Chapter 11

International Accounting for Price Changes

Inflation

Inflation has had a devastating effect on many countries

Brazil and Russia as high as 2,000% 1970s in the U.K. 25%

Some companies are using other methods of accounting to combat the effects of inflation

BP uses replacement costs More companies will likely follow BPs lead

International Accounting & Multinational Enterprises Chapter 11 Radebaugh, Gray, Black

Impact of Inflation on the Corporation

Assets become devalued Liabilities become less expensive to pay off Interest rates on loans increase with inflation Income can be overstated as old costs are matched with new revenues Shareholders could demand more dividends and employees could demand higher wages
International Accounting & Multinational Enterprises Chapter 11 Radebaugh, Gray, Black

Accounting Measurement Alternatives

General purchasing power accounting

Includes all systems designed to maintain the purchasing power of capital or equity Accounts for changes in the level of prices Concerned with the value of money Other names include

Constant dollar accounting (U.S.) General price level accounting (U.S.) Current purchasing power accounting (U.K.)

International Accounting & Multinational Enterprises Chapter 11 Radebaugh, Gray, Black

Accounting Measurement Alternatives

Current value accounting

Includes all systems designed to account for current values or changes in specific prices Concerned with the cost of specific assets Types of accounting include Current cost accounting Replacement value accounting Current exit price accounting

Real value accounting is a combination of current value and general purchasing power accounting

International Accounting & Multinational Enterprises Chapter 11 Radebaugh, Gray, Black

General Purchasing Power Accounting

The monetary unit of measure should be uniform while retaining the basis of measurement used in the financial statements (historical cost) All items except financial assets and liabilities (cash, receivables, payables) are restated to reflect common purchasing power Previous years accounts are also updated to provide comparability
International Accounting & Multinational Enterprises Chapter 11 Radebaugh, Gray, Black

General Purchasing Power Accounting

Example General price level increased by 15% during the year A machine purchased on January 1 cost $10,000 End-of-year purchasing power to buy machine on Dec. 31
= $10,000 + ($10,000 x 0.15) = $11,500

International Accounting & Multinational Enterprises Chapter 11 Radebaugh, Gray, Black

Current Value Accounting

Income is not earned until the company has maintained its capital in current value terms Current cost (replacement cost) method

Should the same asset or one performing a similar function with new technology be used? Values assets at what they could be sold for, less cost to complete and sell the items Going-concern concept asset is valued at estimated sales price on normal completion of production

Current exit price method

International Accounting & Multinational Enterprises Chapter 11 Radebaugh, Gray, Black

Current Value Accounting

Results in holding gains and losses that are

Recognized on the income statement Reflected on the balance sheet as a capital adjustment account

Current values are determined by

Suppliers lists (inventory) Construction cost indices (PP&E) Appraisal values (fixed assets)

International Accounting & Multinational Enterprises Chapter 11 Radebaugh, Gray, Black

Current Value Accounting

Example
Sales = $1,000,000 Current COGS = $900,000 Historical COGS = $700,000
Operating gross profit $100,000 for current cost method $300,000 for historical cost method, part of which is due to holding during a period of price increase

Realized holding gain = $900,000 - $700,000 = $200,000

International Accounting & Multinational Enterprises Chapter 11 Radebaugh, Gray, Black

Real Value Accounting

Example
Value of asset Beginning = $150,000 Current value at year end = $190,000 GPP value at year end = $165,000 Total holding gain $190,000 - $150,000 = $40,000 Real holding gain $190,000 - $165,000 = $25,000

***What matters is the net impact of prices directly affecting the corporation relative to the average level of prices affecting the GPP of money!!!

International Accounting & Multinational Enterprises Chapter 11 Radebaugh, Gray, Black

International Financial Reporting Standards

IAS 6 (1977)

A brief narrowing of options available to deal with inflation

IAS 15, Information Reflecting the Effects of Changing Prices

Recognized the two major methods (GPP or current cost), but did not champion one or the other Required information on the effects of price changes if the historical cost method is used
International Accounting & Multinational Enterprises Chapter 11 Radebaugh, Gray, Black

