INFLATION ACCOUNTING
PhDr. Miroslav ŠKODA, PhD.,
University of Matej Bel, Faculty of Economics, Department of Finance and
Accounting,
Tajovského 10, Banská Bystrica, 974 01, Slovakia, tel.
00421 48 446 63 25,
email address: miroslav.skoda@umb.sk
Abstract
While the use of fair value as a
measurement attribute for purposes of financial statement display has become
increasingly popular in recent years, accounting principles — both most
national GAAP and IFRS — still remain substantially grounded in historical
costing. Notwithstanding that under US
GAAP a major pronouncement has established a hierarchy of fair value
measurement techniques — and that a forthcoming IFRS standard is likely to do
likewise, probably replicating the US GAAP standard — few or no new mandates to
apply fair value accounting have been issued.
In periods of price stability, the
use of historical cost information does not do much of a disservice to
understanding the reporting entity’s financial position and results of
operations. However, in times of price
instability — or, in the case of long-lived assets, even in periods of modest
changes in prices over long stretches of time — financial reporting can be
distorted. Over many decades, a wide
variety of solutions to this problem have been proposed, and, in certain
periods of rampant inflation, some of
these have even been put into practice.
Key words
Accounting, inflation, hyperinflation, price instability, IAS / IFRS, US
GAAP
Introduction
Accounting practice today, on
virtually a worldwide basis, relies heavily on the historical cost measurement
strategy, whereby resources and obligations are given recognition as assets and
liabilities, respectively, at the original (dollar, yen, etc.) amount of the
transaction from which they arose. Once recorded, these amounts are not altered
to reflect changes in value, except to the limited extent that various national
GAAP standards or IFRS require recognition of impairments (e.g., lower of cost
or fair value for inventories, etc.). Most long-lived assets such as buildings
are amortized against earnings on a rational basis over their estimated useful
lives, while short-lived assets are expensed as physically consumed.
Liabilities are maintained at cost until paid off or otherwise discharged.
It is useful to recall that before
the historical cost model of financial reporting achieved nearly universal
adoption, various alternative recognition and measurement approaches were
experimented with. Fair value accounting was in fact widely employed in the
nineteenth and early twentieth centuries, and for some regulatory purposes
(especially in setting utility service prices, where regulated by governmental
agencies) remained in vogue until somewhat more recently. The retreat from fair
value accounting was, in fact, due less to any inherent attractiveness of the
historical cost model than to negative reaction to abuses in fair value
reporting. This came to a climax during the 1920s in much of the industrialized
world, when prosperity and inflation encouraged overly optimistic reflections
of values, much of which were reversed after the onset of the worldwide Great
Depression.
Historical Review of Inflation Accounting
The persistent inflation experienced
by many industrialized nations during the 1960s, 1970s, and early 1980s caused
there to be a reexamination of the long-held and widespread commitment to
historical cost as the principal basis for financial reporting. (An exception had been those nations, such
as many in Latin America, where inflation had been endemic for many decades,
and where price-level adjusted financial reporting was commonly employed.) Popular interest in alternative techniques
of inflation accounting (as the various methods are all called) declined
markedly once price stability was restored, by the mid-1980s. Most of the
financial reporting standards adopted (including those under US and UK GAAP,
and under IFRS) have been revoked, made optional, or fallen into disuse during
this time. As part of the IASB’s Improvements Project, IAS 15, the standard on
inflation accounting, was withdrawn in 2005.
While the standard has been
withdrawn, it does remain as a matter of record as one highly evolved set of
guidance that entities can still utilize, should the decision be made to
present supplementary financial statements on a basis which removes the effects
of cost changes. For reporting entities electing to present inflation adjusted
financial statements, this will continue to be instructive, together with
selected literature published by US and UK standard setters and other bodies
such as the US Securities and Exchange Commission. Thus, although presentation
of inflation–adjusted financial statements is no longer required, for entities
choosing to present such financial data, this guidance continues to be
pertinent.
Most of what are known as generally
accepted accounting principles (GAAP) were developed after the crash of 1929.
