Inflation accounting

McGraw-Hill/Irwin Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved.
Accounting for
Changes prices
(Inflation Accounting)
Upload by
Bishwajit Rout.
FMU

8-2
Additional Financial Reporting Issues
Chapter Topics
 Inflation accounting – general purchasing power and
current cost accounting approaches.
 Inflation accounting – differences in standards
worldwide.

8-3
Additional Financial Reporting Issues
Learning Objectives
1. Explain the concepts underlying two methods of
accounting for changing prices (inflation)—general
purchasing power accounting and current cost
accounting.
2. Describe attempts to account for inflation in different
countries, as well as the rules found in International
Financial Reporting Standards (IFRSs) related to this
issue.

8-4
Introduction
 conventional accounting results in a mix of
attributes being reflected in the asset
section of the balance sheet .
 Accounts receivable are reported at the net
amount expected to receive in the future.
 Inventory is carried at the lower of cost or
market value.
 Short-term investments are reported either
cost or current market value .
 Property, plant and equipment is reported at
cost less accumulated depreciation

8-5
Introduction
 Price of most assets fluctuate, often
increasing .
 Reporting assets on the balance sheet at
their historical cost during a period of price
changes can make the balance sheet
information irrelevant.
 For example, reporting land was
purchased in 1940 in the historical cost at
$1000 (irrelevant)

8-6
Inflation
 inflation is a rise in the general level of
prices of goods and services in an
economy over a period of time.
 inflation is also an erosion in the
purchasing power of money .
 A chief measure of price inflation is the
inflation rate, the annualized percentage
change in a general price index

8-7
Effects of Inflation
 Inflation can have positive and negative effects
on an economy
 negative effects :
 A decrease in the real value of money and other
monetary items over time
 Uncertainty about future inflation may discourage
investment and saving.
 and high inflation may lead to shortages of goods if
consumers begin hoarding out of concern that prices
will increase in the future
 Positive effects
 A mitigation of economic recessions.
 debt relief by reducing the real level of debt.

8-8
Measure of Inflation
 Inflation is usually estimated by calculating
the inflation rate of a price index, usually
the general price level .
 The General price level (Consumer Price
Index) measures prices of a selection of
goods and services (basket) purchased by
a "typical consumer".
 The inflation rate is the percentage rate of
change of a price index over time.

8-9
Measure of Inflation
 For instance, in January 2007, the U.S. general
price level was 202.416, and in January 2008 it
was 211.080. The formula for calculating the
annual percentage rate inflation in the general
price level over the course of 2007 is:
 The resulting inflation rate for the general price
level in this one year period is 4.28%, meaning
the general level of prices for typical U.S.
consumers rose by approximately four percent in
2007
211.080 – 202.416
202.416 = 4.28%)(

8-10
Inflation Accounting – Conceptual Issues
Impact of inflation on financial statements
1. Understated asset values.
 Negative impact on ability to borrow.
 Can invite hostile takeover to the extent that
the current market price of a company's
stock does not reflect the current value of
assets
Learning Objective 1

8-11
2. Overstated income and
overpayment of taxes.
 Understated assets result in
understated expenses (depreciation
and COGS)
 This lead to overstated income, thus
more taxes paid and stockholders
demand a higher level of dividends.
 That may result in high cash outflows
so lead to liquidity problems

8-12
3. Differing impacts across companies
resulting in lack of comparability.
 A company with older fixed assets will
report a higher return on assets than a
company with newer fixed assets.
 Because inflation rates tend to vary
across countries, comparison made by
parent company across its subsidiaries
located in different countries can be
distorted

8-13
purchasing power gains and losses.
 Historical cost also ignores purchasing power
gains and losses during the period of inflation.
 For example $202 can purchases one basket of
good and service, only year later when general
price level stated at $211, the same $202 can
purchases 95.5% percent of the basket, so you
need to $211 to buy the same basket .
 The difference between $211 needed to
maintain the purchasing power and 202 result in
$9 purchasing power loss .

