8-2Additional Financial Reporting IssuesChapter Topics Inflation accounting – general purchasing power andcurrent cost accounting approaches. Inflation accounting – differences in standardsworldwide.
8-3Additional Financial Reporting IssuesLearning Objectives1. Explain the concepts underlying two methods ofaccounting for changing prices (inflation)—generalpurchasing power accounting and current costaccounting.2. Describe attempts to account for inflation in differentcountries, as well as the rules found in InternationalFinancial Reporting Standards (IFRSs) related to thisissue.
8-4Introduction conventional accounting results in a mix ofattributes being reflected in the assetsection of the balance sheet . Accounts receivable are reported at the netamount expected to receive in the future. Inventory is carried at the lower of cost ormarket value. Short-term investments are reported eithercost or current market value . Property, plant and equipment is reported atcost less accumulated depreciation
8-5Introduction Price of most assets fluctuate, oftenincreasing . Reporting assets on the balance sheet attheir historical cost during a period of pricechanges can make the balance sheetinformation irrelevant. For example, reporting land waspurchased in 1940 in the historical cost at$1000 (irrelevant)
8-6Inflation inflation is a rise in the general level ofprices of goods and services in aneconomy over a period of time. inflation is also an erosion in thepurchasing power of money . A chief measure of price inflation is theinflation rate, the annualized percentagechange in a general price index
8-7Effects of Inflation Inflation can have positive and negative effectson an economy negative effects : A decrease in the real value of money and othermonetary items over time Uncertainty about future inflation may discourageinvestment and saving. and high inflation may lead to shortages of goods ifconsumers begin hoarding out of concern that priceswill increase in the future Positive effects A mitigation of economic recessions. debt relief by reducing the real level of debt.
8-8Measure of Inflation Inflation is usually estimated by calculatingthe inflation rate of a price index, usuallythe general price level . The General price level (Consumer PriceIndex) measures prices of a selection ofgoods and services (basket) purchased bya "typical consumer". The inflation rate is the percentage rate ofchange of a price index over time.
8-9Measure of Inflation For instance, in January 2007, the U.S. generalprice level was 202.416, and in January 2008 itwas 211.080. The formula for calculating theannual percentage rate inflation in the generalprice level over the course of 2007 is: The resulting inflation rate for the general pricelevel in this one year period is 4.28%, meaningthe general level of prices for typical U.S.consumers rose by approximately four percent in2007211.080 – 202.416202.416 = 4.28%)(
8-10Inflation Accounting – Conceptual IssuesImpact of inflation on financial statements1. Understated asset values. Negative impact on ability to borrow. Can invite hostile takeover to the extent thatthe current market price of a companysstock does not reflect the current value ofassetsLearning Objective 1
8-11Inflation Accounting – Conceptual Issues2. Overstated income andoverpayment of taxes. Understated assets result inunderstated expenses (depreciationand COGS) This lead to overstated income, thusmore taxes paid and stockholdersdemand a higher level of dividends. That may result in high cash outflowsso lead to liquidity problemsLearning Objective 1
8-12Inflation Accounting – Conceptual Issues3. Differing impacts across companiesresulting in lack of comparability. A company with older fixed assets willreport a higher return on assets than acompany with newer fixed assets. Because inflation rates tend to varyacross countries, comparison made byparent company across its subsidiarieslocated in different countries can bedistortedLearning Objective 1
8-13Inflation Accounting – Conceptual Issuespurchasing power gains and losses. Historical cost also ignores purchasing powergains and losses during the period of inflation. For example $202 can purchases one basket ofgood and service, only year later when generalprice level stated at $211, the same $202 canpurchases 95.5% percent of the basket, so youneed to $211 to buy the same basket . The difference between $211 needed tomaintain the purchasing power and 202 result in$9 purchasing power loss .Learning Objective 1
8-14Inflation Accounting – Conceptual Issues Purchasing power losses result fromholding monetary assets, such as cashand accounts receivable. Purchasing power gains result fromholding monetary liabilities, such asaccounts payable. The two most common approaches toinflation accounting are generalpurchasing power accounting and currentcost accounting.Learning Objective 1
8-15Methods of accounting for changingprices Tow solution have been developed to deal withdistortions caused by historical cost1. Account for in the general price level.This approach makes adjustments to the historicalcost of assets to update for changes in purchasingpower of the currency and therefore is referred to asgeneral price level adjusted historical cost(GPLAHC) accounting or, more simply generalpurchasing power accounting2. Account for specific price changes.By updating the values of assets from historical costto the current cost to replace these assets, this isknown as current replacement cost (CRC) orsimply, current cost (CC) accounting .