The more important of the basic postulates, which underlie most of the historical
cost accounting principles, include the realization concept, the stable
currency assumption, the matching concept, conservatism (or prudence), and
historical costing. Realization means that earnings are not recognized until a
definitive event, involving an arm’s-length transaction in most instances, has
occurred. Stable currency refers to the presumption that a ˆ1,000 machine
purchased today is about the same as a ˆ1,000 machine purchased twenty years
ago, in terms of real productive capacity. The matching concept has come to
suggest a quasi-mechanical relationship between costs incurred in prior periods
and the revenues generated currently as a result; the net of these is deemed to
define earnings. Conservatism, among
other things, implies that all losses be provided for but that gains not be
anticipated, and is often used as an argument against fair value accounting.
Finally, the historical costing convention was adopted as the most objectively
verifiable means of reporting economic events.
The confluence of these underlying
postulates has served to make historical cost based accounting, as it has been
practiced for the past sixty years, widely supported. Even periods of rampant
inflation, as the Western industrialized nations experienced during the 1970s,
has not seriously diminished enthusiasm for this model, despite much academic
research and the fairly sophisticated and complete alternative financial
reporting approaches proposed in the United Kingdom and the United States and a
later international accounting standard that built on those two
recommendations. All of these failed to generate wide support and have largely
been abandoned, being relegated to suggested supplementary information status,
with which very few reporting enterprises comply.
What should accounting measure?
Accounting was invented to measure economic activity in order to facilitate
it. It is an information system, the
product of which is used by one or more groups of decision makers: managers,
lenders, investors, even current and prospective employees. In common with
other types of decision-relevant data, financial statements can be evaluated
along a number of dimensions, of which relevance and objectivity are frequently
noted as being the most valuable. Information measured or reported by
accounting systems should be, on the one hand, objective in the sense that
independent observers will closely agree that the information is correct, and
on the other hand, the information should be computed and reported in such as
way that its utility for decision makers is enhanced.
Objectivity has become what one
critic called an occupational distortion of the accounting profession. While
objectivity connotes a basic attitude of unprejudiced fairness that should be
highly prized, it has also come to denote an excessive reliance on completed
cash transactions as a basis for recording economic phenomena. However,
objectivity at the cost of diminished relevance may not be a valid goal. It has
been noted that “relevance is the more basic of the virtues; while a relevant
valuation may sometimes be wrong, an irrelevant one can never be of use, no
matter how objectively it is reached.” Both the FASB in the United States and
the IASB in the international arena have published conceptual framework
documents which support the notion that more relevant information, even if
necessitating a departure from the historical costing tradition, could be more
valuable to users of financial statements.
Why inflation undermines historical
cost financial reporting? Financial statements that ignore the effects of
general price level changes as well as changes in specific prices are
inadequate for several reasons.
Example
A business starts with one unit of inventory, which cost ˆ2 and which at
the end of the period is sold for ˆ10 at a time when it would cost ˆ7 to
replace that very same unit on the display shelf. Traditional accounting would
measure the earnings of the entity at ˆ10 – ˆ2 = ˆ8, although clearly the
business is only ˆ3 “better off” at the end of the period than at the
beginning, since real economic resources have only grown by ˆ3 (after replacing
the unit sold there is only that amount of extra resource available). The illusion that there was profit of ˆ8
could readily destroy the entity if, for example, dividends of more than ˆ3
were withdrawn or if fiscal policy led to taxes of more than ˆ3 on the ˆ8
profit.
On the other hand, if the financial report showed only ˆ3 profit for the
period, there could be several salutary effects. Owners’ expectations for dividends would be tempered, the
entity’s real capital would more likely be preserved, and projections of future
performance would be more accurate, although projections must always be fine-tuned
since the past will never be replicated precisely.
Evolving use of financial statements
The failure of the historical cost
statement of financial position to reflect values is yet another major
deficiency of traditional financial reporting. True, accounting was never
intended to report values per se, but the excess of assets over liabilities has
always been denoted as net worth, and to many that clearly connotes value.
Similarly, the alternative titles for the statement of financial position, balance
sheet and statement of financial condition, strongly suggest value to the lay
reader. The confusion largely stems from a failure to distinguish realized from
unrealized value changes; if this distinction were carefully maintained, the
statement of financial position could be made more useful while remaining true
to its traditions.