8-14
 Purchasing power losses result from
holding monetary assets, such as cash
and accounts receivable.
 Purchasing power gains result from
holding monetary liabilities, such as
accounts payable.
 The two most common approaches to
inflation accounting are general
purchasing power accounting and current
cost accounting.

8-15
Methods of accounting for changing
prices
 Tow solution have been developed to deal with
distortions caused by historical cost
1. Account for in the general price level.
This approach makes adjustments to the historical
cost of assets to update for changes in purchasing
power of the currency and therefore is referred to as
general price level adjusted historical cost
(GPLAHC) accounting or, more simply general
purchasing power accounting
2. Account for specific price changes.
By updating the values of assets from historical cost
to the current cost to replace these assets, this is
known as current replacement cost (CRC) or
simply, current cost (CC) accounting .

8-16
Net Income and Capital Maintenance
 Historical cost, general purchasing
power and current cost accounting all
flow from different concepts of capital
maintenance.
 Net income represents the amount of
dividends that can be paid out while still
maintaining the company’s capital
balance.

8-17
Net Income and Capital Maintenance
 Historical cost net income maintains a
nominal, not adjusted for inflation, amount
of contributed capital.
 General purchasing power net income
maintains the purchasing power of
contributed capital.
 Current cost net income maintains the
productive capacity of physical capital.

8-18
Example
 Assume that HIE company is formed in
January 1,Year 1 , by investors
contributing 200 in cash . The general
price index (GPI) on that date is 100. HIE
company’s balance sheet on January
1,Year 1 as follows.
Cash 200 Contributed capital 200

8-19
Example
 With the initial equity investment, one unit of
inventory is purchased on January 2,Year 1 at a
cost of $100 and $100 remains in cash, resulting
in the following position 1,Year 1 as follows.
Inventory 100
200 200

8-20
Example
 on January 2,Year 1, the managers of HIE
company go on vocation, returning on
December 31, Year 1 at which time the inventory
is sold for $150 in cash, at December 31, Year 1
the general price index is 120 (20% annual
inflation during the year 1) and the inventory has
current replacement cost of $150 .
 The income statement for year 1 appear as
follows:
Sales 150
Cost of sales (100)
Income 50

8-21
Example
 The balance sheet at December 31, Year 1, prior to any
distribution of dividends is as follow
Retained earning 50
250
The economic definition of income is the
amount that can be distributed to owners
after making sure that the company is as
well at the end of a year as it was at the
beginning of the year.

8-22
Example
 If the company were to distribute a
dividend of $50 equal to year 1 net
income, the resulting balance sheet would
be exactly the same as it was at the
beginning of the year
 HC income is the amount that can be distributed
to owners while maintaining the nominal
amounts of contributed capital at the beginning
of the year .

8-23
Capital Maintenance
IASB Framework
Concepts of Capital maintenance
Financial capital maintenance
 One approach to income measurement.
 Net income represents the increase in net
financial assets, excluding owner
transactions.
 The approach in U.S. GAAP.

8-24
Capital Maintenance
IASB Framework
Concepts of Capital maintenance
Physical capital maintenance
 Another approach to income measurement.
 Net income represents increase in physical
productive capacity excluding owner
transactions.
 Requires current costs for measurement of
certain physical assets.

8-25
Inflation Accounting -- Methods
General Purchasing Power (GPP) Accounting
 Under (GPP) Accounting, nonmonetary assets, liabilities,
stockholders equity, and all income statement items are
restated from the GPI at the transaction date to the GPI
at the at the end of current period.
 Fixed assets and intangible assets and the related
depreciation and amortization would also be restated for
changes in general Purchasing Power .
 Updates historical cost accounting for changes in the
general purchasing power of the monetary unit.
 Also referred to as General Price-Level-Adjusted
Historical Cost Accounting (GPLAHC).
 Requires purchasing power gains and losses to be
included in net income.