International Financial Reporting Standards

IAS 15 suggestions for price change info The amount of the adjustment to or adjusted amount of depreciation of PP&E The amount of the adjustment to or the adjusted amount of cost of sales The adjustments relating to monetary items, the effect of borrowing, or equity interests when those adjustments are used in determining income The overall effect on income of adjustments and any items reflecting the effects of changing prices Current cost of PP&E of inventories Methods adopted to compute information used in the preceding items and any indices used IAS 15 was withdrawn in 2003
International Accounting & Multinational Enterprises Chapter 11 Radebaugh, Gray, Black

International Financial Reporting Standards

IAS 29 (1989)

Focuses on hyperinflationary economies

100% inflation over 3 years

Requires restatements for GPP changes regardless of previous treatment Current value approach is permitted for PP&E Fair value is used Regular revaluations are required
International Accounting & Multinational Enterprises Chapter 11 Radebaugh, Gray, Black

IAS 16 (revised in 1998)

Comparative National Regulation and Practice

U.K.

SSAP 16, requiring current cost accounting, was issued and withdrawn due to lower inflation Only a few companies now provide current cost disclosures Some companies revalue their PP&E at market values

International Accounting & Multinational Enterprises Chapter 11 Radebaugh, Gray, Black

Comparative National Regulation and Practice

U.S.

Accounting Series Release 190 required disclosure of replacement cost info SFAS 33 required disclosure on both GPP and a current cost basis SFAS 33 made an array of information available

International Accounting & Multinational Enterprises Chapter 11 Radebaugh, Gray, Black

Comparative National Regulation and Practice

Australia, Canada, and New Zealand

Developments are more tentative than in U.S. Similar to U.S. current cost system Much less enthusiasm for inflation accounting No professional standards on the subject

Continental Europe

International Accounting & Multinational Enterprises Chapter 11 Radebaugh, Gray, Black

Comparative National Regulation and Practice

Brazil

Inflation accounting used as early as the 1950s Company law in 1976 required indexation approach to restate historical costs in terms of current purchasing power With reduced inflation levels, requirement was withdrawn in 1996 Inflation accounting introduced was the accounting profession 1972 GPP financial statements were recommended Recommendation withdrawn in 1995 due to low inflation
International Accounting & Multinational Enterprises Chapter 11 Radebaugh, Gray, Black

Argentina

Comparative National Regulation and Practice

Current Value Accounting in Holland

Some firms use current cost method Some use partial current cost statements or historical cost statements with supplementary disclosures

International Accounting & Multinational Enterprises Chapter 11 Radebaugh, Gray, Black

Comparative National Regulation and Practice

Theodore Limperg father of replacement value

Focused on the relationship between economics and accounting Believed that income is a function of revenue and replacement value instead of historical costs Believed that current value info should be used by all decision makers

International Accounting & Multinational Enterprises Chapter 11 Radebaugh, Gray, Black

Comparative National Regulation and Practice

Philips

First used current value techniques in 1936 Used current value approach in 1952 for financial reporting purposes Departments of the company determined current values of inventory, equipment, and fixed assets The effect of current value changes showed in cost of goods sold and depreciation expense

International Accounting & Multinational Enterprises Chapter 11 Radebaugh, Gray, Black

Comparative National Regulation and Practice

Philips

Brink (1992) showed that Philips used replacement value techniques to enhance profits The company used inventory value reductions and the gearing adjustment in hyperinflationary countries Recorded a loss of 4.24 billion guilders in 1990, which led to the demise of the replacement value system in 1992

International Accounting & Multinational Enterprises Chapter 11 Radebaugh, Gray, Black

Problems and Prospects

Inflationary accounting is likely to remain a hot topic for the foreseeable future Some South American countries in hyperinflation use GPP accounting Some European companies still make voluntary current value disclosures No current cost accounting regulations exist in the U.K. or the U.S.
International Accounting & Multinational Enterprises Chapter 11 Radebaugh, Gray, Black

Problems and Prospects

Controversy remains over

The gearing adjustment Treatment of gains and losses on monetary items The use of indices with respect to foreign subs Verification of current costs in industries with rapid technological change

International Accounting & Multinational Enterprises Chapter 11 Radebaugh, Gray, Black

Problems and Prospects

Future experimentation with price change accounting systems is hoped for The usefulness of exit prices and cash flows may be better appreciated in the future

International Accounting & Multinational Enterprises Chapter 11 Radebaugh, Gray, Black