The traditional statement of
financial position was the primary, even the only, financial statement
presented during much of accounting’s history. However, beginning during the
1960s, what is currently known as the statement of comprehensive income
achieved greater importance, partly because users came to realize that the
statement of financial position had become the repository for unamortized
costs, deferred debits and credits, and other items that bore no relationship
to real economic assets and obligations. In the aggressive and high-growth
1960s and early 1970s, the focus was largely on summary measures of enterprise
performance, such as earnings per share, which derived from the statement of
comprehensive income. During this era, the matching concept became the key
underlying postulate that drove new accounting rules.
Following a series of unpleasant
economic events, including numerous liquidity crises and recessions in the
1970s and 1980s, the focus substantially shifted back to the statement of
financial position. Partly in response, the major accounting standard-setting
bodies developed conceptual standards that urged the elimination of some of the
items previously found on statements of financial position that were not really
either assets or liabilities. Some of these were the leftovers from double
entry bookkeeping, which was oriented toward achieving statement of
comprehensive income goals (e.g., the optimal matching of revenues and
expenses); an example is the interperiod tax allocations that resulted in the
reporting of ever-growing deferred tax liabilities that were never going to be
paid. While the tension between achieving a meaningful statement of financial
position and an accurate statement of comprehensive income is inherent in the
double-entry accounting model in use for almost 500 years, accountants are
learning that improvements in both can be achieved. Inflation adjusted
accounting can contribute to this effort, as will be demonstrated.
General vs. specific price changes
An important distinction to be
understood is that between general and specific price changes, and how the
effects of each can be meaningfully reported on in financial statements.
Changes in specific prices, as with the inventory example above, should not be
confused with changes in the general level of prices, which give rise to what
are often referred to as purchasing power gains or losses, and result from
holding net monetary assets or liabilities during periods of changing general
prices. As most consumers are well aware, during periods of general price
inflation, holding net monetary assets typically results in experiencing a loss
in purchasing power, while a net liability position leads to a gain, as
obligations are repaid with “cheaper” dollars. Among other effects, prolonged
periods of general price inflation motivates entities to become more leveraged
(more indebted to others) because of these purchasing power gains, although in
reality creditors are aware of this and adjust interest rates to compensate.
Specific prices may change in ways
that are notably different from the trend in overall prices, and they may even
move in opposite directions. This is particularly true of basic commodities
such as agricultural products and minerals, but may also be true of
manufactured goods, especially if technological changes have great influence.
For example, even during the years of rampant inflation during the 1970s some
commodities, such as copper, were dropping in price, and certain goods, such as
computer memory chips, were also declining even in nominal prices. For entities
dealing in either of these items, holding inventories of these non-monetary
goods (usually a hedge against price inflation) would have produced large
economic losses during this time. Thus, not only the changes in general prices,
but also the changes in specific prices, and very important, the interactions
between these can have major effects on an enterprise’s real wealth. Measurement
of these phenomena should be within the province of accounting.
Over the past fifty years there have
been a number of proposals for pure price level accounting, financial reporting
that would be sensitive to changes in specific prices, and combinations of
these. There have been proposals (academic proposals) for comprehensive
financial statements that would be adjusted for inflation, as well as for
supplemental disclosures that would isolate the major inflation effects without
abandoning primary historical cost based statements (generally, the
professional proposals and regulatory requirements were of this type). To place
the former requirements of the now-withdrawn standard IAS 15 in context, a
number of its more prominent predecessors will be reviewed in brief.
At its simplest, price level
accounting views any given currency at different points in time as being
analogous to different currencies at the same point in time. That is, 1955 US
dollars have the same relationship to 2008 dollars as 2008 Swiss francs have to
2008 dollars or euros. They are “apples
and oranges” and cannot be added or subtracted without first being converted to
a common measuring unit. Thus, “pure” price level accounting is held to be within
the mainstream historical cost tradition and is merely a translation of one
currency into another for comparative purposes. A broadly based measure of all
prices in the economy should be used in accomplishing this (often, a consumer
price index of some sort is employed).
A number of proposals have been
offered over the years for either replacing traditional financial statements
with price level adjusted statements, or for including supplementary price
level statements in the annual report to shareholders. In the United States,
the predecessor of the current accounting standard setter, the Accounting
Principles Board, proposed supplementary reporting in 1969; no major publicly
held corporation complied with this request, however. The FASB made a similar
proposal in 1974 and might have succeeded in imposing this standard had not the
US securities market watchdog, the SEC, suggested instead that a current value
approach be developed. (Later the SEC did impose a replacement costing
requirement on large companies, and the FASB followed with its own version a
few years thereafter.)
