Chapter 11

International Accounting for Price Changes

Inflation

Inflation has had a devastating effect on many countries Brazil and Russia – as high as 2,000% 1970s in the U.K. – 25%

Some companies are using other methods of accounting to combat the effects of inflation BP uses replacement costs More companies will likely follow BP’s lead

Impact of Inflation on the Corporation

Assets become devalued Liabilities become less expensive to pay off Interest rates on loans increase with inflation Income can be overstated as old costs are

matched with new revenues Shareholders could demand more dividends

and employees could demand higher wages

Accounting Measurement Alternatives

General purchasing power accounting Includes all systems designed to maintain the

purchasing power of capital or equity Accounts for changes in the level of prices Concerned with the value of money Other names include

Constant dollar accounting (U.S.) General price level accounting (U.S.) Current purchasing power accounting (U.K.)

Accounting Measurement Alternatives

Current value accounting Includes all systems designed to account for current values

or changes in specific prices Concerned with the cost of specific assets Types of accounting include

Current cost accounting Replacement value accounting Current exit price accounting

Real value accounting is a combination of current value and general purchasing power accounting

General Purchasing Power Accounting

The monetary unit of measure should be uniform while retaining the basis of measurement used in the financial statements (historical cost)

All items except financial assets and liabilities (cash, receivables, payables) are restated to reflect common purchasing power

Previous year’s accounts are also updated to provide comparability

General Purchasing Power Accounting

Example General price level increased by 15% during

the year A machine purchased on January 1 cost

$10,000 End-of-year purchasing power to buy machine

on Dec. 31= $10,000 + ($10,000 x 0.15) = $11,500

Current Value Accounting

Income is not earned until the company has maintained its capital in current value terms

Current cost (replacement cost) method Should the same asset or one performing a similar function

with new technology be used?

Current exit price method Values assets at what they could be sold for, less cost to

complete and sell the items Going-concern concept – asset is valued at estimated

sales price on normal completion of production

Current Value Accounting

Results in holding gains and losses that are Recognized on the income statement Reflected on the balance sheet as a capital

adjustment account Current values are determined by

Suppliers’ lists (inventory) Construction cost indices (PP&E) Appraisal values (fixed assets)

Current Value Accounting

Example

Sales = $1,000,000Current COGS = $900,000Historical COGS = $700,000

Operating gross profit $100,000 for current cost method$300,000 for historical cost method, part of which is due to holding during a period of price increase

Realized holding gain = $900,000 - $700,000 = $200,000

Real Value AccountingExample

Value of asset Beginning = $150,000Current value at year end = $190,000GPP value at year end = $165,000

Total holding gain $190,000 - $150,000 = $40,000

Real holding gain$190,000 - $165,000 = $25,000

***What matters is the net impact of prices directly affecting the corporation relative to the average level of prices affecting the GPP of money!!!

International Financial Reporting Standards

IAS 6 (1977) A brief narrowing of options available to deal with

inflation IAS 15, Information Reflecting the Effects of

Changing Prices Recognized the two major methods (GPP or

current cost), but did not champion one or the other

Required information on the effects of price changes if the historical cost method is used

International Financial Reporting Standards IAS 15 suggestions for price change info

The amount of the adjustment to or adjusted amount of depreciation of PP&E

The amount of the adjustment to or the adjusted amount of cost of sales

The adjustments relating to monetary items, the effect of borrowing, or equity interests when those adjustments are used in determining income

The overall effect on income of adjustments and any items reflecting the effects of changing prices

Current cost of PP&E of inventories Methods adopted to compute information used in the preceding

items and any indices used IAS 15 was withdrawn in 2003

International Financial Reporting Standards

IAS 29 (1989) Focuses on hyperinflationary economies

100% inflation over 3 years Requires restatements for GPP changes

regardless of previous treatment IAS 16 (revised in 1998)

Current value approach is permitted for PP&E “Fair value” is used Regular revaluations are required

Comparative National Regulation and Practice

U.K. SSAP 16, requiring current cost accounting, was

issued and withdrawn due to lower inflation Only a few companies now provide current cost

disclosures Some companies revalue their PP&E at market

values

Comparative National Regulation and Practice

U.S. Accounting Series Release 190 required

disclosure of replacement cost info SFAS 33 required disclosure on both GPP and a

current cost basis SFAS 33 made an array of information available

Comparative National Regulation and Practice

Australia, Canada, and New Zealand Developments are more tentative than in U.S. Similar to U.S. current cost system

Continental Europe Much less enthusiasm for inflation accounting No professional standards on the subject

Comparative National Regulation and Practice

Brazil Inflation accounting used as early as the 1950s Company law in 1976 required indexation approach to

restate historical costs in terms of current purchasing power

With reduced inflation levels, requirement was withdrawn in 1996

Argentina Inflation accounting introduced was the accounting

profession 1972 – GPP financial statements were recommended Recommendation withdrawn in 1995 due to low inflation

Comparative National Regulation and Practice

Current Value Accounting in Holland Some firms use current cost method Some use partial current cost statements or historical cost

statements with supplementary disclosures

Comparative National Regulation and Practice

Theodore Limperg – father of replacement value Focused on the relationship between economics and

accounting Believed that income is a function of revenue and

replacement value instead of historical costs Believed that current value info should be used by all

decision makers

Comparative National Regulation and Practice

Philips First used current value techniques in 1936 Used current value approach in 1952 for financial

reporting purposes Departments of the company determined current

values of inventory, equipment, and fixed assets The effect of current value changes showed in

cost of goods sold and depreciation expense

Comparative National Regulation and Practice

Philips Brink (1992) showed that Philips used

replacement value techniques to enhance profits The company used inventory value reductions

and the gearing adjustment in hyperinflationary countries

Recorded a loss of 4.24 billion guilders in 1990, which led to the demise of the replacement value system in 1992

Problems and Prospects

Inflationary accounting is likely to remain a hot topic for the foreseeable future

Some South American countries in hyperinflation use GPP accounting

Some European companies still make voluntary current value disclosures

No current cost accounting regulations exist in the U.K. or the U.S.

Problems and Prospects

Controversy remains over The gearing adjustment Treatment of gains and losses on monetary items The use of indices with respect to foreign subs Verification of current costs in industries with rapid

technological change

Problems and Prospects

Future experimentation with price change accounting systems is hoped for

The usefulness of exit prices and cash flows may be better appreciated in the future