8-16Inflation Accounting – Conceptual IssuesNet Income and Capital Maintenance Historical cost, general purchasingpower and current cost accounting allflow from different concepts of capitalmaintenance. Net income represents the amount ofdividends that can be paid out while stillmaintaining the company’s capitalbalance.Learning Objective 1
8-17Inflation Accounting – Conceptual IssuesNet Income and Capital Maintenance Historical cost net income maintains anominal, not adjusted for inflation, amountof contributed capital. General purchasing power net incomemaintains the purchasing power ofcontributed capital. Current cost net income maintains theproductive capacity of physical capital.Learning Objective 1
8-18Example Assume that HIE company is formed inJanuary 1,Year 1 , by investorscontributing 200 in cash . The generalprice index (GPI) on that date is 100. HIEcompany’s balance sheet on January1,Year 1 as follows.Cash 200 Contributed capital 200
8-19Example With the initial equity investment, one unit ofinventory is purchased on January 2,Year 1 at acost of $100 and $100 remains in cash, resultingin the following position 1,Year 1 as follows.Cash 100 Contributed capital 200Inventory 100200 200
8-20Example on January 2,Year 1, the managers of HIEcompany go on vocation, returning onDecember 31, Year 1 at which time the inventoryis sold for $150 in cash, at December 31, Year 1the general price index is 120 (20% annualinflation during the year 1) and the inventory hascurrent replacement cost of $150 . The income statement for year 1 appear asfollows:Sales 150Cost of sales (100)Income 50
8-21Example The balance sheet at December 31, Year 1, prior to anydistribution of dividends is as followCash 250 Contributed capital 200Retained earning 50250The economic definition of income is theamount that can be distributed to ownersafter making sure that the company is aswell at the end of a year as it was at thebeginning of the year.
8-22Example If the company were to distribute adividend of $50 equal to year 1 netincome, the resulting balance sheet wouldbe exactly the same as it was at thebeginning of the yearCash 200 Contributed capital 200 HC income is the amount that can be distributedto owners while maintaining the nominalamounts of contributed capital at the beginningof the year .
8-23Capital MaintenanceIASB FrameworkConcepts of Capital maintenanceFinancial capital maintenance One approach to income measurement. Net income represents the increase in netfinancial assets, excluding ownertransactions. The approach in U.S. GAAP.
8-24Capital MaintenanceIASB FrameworkConcepts of Capital maintenancePhysical capital maintenance Another approach to income measurement. Net income represents increase in physicalproductive capacity excluding ownertransactions. Requires current costs for measurement ofcertain physical assets.
8-25Inflation Accounting -- MethodsGeneral Purchasing Power (GPP) Accounting Under (GPP) Accounting, nonmonetary assets, liabilities,stockholders equity, and all income statement items arerestated from the GPI at the transaction date to the GPIat the at the end of current period. Fixed assets and intangible assets and the relateddepreciation and amortization would also be restated forchanges in general Purchasing Power . Updates historical cost accounting for changes in thegeneral purchasing power of the monetary unit. Also referred to as General Price-Level-AdjustedHistorical Cost Accounting (GPLAHC). Requires purchasing power gains and losses to beincluded in net income.Learning Objective 1
8-26Inflation Accounting -- MethodsGeneral Purchasing Power (GPP) Accounting Because inventory was acquired on January 1, Year 1,when the GPI was 100, and GPI at December 31, Year1, is 120, the cost of sales (inventory) is restated usingthe 120/100 . Because the sales occurred on December 31, Year 1,when the GPI was 120, there is no need to restate sales(or the restatement ratio can be expressed as 120/120). In addition to restating sales and cost of sales GPPaccounting also requires a net purchasing power gainsand losses to be included in net income
8-27Follow the Example At January 1, Year 1, HIE company hasmonetary assets 100 and no monetary liabilities,yielding a net monetary asset position of $100. Because HIE holding this cash for entire year, anet purchasing power loss (PPL) of $20 arises. In addition HIE receiving $150 cash onDecember 31, Year 1 from the sales of theinventory, because this cash on December 31,Year 1 there is no loss on purchasing power bythe end of the year .
