This chapter discusses accounting for inflation and changing prices. It covers inflation, price indexes, inflation accounting methods, income measurement systems, and Statements of Financial Accounting Standards (SFAS) No. 33. Under historical cost accounting, inflation can lead to financial statements that are not economically relevant or comparable. Price indexes measure inflation. Inflation accounting aims to translate historical costs into current purchasing power. SFAS No. 33 initially required supplementary inflation disclosures but requirements were later removed due to issues with understandability and usefulness.

1. Chapter 13:
Accounting for Inflation & Changing Prices
Inflation
Price indexes
Inflation accounting
Income measurement
systems
SFAS No. 33

2. Inflation
The rise in the average price level for all
goods and services produced in an economy
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

3. Inflation and Historical Costing
Likely predictive value is diminished
Comparability among financial statements
of different firms is restricted
Capital maintenance
 Income usually overstated relative to amounts
that can be distributed to stockholders
 Many dividends are really liquidating in nature

4. Price Indexes
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 indexes
 Specific price index
 General price index

5. Price Indexes
Paasche-type indexes
 Uses current-year
quantities
 Wholesale Price Index
 Consumer price Index
Laspeyres-type
indexes
 Uses base-year
quantities
 Less costly to construct

6. 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

7. 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

8. 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

9. 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

10. 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

11. 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

12. 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

13. 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

14. 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. .

15. 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

16. 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

17. SFAS No. 89
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

18. Chapter 13:
Accounting for Inflation & Changing Prices
Inflation
Price indexes
Inflation accounting
Income measurement
systems
SFAS No. 33