Inflation Accounting

Inflation accounting From Wikipedia, the free encyclopedia Jump to: navigation, search In countries experiencing hyperinflation the International Accounting Standards Board requires corporate financial statements to be adjusted for changes in purchasing power using a price index.

Contents [hide] •

1 Historical cost basis in financial statements ○

1.1 Measuring unit principle

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1.2 Misleading reporting under historical cost accounting

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2 History of inflation accounting

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3 Inflation accounting models ○

3.1 Constant dollar accounting

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4 International standard for hyperinflationary accounting

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5 See also

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6 Notes and references

[edit] Historical cost basis in financial statements Fair value accounting (also called replacement cost accounting or current cost accounting) was widely used in the 19th and early 20th centuries, but historical cost accounting became more widespread after values overstated during the 1920s were reversed during the Great Depression of the 1930s. Most principles of historical cost accounting were developed after the Wall Street Crash of 1929, including the presumption of a stable currency [1] based on the international gold standard. It has been argued that when using gold as the base currency the US$ is in hyperinflation under IAS 29. [2]

[edit] Measuring unit principle For thousands of years gold or silver functioned as monetary commodities and were the measuring unit. Because turmoil resulting from the collapse of fiat currency in 1695 the United Kingdom followed the advice of Isaac Newton, Master of the Mint, and adopted the gold standard. He was subsequently knighted for his work in monetary science in 1705 by Queen Anne. In the 20th century the Bretton Woods system established an international gold standard with the dollar as the world reserve currency. President Richard Nixon, in the Nixon shock, closed the convertibility of $35 for 1 ounce of gold on August 15, 1971. The current worldwide monetary system is based on fiat currency and subject to payment risk [3]. Under a historical cost-based system of accounting, inflation leads to two basic problems. First, many of the historical numbers appearing on financial statements are not economically relevant because prices have changed since they were incurred.... Second, since the numbers on financial

statements represent dollars expended at different points of time and, in turn, embody different amounts of purchasing power, they are simply not additive. Hence, adding cash of $10,000 held on December 31, 2002, with $10,000 representing the cost of land acquired in 1955 (when the price level was significantly lower) is a dubious operation because of the significantly different amount of purchasing power represented by the two numbers.[4] By adding dollar amounts that represent different amounts of purchasing power, the resulting sum is misleading, as would be adding 10,000 dollars to 10,000 Euros to get a total of 20,000. Likewise subtracting dollar amounts that represent different amounts of purchasing power may result in an apparent capital gain which is actually a capital loss. If a building purchased in 1970 for $20,000 is sold in 2006 for $200,000 when its replacement cost is $300,000, the apparent gain of $180,000 is illusory. Accounting based on commodity money, like gold or silver, is never subject to these illusions because the unit of account has intrinsic value (numismatics).

[edit] Misleading reporting under historical cost accounting “In most countries, primary financial statements are prepared on the historical cost basis of accounting without regard either to changes in the general level of prices or to increases in specific prices of assets held, except to the extent that property, plant and equipment and investments may be revalued.”[5] Ignoring general price level changes in financial reporting creates distortions in financial statements such as[6] •

reported profits may exceed the earnings that could be distributed to shareholders without impairing the company's ongoing operations

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the asset values for inventory, equipment and plant do not reflect their economic value to the business

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future earnings are not easily projected from historical earnings

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the impact of price changes on monetary assets and liabilities is not clear

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future capital needs are difficult to forecast and may lead to increased leverage, which increases the business's risk

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when real economic performance is distorted, these distortions lead to social and political consequenses that damage businesses (examples: poor tax policies and public misconceptions regarding corporate behavior)

[edit] History of inflation accounting Accountants in the United Kingdom and the United States have discussed the effect of inflation on financial statements since the early 1900s, beginning with index number theory and purchasing power. Irving Fisher's 1911 book The Purchasing Power of Money was used as a source by Henry W. Sweeney in his 1936 book Stabilized Accounting, which was about constant purchasing power accounting. This model by Sweeney was used by The American Institute of Certified Public Accountants for their 1963 research study (ARS6) Reporting the Financial Effects of Price-Level Changes, and later used by the Accounting Principles Board (USA), the Financial Standards Board (USA), and the Accounting Standards Steering Committee (UK). Sweeney advocated using a price index that covers everything in the gross national product. In March 1979, the Financial Accounting Standards Board (FASB) wrote Constant Dollar

Accounting, which advocated using the Consumer Price Index for All Urban Consumers (CPI-U) to adjust accounts because it is calculated every month.[7] During the Great Depression, some corporations restated their financial statements to reflect inflation. At times during the past 50 years standard-setting organizations have encouraged companies to supplement cost-based financial statements with price-level adjusted statements. During a period of high inflation in the 1970s, the FASB was reviewing a draft proposal for price-level adjusted statements when the Securities and Exchange Commission (SEC) issued ASR 190, which required approximately 1,000 of the largest US corporations to provide supplemental information based on replacement cost. The FASB withdrew the draft proposal.[8]

[edit] Inflation accounting models Inflation accounting is not fair value accounting. Inflation accounting, also called price level accounting, is similar to converting financial statements into another currency using an exchange rate. Under some (not all) inflation accounting models, historical costs are converted to price-level adjusted costs using general or specific price indexes.[9] Income statement general price-level adjustment example[10] On the income statement, depreciation is adjusted for changes in general price levels based on a general price index. 2001 2002 2003 Total Revenue 33,000 36,302 39,931 109,233 Depreciation 30,000 31,500 (a) 33,000 (b) 94,500 Operating income 3,000 4,802 6,931 14,733 Purchasing power loss 1,500 (c) 3,000 (d) 4,500 Net income 3,000 3,302 3,931 10,233 (a) 30,000 x 105/100 = 31,500 (b) 30,000 x 110/100 = 33,000 (c) (30,000 x 105/100) - 30,000 = 1,500 (d) (63,000 x 110/105) - 63,000 = 3,000

[edit] Constant dollar accounting Constant dollar accounting is an accounting model that converts nonmonetary assets and equities from historical dollars to current dollars using a general price index. This is similar to a currency conversion from old dollars to new dollars. Monetary items are not adjusted, so they gain or lose purchasing power. There are no holding gains or losses recognized in converting values.[11]

[edit] International standard for hyperinflationary accounting The International Accounting Standards Board defines hyperinflation in IAS 29 as:"the cumulative inflation rate over three years is approaching, or exceeds, 100%." [12] Companies are required to restate their historical cost financial reports in terms of the period end hyperinflation rate in order to make these financial reports more meaningful.[13] [14] [15] The restatement of historical cost financial statements in terms of IAS 29 does not signify the abolishment of the historical cost model. This is confirmed by PricewaterhouseCoopers:

"Inflation-adjusted financial statements are an extension to, not a departure from, historical cost accounting."