Chapter 14:

Accounting for Inflation and Changing Prices

Lecture

Inflation defined
Price indices
Inflation accounting
Income measurement
systems
Relevant SFASs
Inflation Defined

The rise in the average price level for all

goods and services produced in an economy
Measurement of inflation requires use of a
price index to quantify the price changes
from period-to-period.
Price Index
Is a weighted average of the current prices
of goods and services
 Averages are related to prices in a base period
 Purpose is to determine how much change has
occurred
Types of price indices
 Specificprice index
 General price index
Price Indices (Indexes)
Paasche-type indices
 Uses current-year
quantities
 CPI
 WPI or PPI

Laspeyres-type indices
 Uses base-year
quantities
 Less costly to construct
Accounting History
As early as the 1920s, some U.S.
corporations restated their primary financial
statements for the effects of changes in
specific prices.
AAA and AICPA strongly supported the
historical cost model in the mid-1930s.
However, by the early 1950s both the AAA
and AICPA began to modify their positions.
Accounting History
Shortly after its inception, the Financial
Accounting Standards Board (FASB) issued an
exposure draft entitled “Financial Reporting in
Units of General Purchasing Power.”
 Proposed to require the presentation, as supplementary
information, of the balance sheet and income statement
restated in units of general purchasing power.
 The FASB deferred action on its exposure draft because
the Securities and Exchange Commission (SEC) issued
Accounting Series Release (ASR) 190, which reversed
the SEC’s long- standing position of forbidding the
presentation of information other than historical cost.
ASR 190
Accountants in general and accounting
organizations, such as the AAA, AICPA, and
FASB, tended to favor price-level restated
historical cost until the SEC’s rather dramatic
action of issuing ASR 190.
FASB immediately reconsidered its position
(general price-level restatement at that time) and
led to the dual approach eventually adopted in
SFAS No. 33.
Traditional Accounting
Under a historical cost-based system of
accounting, inflation leads to two basic
problems
 Many historical numbers are not economically
relevant
 Historical numbers are not additive

Price changes (inflation) are problematic

Inflation and Historical Costing
Likely predictive value is diminished
Comparability among financial statements
of different firms is limited
Capital maintenance
 Income usually overstated relative to amounts
that can be distributed to stockholders
 Many dividends are really liquidating in nature
Inflation Accounting
General purchasing power adjustment
translates historical dollars into dollars
having equivalent purchasing power
Current valuation, also called current cost,
attempts to derive the specific value or
worth for a particular point ...
 Entry values
 Exit values
Entry vs. Exit Values
Entry values
 Value in use is best represented by replacement
costs
 Strong argument in support of use

Exit values
 Are a form of opportunity costs
 The balance sheet becomes the principal
financial statement
Purchasing Power Gains & Losses
Arise as a result of holding net monetary
assets or liabilities during a period when the
price level changes
Monetary assets and liabilities include
cash itself and other assets and liabilities
that are receivable or payable in a fixed
number of dollars
Purchasing Power Gains & Losses

State of the
Inflation Deflation
Enterprise

Net Monetary Purchasing Purchasing

Asset Position Power Loss Power Gain

Net Monetary Purchasing Purchasing

Liability Position Power Gain Power Loss
Holding Gains & Losses
Holding gains and losses on real (nonmonetary)
assets can be divided into two parts
 monetary holding gains and losses, which arise purely
because of the change in the general price level during
the period; and
 real holding gains and losses, which are the difference
between general price-level-adjusted amounts and
current values.
Are capital adjustments only; they are not a
component of income
The Gearing Adjustment
Somewhat related to the holding gain
Was used in Great Britain as part of that
country’s inflation accounting mechanism
Results in gains to equity capital during
inflation because debt capital does not have
any claim on holding gains
proved to be an extremely confusing
concept
Income Measurement Systems
Current Value Approaches
 Distributable Income (DI)
 Realized Income (RI)
 Earning Power Income (EPI)

Methods differ in terms of disposition of

real holding gains and the resulting type of
capital maintenance measure
SFAS No. 33
FASB decided to keep nominal historical costs as
the basis of primary financial statements
Specified that the effects of changing prices
should be presented as supplementary information
in annual reports
FASB realized that a consensus could not be
obtained on which method of accounting should
be adopted
SFAS No. 33
Not all enterprises had to comply with
SFAS No. 33
For constant dollar reporting, the SFAS
required disclosure of
 Information on income from continuing
operations for the current fiscal year on a
historical cost/constant dollar basis . . .
 The purchasing power gain or loss on net
monetary items for the current fiscal year. .
SFAS No. 33’s Failure
There was a dramatic
decline of inflation
during the early 1980s
Measurement
problems were present
Questions of
understandability and
usefulness for
predictive purposes
SFAS No. 82 issued in 1984
Eliminated the constant dollar income
disclosures that had previously been
required by SFAS No. 33
SFAS No. 33
 information confused users
 may have caused “information overload”
because of the presence of similar current cost
income disclosures
SFAS No. 89 issued in 1986
Two parts of SFAS No. 33 remained in
effect; were “encouraged” but not required
 currentcost income measurement, purchasing
power gain or loss, and
 holding gain information

FASB beat a hasty retreat from the problem

of accounting for changing prices
SFAS No. 157 issued in 2006
Grounded in the belief that current values
(now called fair values) are more relevant
for decision-making purposes than
historical costing for all users and user
groups.
Fair value system of SFAS No. 157 is
basically an exit value system.
SFAS No. 157 issued in 2006
Measurement Considerations
Valuation Techniques
 Market approach
 Income approach
 Cost approach

The Fair Value Pricing Hierarchy, 3 levels

 Category SFAS 157 Comments

How assets are used In use versus in- Applicable only to

exchange assets. Joint costs
may impede in-use
category

Valuation techniques Market, income, cost Provides an

approaches overview
of valuations.
Fair value hierarchy Levels 1, 2, 3 provides the
specifics of
pricing going from
higher to lower
verifiability.
SFAS No. 157: Evaluation
SFAS No. 157 affected…
 24 FASB standards
 3 APB Opinions

Omissions
 Income Statement
 Holding Gains and Losses
SFAS No. 157: Evaluation
Theoretical Issues
 The Exit Value Choice
 Market Based versus Entity Specific Prices
 Pricing Approaches and Techniques
 Capital Maintenance
 Comparability and Reliability

Likely to see multiple revisions in the future

Lecture
Inflation
Price indexes
Inflation accounting
Income measurement
systems
SFAS No.
 33
 82
 89
 157