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

Specific

price 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 SECs 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 SECs 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
Enterprise

Inflation

Deflation

Net Monetary
Asset Position

Purchasing
Power Loss

Purchasing
Power Gain

Net Monetary
Liability Position

Purchasing
Power Gain

Purchasing
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
countrys 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. 33s 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
current

cost 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
How assets are used

SFAS 157
In use versus inexchange

Comments
Applicable only to
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