8-28Follow the ExampleThe PPl calculated as follow:Cash 1/1/Y1 ……….…… $100 x (120/100) = $120 (need to maintain pp)+ increase in cash,Year1 $150 x (120/120) = $150ٍSubtotal …………………………………………$270Less : cash 12/31/Y1…………………………. ($250)purchasing power loss……………………….. $ 20Combining the restatement with PPL, GPP income is calculatedas follows:HC Restatement ratio GPPSales ……… $150 x (120/120) $150Cost of sales 100 x (120/100) 120Subtotal ………………… $ 50 $ 30purchasing power loss……………………….. ................. 20Income……………………………………………………….. $ 10To calculatedthe purchasingpower loss
8-29Follow the Example Contributed capital must also be restated for year 1inflation as follow:HC Restatement ratio GPPContributed capital 200 x(120/100) $240The journal entry needed to account for GPP adjustmentis as follow:Dr. Inventory (cost of sales) 20Purchasing power loss 20Cr. Contributed capital 40GPP income represent the amount that can bedistributed to owners while marinating the purchasingpower of capital at the beginning of the year.
8-30Follow the Example The balance sheet at December 31, Year 1, prior to any distributionof dividends at historical cost model is as follow:Cash 250 Contributed capital 200Retained earning 50250 After adjusting the accounts for GPP the balance sheet atDecember 31, Year1, prior to any distribution of dividends at (GPP)model is asCash 240 Contributed capital 240Retained earning 10250 After paying dividends at $10, the balance sheet at December 31,Year 1, is as follow:Cash 240 Contributed capital 240
8-31Inflation Accounting -- MethodsCurrent Cost (CC) Accounting Maintaining the purchasing power of equity does notnecessarily ensure that the company is able to continue tooperate at its existing level of capacity. To determine the amount of income that can be distributedto owners while maintaining the company productivecapacity or physical capital , Current Cost (CC) Accountingmust be used. Under Current Cost (CC) Accounting ,historical cost ofnonmonetary assets are replaced with currentreplacement . Also referred to as Current Replacement Cost Accounting. Nonmonetary assets are restated to current replacementcosts and expense items are based on these restatedcosts. Holding gains and losses included in equity.Learning Objective 1
8-32Inflation Accounting InternationallyUnited States and United Kingdom SFAS 33, Financial Reporting and Changing Pricesbriefly required large U.S. companies to provide GP andCC accounting disclosures. This information is now optional and few companiesprovide it. In the UK, SSAP 16 required current cost information,this was also was only briefly required. Both countries have experienced low rates of inflationsince the 1980s.Learning Objective 2
8-33Inflation Accounting InternationallyLatin America Latin America has a long history of significant inflation. Brazil, Chile, and Mexico have developed sophisticatedinflation accounting standards over time. Like the U.S. and UK, Brazil has abandoned inflationaccounting. Mexico’s Bulletin B-10, Recognition of the Effects ofInflation in Financial Information, is a well-knownexample.Learning Objective 2
8-34Inflation Accounting InternationallyMexico – Bulletin B-10 Requires restatement of nonmonetary assets andliabilities using the central bank’s general price levelindex. An exception is the option to use replacement cost forinventory and related cost of goods sold. Another exception is imported machinery andequipment. This exception allows a combination of country of originprice index and the exchange rate between Mexico andcountry of origin.Learning Objective 2
8-35Inflation Accounting InternationallyNetherlands – Replacement Cost Accounting Prior to the required use of IFRSs in 2005, Dutchcompanies could use replacement cost accounting. In 2003 only Heineken used this approach. Heineken presented inventories and fixed assets atreplacement cost. Cost of sales and depreciation were also based onreplacement costs. The entry accompanying the asset revaluation wasreported in stockholders’ equity.Learning Objective 2
8-36Inflation Accounting InternationallyInternational Financial Reporting Standards IAS 15, Information Reflecting the Effects of ChangingPrices was issued in 1981. This standard has been withdrawn due to lack ofsupport. The relevant standard now is IAS 29, FinancialReporting in Hyperinflationary Economies. IAS 29 is required for some companies located inenvironments experiencing very high levels of inflation.Learning Objective 2
8-37IAS 29 Financial Reporting inHyperinflationary Economies This Standard shall be applied to thefinancial statements, including theconsolidated financial statements, ofany entity whose functional currency isthe currency of a hyperinflationaryeconomy.
8-38Hyperinflationary Economies Hyperinflation is indicated by characteristics of the economicenvironment of a country which include, but are not limited to, thefollowing:1. The general population prefers to keep its wealth in non-monetaryassets or in a relatively stable foreign currency. Amounts of localcurrency held are immediately invested to maintain purchasingpower;2. The general population regards monetary amounts not in terms ofthe local currency but in terms of a relatively stable foreigncurrency. Prices may be quoted in that currency;3. Sales and purchases on credit take place at prices that compensatefor the expected loss of purchasing power during the credit period,even if the period is short4. Interest rates, wages and prices are linked to a price index; and5. The cumulative inflation rate over three years is approaching, orexceeds,100%.
