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Chapter 14:

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

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Chapter 14:

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  1. Chapter 14: Accounting for Inflation and Changing Prices

  2. Lecture • Inflation defined • Price indices • Inflation accounting • Income measurement systems • Relevant SFASs

  3. 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.

  4. 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

  5. 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

  6. 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.

  7. 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.

  8. 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.

  9. 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

  10. 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

  11. 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

  12. 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

  13. Purchasing Power Gains & Losses • Arise as a result of holding net monetary assets or liabilities during a period when the price level changes • Monetaryassets and liabilities include cash itself and other assets and liabilities that are receivable or payable in a fixed number of dollars

  14. Purchasing Power Gains & Losses

  15. Holding Gains & Losses • Holding gains and losseson 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

  16. 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

  17. 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

  18. 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

  19. 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. .

  20. 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

  21. 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

  22. 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

  23. 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.

  24. SFAS No. 157 issued in 2006 • Measurement Considerations • Valuation Techniques • Market approach • Income approach • Cost approach • The Fair Value Pricing Hierarchy, 3 levels

  25. SFAS No. 157: Evaluation • SFAS No. 157 affected… • 24 FASB standards • 3 APB Opinions • Omissions • Income Statement • Holding Gains and Losses

  26. 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

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

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