8-26
General Purchasing Power (GPP) Accounting
 Because inventory was acquired on January 1, Year 1,
when the GPI was 100, and GPI at December 31, Year
1, is 120, the cost of sales (inventory) is restated using
the 120/100 .
 Because the sales occurred on December 31, Year 1,
when the GPI was 120, there is no need to restate sales
(or the restatement ratio can be expressed as 120/120).
 In addition to restating sales and cost of sales GPP
accounting also requires a net purchasing power gains
and losses to be included in net income

8-27
Follow the Example
 At January 1, Year 1, HIE company has
monetary assets 100 and no monetary liabilities,
yielding a net monetary asset position of $100.
 Because HIE holding this cash for entire year, a
net purchasing power loss (PPL) of $20 arises.
 In addition HIE receiving $150 cash on
December 31, Year 1 from the sales of the
inventory, because this cash on December 31,
Year 1 there is no loss on purchasing power by
the end of the year .

8-28
Follow the Example
The PPl calculated as follow:
Cash 1/1/Y1 ……….…… $100 x (120/100) = $120 (need to maintain pp)
+ increase in cash,Year1 $150 x (120/120) = $150
ٍSubtotal …………………………………………$270
Less : cash 12/31/Y1…………………………. ($250)
purchasing power loss……………………….. $ 20
Combining the restatement with PPL, GPP income is calculated
as follows:
HC Restatement ratio GPP
Sales ……… $150 x (120/120) $150
Cost of sales 100 x (120/100) 120
Subtotal ………………… $ 50 $ 30
purchasing power loss……………………….. ................. 20
Income……………………………………………………….. $ 10
To calculated
the purchasing
power loss

8-29
Follow the Example
 Contributed capital must also be restated for year 1
inflation as follow:
HC Restatement ratio GPP
Contributed capital 200 x(120/100) $240
The journal entry needed to account for GPP adjustment
is as follow:
Dr. Inventory (cost of sales) 20
Purchasing power loss 20
Cr. Contributed capital 40
GPP income represent the amount that can be
distributed to owners while marinating the purchasing
power of capital at the beginning of the year.

8-30
Follow the Example
 The balance sheet at December 31, Year 1, prior to any distribution
of dividends at historical cost model is as follow:
Retained earning 50
250
 After adjusting the accounts for GPP the balance sheet at
December 31, Year1, prior to any distribution of dividends at (GPP)
model is as
Retained earning 10
250
 After paying dividends at $10, the balance sheet at December 31,
Year 1, is as follow:

8-31
Current Cost (CC) Accounting
 Maintaining the purchasing power of equity does not
necessarily ensure that the company is able to continue to
operate at its existing level of capacity.
 To determine the amount of income that can be distributed
to owners while maintaining the company productive
capacity or physical capital , Current Cost (CC) Accounting
must be used.
 Under Current Cost (CC) Accounting ,historical cost of
nonmonetary assets are replaced with current
replacement .
 Also referred to as Current Replacement Cost Accounting.
 Nonmonetary assets are restated to current replacement
costs and expense items are based on these restated
costs.
 Holding gains and losses included in equity.

8-32
Inflation Accounting Internationally
United States and United Kingdom
 SFAS 33, Financial Reporting and Changing Prices
briefly required large U.S. companies to provide GP and
CC accounting disclosures.
 This information is now optional and few companies
provide it.
 In the UK, SSAP 16 required current cost information,
this was also was only briefly required.
 Both countries have experienced low rates of inflation
since the 1980s.

8-33
Latin America
 Latin America has a long history of significant inflation.
 Brazil, Chile, and Mexico have developed sophisticated
inflation accounting standards over time.
 Like the U.S. and UK, Brazil has abandoned inflation
accounting.
 Mexico’s Bulletin B-10, Recognition of the Effects of
Inflation in Financial Information, is a well-known
example.

8-34
Mexico – Bulletin B-10
 Requires restatement of nonmonetary assets and
liabilities using the central bank’s general price level
index.
 An exception is the option to use replacement cost for
inventory and related cost of goods sold.
 Another exception is imported machinery and
equipment.
 This exception allows a combination of country of origin
price index and the exchange rate between Mexico and
country of origin.

