The concept of general purchasing power implies the use of a general price-level index In the USA, the Department of Commerce and the Department of Labor regularly maintain and publish price-level indices. Among the most common are: 1.The Consumer Price Index (CPI) 2.The Wholesale Price Index 3.The Composite Construction-Cost Index 4.The GNP (Gross National Product) Implicit Price Deflator (IPD)

39. Choice of a general price-level index (cont’d) The two price indices most commonly suggested for general price-level accounting are: –the CPI, a base-weighted index designed to measure price changes as they would affect a basket of retail goods and services acquired by middle-income families of specific size living in urban centres –the GNP (implicit price deflator (IPD)), a currently weighted index designed to measure price changes in all goods and services produced in a given year

40. Limitations of the CPI and the IPI The base-weighted CPI fails to account for the substitution of relatively lower-priced goods that takes place when relative prices change: –in other words, the CPI has an upward bias, in that it overstates the effect of changes in prices on the cost of living The IPI has a downward bias and understates the price increase in the cost of living The IPI covers all goods and services produced in the economy, whereas the CPI covers only goods and services purchased by a ‘typical consumer’

41. Arguments in favour of general price-level accounting First argument: –financial statements that are not adjusted for general price-level changes include diverse kinds of assets and claims expressed in dollars of different purchasing power –general price-level accounting is designed to express the level of changes in the price of assets and in the purchasing power of claims –general priced-level statements present data on the basis of a common denominator – the purchasing power of the dollar at the end of the period – and facilitate comparisons between firms

42. Arguments in favour of general price- level accounting (cont’d) Second argument: –conventional historical-cost accounting does not measure income properly as a result of the matching of dollars of different ‘size’ on the profit and loss statement –expenses incurred in previous periods are set off against revenues that are used in current dollars –general price-level accounting provides a better matching of revenues and expenses because common dollars are used

43. Arguments in favour of general price- level accounting (cont’d) Third argument: –general price-level accounting is relatively easy to apply –general price-level accounting represents the last departure from generally accepted accounting principles Fourth argument: –general price-level accounting provides relevant information for management evaluation and use –general price-level accounting presents the impact of general inflation on profit and provides more realistic returns on investment rates

44. Arguments against general price-level accounting Most empirical studies indicate that the relevance of general price-level information is either weak or not accepted General price-level changes account only for changes in the general price level and do not account for changes in the specific price level The impact of inflation differs among firms The costs of implementing general price- level accounting may exceed the benefits

45. Technical problems with price- level accounting The first problem is related to the choice of an appropriate general price- level index The second problem is that general price-level accounting requires assets and liabilities to be identified and classified as monetary or non-monetary items