In the United Kingdom a similar
course of events occurred. After an early postwar recommendation (not
implemented) that there be earnings set aside for asset replacements, a late
1960s proposal for supplementary price level adjusted reporting was made,
followed a few years later by a more comprehensive constant dollar
recommendation. As happened in the
United States at about the same time, what appeared to be a private sector
juggernaut favoring price level adjustments was derailed by governmental
intervention. A Royal Commission, established in 1973, eventually produced the
Sandilands report, supporting current value accounting and not addressing the
reporting of purchasing power gains or losses at all. This marked the end of
British enthusiasm for general price level adjusted financial statements. Even
a fairly complex later proposal (ED 18) made in 1977 did not incorporate any
measure of purchasing power gains or losses, although it did add some novel
embellishments to what basically was a current value model.
Other European nations have never
been disposed favorably toward general price level accounting, with the
exception of France. However, Latin American nations, having dealt with
virtually runaway inflation for decades, have generally welcomed this type of
financial reporting and in some cases have required it, even for some tax
purposes. While price level adjustments are no more logical in Brazil, for
example, than in the United States, since specific prices are changing, often
at widely disparate rates, the role of accounting in those nations, serving as
much more of an adjunct to the countries’ respective tax collection and
macroeconomic policy efforts than in European or other Western nations, has
tended to encourage support for this approach to accounting for changing
prices.
Current value models and proposals
By whatever name it is referred to,
current value (replacement cost, current cost) accounting is really based on a
wholly different concept than is price level (constant dollar) accounting.
Current value financial reporting is far more closely tied to the original
intent of the accounting model, which is to measure enterprise economic wealth
and the changes therein from period to period. This suggests essentially a
“statement of financial position orientation” to income measurement, with the
difference between net worth (as measured by current values) at year beginning
and year-end being, after adjustment for capital transactions, the measure of
income or loss for the intervening period. How this is further analyzed and
presented in the statement of comprehensive income (as realized and unrealized
gains and losses) or even whether some of these changes even belong in the
statement of comprehensive income (or instead, are reported in a separate
statement of movements in equity, or are taken directly into equity) is a
rather minor bookkeeping concern.
Although the proliferation of
terminology of the many competing proposals can be confusing, four candidates
as measures of current value can readily be identified: economic value, net present value, net
realizable value (also known as exit value), and replacement cost (which is a
measure of entry value). A brief explanation will facilitate the discussion of
the IAS / IFRS requirements later in this chapter.
Economic value is usually understood
to mean the equilibrium fair market value of an asset. However, apart from items traded in auction
markets, typically only securities and raw commodities, direct observation of economic
value is not possible.
Net present value is often suggested
as the ideal surrogate for economic value, since in a perfect market values are
driven by the present value of future cash flows to be generated by the assets.
Certain types of assets, such as rental properties, have predictable cash flows
and in fact are often priced in this manner. On the other hand, for assets such
as machinery, particularly those that are part of a complex integrated
production process, determining cash flows is difficult.
Net realizable values (NRV) are more
familiar to most accountants, since even under existing US, UK, and
international accounting standards, there are numerous instances when
references to NRV must be made to ascertain whether asset write-downs are to be
required. NRV is a measure of “exit
values” since these are the amounts that the organization would realize on
asset disposition, net of all costs; from this perspective, this is a
conservative measure (exit values are lower than entry values in almost all
cases, since transactions are not costless), but also is subject to criticism
since under the going concern assumption it is not anticipated that the
enterprise will dispose of all its productive assets at current market prices,
indeed, not at any prices, since these assets will be retained for use in the
business.
The biggest failing of this measure,
however, is that it does not assist in measuring economic income, since that
metric is intended to reveal how much income an entity can distribute to its
owners, and so on, while retaining the ability to replace its productive
capacity as needed. In general, an
income measure based on exit values would overstate earnings (since
depreciation and cost of sales would be based on lower exit values for plant assets
and inventory) when compared with an income measure based on entry values.
Thus, while NRV is a familiar concept to many accountants, this is not the
ideal candidate for a current value model.