8-35
Netherlands – Replacement Cost Accounting
 Prior to the required use of IFRSs in 2005, Dutch
companies could use replacement cost accounting.
 In 2003 only Heineken used this approach.
 Heineken presented inventories and fixed assets at
replacement cost.
 Cost of sales and depreciation were also based on
replacement costs.
 The entry accompanying the asset revaluation was
reported in stockholders’ equity.

8-36
International Financial Reporting Standards
 IAS 15, Information Reflecting the Effects of Changing
Prices was issued in 1981.
 This standard has been withdrawn due to lack of
support.
 The relevant standard now is IAS 29, Financial
Reporting in Hyperinflationary Economies.
 IAS 29 is required for some companies located in
environments experiencing very high levels of inflation.

8-37
IAS 29 Financial Reporting in
Hyperinflationary Economies
 This Standard shall be applied to the
financial statements, including the
consolidated financial statements, of
any entity whose functional currency is
the currency of a hyperinflationary
economy.

8-38
Hyperinflationary Economies
 Hyperinflation is indicated by characteristics of the economic
environment of a country which include, but are not limited to, the
following:
1. The general population prefers to keep its wealth in non-monetary
assets or in a relatively stable foreign currency. Amounts of local
currency held are immediately invested to maintain purchasing
power;
2. The general population regards monetary amounts not in terms of
the local currency but in terms of a relatively stable foreign
currency. Prices may be quoted in that currency;
3. Sales and purchases on credit take place at prices that compensate
for the expected loss of purchasing power during the credit period,
even if the period is short
4. Interest rates, wages and prices are linked to a price index; and
5. The cumulative inflation rate over three years is approaching, or
exceeds,100%.

8-39
International Financial Reporting Standards
 IAS 29 includes guidelines for determining the
environments where it must be used.
 Nonmonetary assets and liabilities and stockholders’
equity are restated using a general price index.
 Income statement items are restated using a general
price index from the time of the transaction.
 Purchasing power gains and losses are included in net
income.

8-40
Statement of financial position
 Statement of financial position amounts not already
expressed in terms of the measuring unit current at the
end of the reporting period are restated by applying a
general price index.
 Monetary items are not restated because they are
already expressed in terms of the monetary unit current
at the end of the reporting period.
 Monetary items are money held and items to be received
or paid in money.
 Items stated at current cost are not restated because
they are already expressed in terms of the measuring
unit current at the end of the reporting period. Other
items in the statement of financial position are restated

8-41
Statement of
comprehensive income
 The current cost statement of comprehensive
income, before restatement, generally reports
costs current at the time at which the underlying
transactions or events occurred.
 Cost of sales and depreciation are recorded at
current costs at the time of consumption; sales
and other expenses are recorded at their money
amounts when they occurred.
 Therefore all amounts need to be restated into
the measuring unit current at the end of the
reporting period by applying a general price
index.

8-42
Consolidated financial
statements
 parent that reports in the currency of a
hyperinflationary economy may have
subsidiaries that also report in the currencies of
hyperinflationary economies.
 The financial statements of any such subsidiary
need to be restated by applying a general price
index of the country in whose currency it reports
before they are included in the consolidated
financial statements issued by its parent.
 Where such a subsidiary is a foreign subsidiary,
its restated financial statements are translated at
closing rates.

8-43
 Illustration example
 ABC corporation work in a highly inflation
country and prepare its financial
statements in general purchasing power in
accordance with IAS29 .
 The financial statements of ABC
corporation is as follow:

8-44
Conventional Balance Sheet.
Conventional Balance Sheet.
January 1. and December 31. 1989
Opening Closing
Assets
Monetary assets $100 $110
Inventories 80 100
Shares 50 50
Depreciable assets 200 180
Land 50 50
Total 480 490
Liabilities and Equities
Liabilities $350 310
Capital stock 50 50
Retained earnings 80 130
Total 480 490