8-39Inflation Accounting InternationallyInternational Financial Reporting Standards IAS 29 includes guidelines for determining theenvironments where it must be used. Nonmonetary assets and liabilities and stockholders’equity are restated using a general price index. Income statement items are restated using a generalprice index from the time of the transaction. Purchasing power gains and losses are included in netincome.Learning Objective 2
8-40Statement of financial position Statement of financial position amounts not alreadyexpressed in terms of the measuring unit current at theend of the reporting period are restated by applying ageneral price index. Monetary items are not restated because they arealready expressed in terms of the monetary unit currentat the end of the reporting period. Monetary items are money held and items to be receivedor paid in money. Items stated at current cost are not restated becausethey are already expressed in terms of the measuringunit current at the end of the reporting period. Otheritems in the statement of financial position are restated
8-41Statement ofcomprehensive income The current cost statement of comprehensiveincome, before restatement, generally reportscosts current at the time at which the underlyingtransactions or events occurred. Cost of sales and depreciation are recorded atcurrent costs at the time of consumption; salesand other expenses are recorded at their moneyamounts when they occurred. Therefore all amounts need to be restated intothe measuring unit current at the end of thereporting period by applying a general priceindex.
8-42Consolidated financialstatements parent that reports in the currency of ahyperinflationary economy may havesubsidiaries that also report in the currencies ofhyperinflationary economies. The financial statements of any such subsidiaryneed to be restated by applying a general priceindex of the country in whose currency it reportsbefore they are included in the consolidatedfinancial statements issued by its parent. Where such a subsidiary is a foreign subsidiary,its restated financial statements are translated atclosing rates.
8-43 Illustration example ABC corporation work in a highly inflationcountry and prepare its financialstatements in general purchasing power inaccordance with IAS29 . The financial statements of ABCcorporation is as follow:
8-45Conventional Income statement.Conventional Income statement.For the year ended December 31. 1989Sales ……………………………….. $800Inventory, opening ……….. (80)Purchases ……………….... (500)Inventory, closing ………… 100Cost of sales………………………… (480)Expenses………………….. (200)Depreciation………………. (20)interest on loans ……………(50)(270)Net income …………………………….50
8-46Other data• Given 20% inflation during 1989• During 1989 the company neither invested nor disposed of sharesor fixed assets, also no equity additions or withdrawals occurred.• Therefore, the recorded nominal value of the shares, land andcapital stock did not change during the year.• The recorded value of the depreciable assets declined only by thenominal depreciation of $20.• The retained earnings increased by $50 as determined by theconventional income statement.• All the item in the statement are recorded at historical values .• Sales, purchases, expenses and interest incurred during the year.• The opening inventory value and depreciation represent costincurred before 1989.• The net income of $50 is retained, given that the company does notpay income tax.
8-481- Restating the opening balance sheet The individual items in the conventional opening balancesheet (December 31, 1988) should be restated toDecember 1988 prices. Assets: The monetary assets (cash, receivables, investment inbonds, etc.), which are stated in nominal money units, donot require any restatement. Because the nominal valuerepresents the real value of the asset concerned. The nonmonetary assets - inventories, shares,depreciable assets, and land are restated. Therestatement can be carried out by applying thecorresponding restatement factor to each recordedtransaction in these assets over the companys history.
8-49Restatement Factor Restatement factor is used to inflate a givenvalue in proportion to the inflation that hasoccurred since the recording date. Given That the restatement process of thenonmonetary assets inflated the values of thefour categories of assets from $380 (80 + 50 +200 + 50, respective historical values) to $570(100 + 70 + 300 + 100, respective restatedvalues).Restatement Factor =Price index at end of analyzed periodPrice index at recording date
8-501- Restating the opening balance sheet The liabilities and Equities The liabilities (payables, received loans, etc.), which aremonetary items and stated in nominal money units, donot require any restatement as the nominal valuerepresents the real value of the liability concerned,Therefore, the restated value equals the recorded valuein the conventional statement. The capital stock, which has been issued in the past, isrestated. The restatement is carried out by applying thecorresponding restatement factor to each recordedcapital stock transaction (equity addition) over thecompanys history. The retained earnings item is not restated; it is derivedby subtracting the liabilities and capital stock from thetotal restated assets, that is, (670 - 350 - 200 = $120)
8-512- Restating Intra-Year CapitalTransactions Intra-year capital transactions are those transactionsincurred during the year which directly affect the level ofbalance-sheet items, such as investments ordisinvestments in shares, fixed assets, and equityadditions or withdrawals. These transactions should be restated to year-endprices. The restatement of these items can be carried out intwo ways :1. Applying the corresponding restatement factor to eachrecorded transaction, or.2. Using the average price index for the restatementfactor, assuming that the transactions incurred more-or-less evenly during the year
8-522- Restating Intra-Year CapitalTransactionsRestatement Factor =In our example there are no Intra-year capital transactions.Price index Dec. 1989Average price index Dec. 1988 - Dec. 1989The restatement of these items can be carried out intwo ways :1.Applying the corresponding restatement factor toeach recorded transaction, or.2.Using the average price index for the restatementfactor, assuming that the transactions incurredmore-or-less evenly during the year
8-543- Restating the Closing Balance Sheet The restated closing balance sheet la theresult of adjusting data from three sources Monetary assets and liabilities - derivedfrom the conventional closing balancesheet. These items are treated accordingto the procedures outlined in restating themonetary assets in restating the openingBalance Sheet.