Replacement cost is intended as a
measure of entry value and hence of the earnings reinvestment needed to
maintain real economic productive capacity. Actually, competing proposals have
engaged in much hairsplitting over alternative concepts of entry value, and
this deserves some attention here. The simplest concept of replacement value is
the cost of replacing a specific machine, building, and so on, and in some
industries it is indeed possible to determine these prices, at least in the
short run, before technology changes occur.
However, in many more instances (and in the long run, in all cases)
exact physical replacements are not available, and even nominally identical
replacements offer varying levels of productivity enhancements that make
simplistic comparisons distortive. The next example shows what is discussed
about.
Consider a machine with a cost of ˆ 40,000 that can produce 100 widgets
per hour. The current price of the
replacement machine is ˆ 50,000 that superficially suggests a specific price
increase of 25% has occurred. However, on closer examination, it is determined
that while nominally the same machine, some manufacturing enhancements have
been made (e.g., the machine will require less maintenance, will require fewer
labor inputs, runs at a higher speed, etc.) which have altered its effective capacity
(considering reduced downtime, etc.) to 110 widgets per hour. Clearly, a naive
adjustment for what is sometimes called “reproduction cost” would overstate the
machine’s value on the statement of financial position and overstate periodic
depreciation charges, thereby understating earnings. A truer measure of the
replacement cost of the service potential of the asset, not the physical asset
itself, would be given as
ˆ 40,000 × (50,000/40,000) × 100/110 = ˆ 45,454
That is, the service potential represented by the asset in use has a
current replacement cost of ˆ 45,454, considering that a new machine costs 25%
more but is 10% more productive.
Consider another example: An integrated production process uses machines
A and B, which have reproduction costs today of ˆ 40,000 and ˆ 45,000,
respectively. However, management plans to acquire a new type of machine, C,
which at a cost of ˆ 78,000 will replace both machines A and B and will produce
the same output as its predecessors. The combined reproduction cost of ˆ 85,000
clearly overstates the replacement cost of the service potential of the
existing machines in this case, even if there had been no technological changes
affecting machines A and B.
Some, but not all, proposals that
have been made in academia over the past sixty years, and by standards setters
and regulatory authorities over the past twenty-five years, have understood the
foregoing distinctions. For example, the US SEC requirements of the mid-1970s
called for measures of the replacement cost of productive capacity, which
clearly implied that productivity changes had to be factored in. The subsequent
private sector rules issued by FASB seemed to redefine what the SEC had
mandated to highlight its own current cost requirement; in essence, the FASB’s
current costs were nothing other than the SEC’s replacement costs. Other
proposals have been more ambiguous, however. Furthermore, measuring the impact
of technological change adds vastly to the complexity of applying replacement
cost measures, since raw replacement costs (known as reproduction costs) are
often easily obtained (from catalog prices, etc.), but productivity adjustments
must be ascertained by carefully evaluating advertising claims, engineering
studies, and other sources of information, which can be a complex and costly
process.
Conclusion
The experience of the international
accounting standard that was designed to reveal the effects of inflation is
very similar to the experiences in the United States and the United
Kingdom. That is, while there was a
great clamor, primarily from the financial analyst community, in favor of this
supplementary financial reporting model, once it was mandated there was a
noticeable decline in interest. It would appear that analysts much prefer to
develop their own estimates of the impact of inflation on the companies they
follow and may have an inherent distrust of management-supplied data. As for
management, it generally argued that such information was useless before the
standard was imposed, which at the time seemed to be self-serving posturing in
the hope that an expensive new mandate could be averted.
As in the United States, after a few
years of mandatory presentation of supplementary inflation adjusted information
(IAS 15 was imposed in 1981), the IASC announced in 1989 that presentation
would no longer be required to comply with the standard, although it would
still be encouraged. This status continued until the Improvements Project
determined to eliminate the guidance entirely.
The Improvements Project concluded
that IAS 15 was no longer needed and should be withdrawn. The IASB stated that,
“the Board does not believe that entities should be required to disclose
information that reflects the effects of changing prices in the current
economic environment.” In the authors’ view, for those (few) entities which
believe that inflation adjusted financial reporting continues to serve a useful
purpose, the guidance in IAS 15 and in the foregoing discussion of this chapter
continues to be germane.
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