8-45
Conventional Income statement.
Conventional Income statement.
For the year ended December 31. 1989
Sales ……………………………….. $800
Inventory, opening ……….. (80)
Purchases ……………….... (500)
Inventory, closing ………… 100
Cost of sales………………………… (480)
Expenses………………….. (200)
Depreciation………………. (20)
interest on loans ……………(50)
(270)
Net income …………………………….50

8-46
Other data
• Given 20% inflation during 1989
• During 1989 the company neither invested nor disposed of shares
or fixed assets, also no equity additions or withdrawals occurred.
• Therefore, the recorded nominal value of the shares, land and
capital stock did not change during the year.
• The recorded value of the depreciable assets declined only by the
nominal depreciation of $20.
• The retained earnings increased by $50 as determined by the
conventional income statement.
• All the item in the statement are recorded at historical values .
• Sales, purchases, expenses and interest incurred during the year.
• The opening inventory value and depreciation represent cost
incurred before 1989.
• The net income of $50 is retained, given that the company does not
pay income tax.

8-47
1- Restating the opening balance sheet
Conventional and restated Balance Sheet.
January 1. 1989
Conventional Restated
Assets
Monetary assets $100 100
Inventories 80 100
Shares 50 70
Depreciable assets 200 300 (Net (depreciated) value.)
Land 50 100
Total 480 670
Liabilities $350 350
Capital stock 50 200
Retained earnings 80 120 (To balance)
Total 480 670

8-48
 The individual items in the conventional opening balance
sheet (December 31, 1988) should be restated to
December 1988 prices.
 Assets:
 The monetary assets (cash, receivables, investment in
bonds, etc.), which are stated in nominal money units, do
not require any restatement. Because the nominal value
represents the real value of the asset concerned.
 The nonmonetary assets - inventories, shares,
depreciable assets, and land are restated. The
restatement can be carried out by applying the
corresponding restatement factor to each recorded
transaction in these assets over the company's history.

8-49
Restatement Factor
 Restatement factor is used to inflate a given
value in proportion to the inflation that has
occurred since the recording date.
 Given That the restatement process of the
nonmonetary assets inflated the values of the
four categories of assets from $380 (80 + 50 +
200 + 50, respective historical values) to $570
(100 + 70 + 300 + 100, respective restated
values).
Restatement Factor =
Price index at end of analyzed period
Price index at recording date

8-50
 The liabilities and Equities
 The liabilities (payables, received loans, etc.), which are
monetary items and stated in nominal money units, do
not require any restatement as the nominal value
represents the real value of the liability concerned,
Therefore, the restated value equals the recorded value
in the conventional statement.
 The capital stock, which has been issued in the past, is
restated. The restatement is carried out by applying the
corresponding restatement factor to each recorded
capital stock transaction (equity addition) over the
company's history.
 The retained earnings item is not restated; it is derived
by subtracting the liabilities and capital stock from the
total restated assets, that is, (670 - 350 - 200 = $120)

8-51
2- Restating Intra-Year Capital
Transactions
 Intra-year capital transactions are those transactions
incurred during the year which directly affect the level of
balance-sheet items, such as investments or
disinvestments in shares, fixed assets, and equity
additions or withdrawals.
 These transactions should be restated to year-end
prices.
 The restatement of these items can be carried out in
two ways :
1. Applying the corresponding restatement factor to each
recorded transaction, or.
2. Using the average price index for the restatement
factor, assuming that the transactions incurred more-or-
less evenly during the year

8-52
2- Restating Intra-Year Capital
Transactions
Restatement Factor =
In our example there are no Intra-year capital transactions.
Price index Dec. 1989
Average price index Dec. 1988 - Dec. 1989
The restatement of these items can be carried out in
two ways :
1.Applying the corresponding restatement factor to
each recorded transaction, or.
2.Using the average price index for the restatement
factor, assuming that the transactions incurred
more-or-less evenly during the year

8-53
3- Restating the Closing Balance Sheet
Conventional and restated Balance Sheet.
January 1. 1989 December 31. 1989
Restated 1/1 Conventional Restated
Assets
Monetary assets 100 $110 110
Inventories 100 100 110
Shares 70 50 84
Depreciable assets 300 180 328
Land 100 50 120
Total 670 490 752
Liabilities 350 $310 310
Capital stock 200 50 240
Retained earnings 120 130 202 (To balance)
Total 670 490 752

8-54
 The restated closing balance sheet la the
result of adjusting data from three sources
 Monetary assets and liabilities - derived
from the conventional closing balance
sheet. These items are treated according
to the procedures outlined in restating the
monetary assets in restating the opening
Balance Sheet.