8-553- Restating the Closing Balance Sheet The restatement of Inventories can be carriedout by applying the corresponding restatementfactor to each recorded transaction in theseInventories over the Year, The restatementprocess inflated the value of the closinginventories from $100 to $110. . Shares, land, (Nondepreciable Assets) andcapital stock derived from the opening restatedbalance sheet. These items are updated to year-end prices (we given that Inflation rate is 20%) .
8-563- Restating the Closing Balance SheetUpdating means translating figures from restated dollars for a givendate in the past to dollars of purchasing power at a later date, using arestatement factor.Ill. Example: Adjusted financial figures for December 31, 1988 andDecember 31, 1989 are compared, as follows.December 31, 1988 December 31, 1989Price Index 100 120Restatement factor 120/100 = 1.2 120/120 = 1Shares 70 84Land 100 120Capital stock 200 240
8-573- Restating the Closing Balance Sheet Depreciable assets: The treatment of depreciable assets, such asplant and equipment, involves the restatementof both assets value and depreciationexpenses, to December 1989 prices. . Given that there was neither investment nordisinvestment in these assets during 1989 andthat the inflation rate was 20% during theyear, the corresponding restated values are asfollow :
8-583- Restating the Closing Balance SheetOpening Closing$400 Acquisition cost $480(100) Less: Accumulated depreciation (120)1989s depreciation (32)300 Net (depreciated) value 328The restated opening acquisition cost of $400 is updated to $480in December 1989 prices (restatement factor of 1.2).The $32 depreciation for 1989 is derived from the restatedacquisition cost, and stated in December 1989 prices.
8-594- Deriving the Years Adjusted Net IncomeThe simplest way to derive the inflation-adjusted net income of acompany is by measuring the change in equity between the closing andopening balance sheets, where the figures are stated in year-end prices.The adjusted net income for the illustrative company in 1989 iscalculated as follow :-Opening ClosingDec. 1988 Prices Dec. 1989 Prices*Assets $670 $804 $752Less: Liabilities (350) (420) (310)Equity 320 384 442Less: Opening equity (384)Adjusted net income 58*December 1988 prices times 1.2 restatement factor (given 20% inflation during 1989.
8-605- Adjusting the IncomeStatement Adjustment of the conventional incomestatement can be carried out by restating all theitems to year-end prices. This procedureprovides improved information for planning andcontrol purposes, but it is more cumbersome toapply and difficult to comprehend. The conventional income statement for 1989and the adjusted statement, following the abovementioned procedure, are presented as follow:
8-61Income Statement for the year ended December 31, 1989Conventional and fully RestatedConventional Restated *Sales $ 800 $880**Inventory, opening $(80) $(120)Purchases (500) (550)Inventory, closing 100 110Cost of sales (480) (560)Expenses (200) (220)**Depreciation (20) (32)Interest on loans (50) (50)(270) (302)Net income, retained 50 18Gain on net monetary position 40Adjusted net income 58
8-62• Sales, Purchases, closing Inventory, and Expenses are restated byusing restatement factor 1.1, based on average price indexes forDec. 1989 .Average Price IndexAn average price index for a given period should be used for restatingvalues that are incurred evenly throughout the period.Example: Consider the following price indexes• Inventory, opening carried from the opening restated balance sheetand then Restated using the restatement factor 1.2 (given 20%inflation in 1989).Oct. 1989 – 307Nov. 1989 – 320Dec. 1989 - 330The average price index is :(310+320+330)/3 = 320The corresponding restatement factoris 330/320 = 1.03125