8-55
 The restatement of Inventories can be carried
out by applying the corresponding restatement
factor to each recorded transaction in these
Inventories over the Year, The restatement
process inflated the value of the closing
inventories from $100 to $110. .
 Shares, land, (Nondepreciable Assets) and
capital stock derived from the opening restated
balance sheet. These items are updated to year-
end prices (we given that Inflation rate is 20%) .

8-56
Updating means translating figures from restated dollars for a given
date in the past to dollars of purchasing power at a later date, using a
restatement factor.
Ill. Example: Adjusted financial figures for December 31, 1988 and
December 31, 1989 are compared, as follows.
December 31, 1988 December 31, 1989
Price Index 100 120
Restatement factor 120/100 = 1.2 120/120 = 1
Shares 70 84
Land 100 120
Capital stock 200 240

8-57
 Depreciable assets:
 The treatment of depreciable assets, such as
plant and equipment, involves the restatement
of both assets value and depreciation
expenses, to December 1989 prices. .
 Given that there was neither investment nor
disinvestment in these assets during 1989 and
that the inflation rate was 20% during the
year, the corresponding restated values are as
follow :

8-58
Opening Closing
$400 Acquisition cost $480
(100) Less: Accumulated depreciation (120)
1989's depreciation (32)
300 Net (depreciated) value 328
The restated opening acquisition cost of $400 is updated to $480
in December 1989 prices (restatement factor of 1.2).
The $32 depreciation for 1989 is derived from the restated
acquisition cost, and stated in December 1989 prices.

8-59
4- Deriving the Year's Adjusted Net Income
The simplest way to derive the inflation-adjusted net income of a
company is by measuring the change in equity between the closing and
opening balance sheets, where the figures are stated in year-end prices.
The adjusted net income for the illustrative company in 1989 is
calculated as follow :-
Opening Closing
Dec. 1988 Prices Dec. 1989 Prices*
Assets $670 $804 $752
Less: Liabilities (350) (420) (310)
Equity 320 384 442
Less: Opening equity (384)
Adjusted net income 58
*December 1988 prices times 1.2 restatement factor (given 20% inflation during 1989.

8-60
5- Adjusting the Income
Statement
 Adjustment of the conventional income
statement can be carried out by restating all the
items to year-end prices. This procedure
provides improved information for planning and
control purposes, but it is more cumbersome to
apply and difficult to comprehend.
 The conventional income statement for 1989
and the adjusted statement, following the above
mentioned procedure, are presented as follow:

8-61
Income Statement for the year ended December 31, 1989
Conventional and fully Restated
Conventional Restated *
Sales $ 800 $880**
Inventory, opening $(80) $(120)
Purchases (500) (550)
Inventory, closing 100 110
Cost of sales (480) (560)
Expenses (200) (220)**
Depreciation (20) (32)
Interest on loans (50) (50)
(270) (302)
Net income, retained 50 18
Gain on net monetary position 40
Adjusted net income 58

8-62
• Sales, Purchases, closing Inventory, and Expenses are restated by
using restatement factor 1.1, based on average price indexes for
Dec. 1989 .
Average Price Index
An average price index for a given period should be used for restating
values that are incurred evenly throughout the period.
Example: Consider the following price indexes
• Inventory, opening carried from the opening restated balance sheet
and then Restated using the restatement factor 1.2 (given 20%
inflation in 1989).
Oct. 1989 – 307
Nov. 1989 – 320
Dec. 1989 - 330
The average price index is :
(310+320+330)/3 = 320
The corresponding restatement factor
is 330/320 = 1.03125

Inflation accounting

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