International Accounting, 6/e

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International Accounting, 6/e

• Frederick D.S. Choi
• Gary K. Meek

Chapter 7 Financial Reporting and Changing Prices
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Learning Objectives

• What do we mean by the term, changing prices?
• Why are financial statements misleading during
  periods of changing prices?
• What are the various ways of adjusting financial
  statements for changing prices?
• Do adjustments for changing prices vary
  internationally?
• What does IAS 21 have to say about inflation
  adjustments in hyperinflationary countries?
• What is the restate-translate controversy all
  about?
• Is it possible to double-count for the effects of
  foreign inflation?

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What Does Changing Prices Mean and How are
Price Changes Measured?

• General price level change refers to a movement
  in the prices of all goods and services in an
  economy on average.
• Positive price movement is termed inflation.
• A negative price movement is called deflation.
• Specific price change refers to the movement in
  the price of a specific asset e.g., a change in
  the price of inventory, plant, or equipment.
• General price level changes are measured by use
  of a general price level index (GPL).
• GPL is a cost ratio that compares the cost of a
  basket of goods in the current period with the
  cost of that same basket in a prior or base
  period.
• The reciprocal of the GPL is a measure of the
  general purchasing power of the monetary unit.
• Specific price changes are measured by a specific
  price index (SPL).
• SPL is a cost ratio that compares the cost of a
  specific item with its cost in a prior or base
  period.

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Why are Financial Statement Potentially
Misleading During Periods of Changing Prices?

• During periods of inflation, revenues are based
  on the general purchasing power of the current
  period.
• Expenses, such as depreciation and amortization,
  may be based on currency of higher general
  purchasing power because their related assets
  were typically acquired in the past when GPLs
  were lower.
• Deducting expenses based on historical purchasing
  power from revenues that expressed in currency of
  current purchasing power yields a nonsensical
  index of performance.

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Why are Financial Statements Potentially
Misleading During Periods of Changing Prices?
(contin)

• During a period of specific price changes, assets
  recorded at their original acquisition costs
  seldom reflect the assets current (higher) value
  resulting in an overstatement in reported income.
  This, in turn, may lead to
• Higher taxes
• Higher dividends
• Higher wages
• From a managerial perspective, accounting numbers
  unadjusted for changing prices distort
• Financial projections
• Budget comparisons
• Performance data

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Types of Adjustments for Changing Prices

• Objective of conventional historical cost
  accounting maintain a firms original
  investment.
• Assume a firm begins operations with an initial
  cash investment of 1,000. Cash is immediately
  converted to saleable inventory which is all sold
  at 50 mark-up by the end of the year for 1,500.
  There are no price changes during the period.
• Revenues would be 1,500 received uniformly over
  the period, expenses would be 1,000, and net
  income would be 500.
• Net income of 500 represents the amount that
  could be withdrawn from the firm and leave the
  owners with their original investment intact.

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General Price Level Adjustments

• Objective to measure income such that it
  represents an amount that could be withdrawn from
  the business while preserving the general
  purchasing power of the firms original
  investment.
• Assume the same facts as previously except that
  the GPL advances from a level of 100 at the
  beginning of the period to 121 at periods end
  and averaged 110 during the year.
• To keep up with inflation, owners equity should
  grow by at least 210 i.e., beginning equity
  1,000 x 121/100 ending owners equity of
  1,210.
• To accomplish this, revenues are expressed in end
  of period purchasing power by multiplying 1,500
  by 121/110 (110 is used as an expedient to
  reflect the fact that revenues are received
  uniformly over the year).
• Expenses (cost of sales in this example) would
  also be expressed in end of period purchasing
  power by multiplying 1,000 (incurred at the
  beginning of the year) by 121/100.
• This produces an adjusted operating income of
  440 (1.650 - 1,210).

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General Price Level Adjustments (contin)

• During inflation, an additional consideration
  must be accounted for. These are the gains and/or
  losses attributed to holding monetary items.
• Monetary asset cash or a claim to a fixed
  number of currency in the future e.g. cash or
  accounts receivable.
• Monetary liability obligations to pay a fixed
  number of currency in the future e.g., most
  payables excluding customer advances.
• During inflation, a firm holding monetary assets
  experiences a purchasing power loss as cash or
  receivables are not adjusted for inflation a
  firm holding monetary liabilities experiences a
  purchasing power gain, as monetary liabilities
  are not adjusted for inflation.

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General Price Level Adjustments (contin)

• In the foregoing example, the firm received
  1,500 in cash from sales uniformly during the
  year. If this monetary asset were adjusted for
  inflation its ending balance should be 1,650 (
  1,500 x 121/100). Its actual ending cash balance
  is only 1,500, giving rise to a purchasing power
  loss (monetary loss) of 150.
• Price level adjusted net income would be 290 (
  440 - 150).
• Withdrawing 290 from the business would leave
  the firm with 1,210, the amount necessary to
  keep up with inflation.
• For balance sheet purposes, all non-monetary
  assets and liabilities would be adjusted to their
  end of period purchasing power equivalents by
  multiplying them by the end of period index over
  the index that prevailed when these items were
  acquired.

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Adjustments for Specific Price Changes

• Objective to measure income such that it
  represents an amount that could be withdrawn from
  the business while preserving the firms
  productive capacity i.e., ability to replace
  specific assets whose prices have risen during
  the period.
• Continuing the previous example, assume that in
  addition to general inflation, specific prices of
  inventory have increased by 30.
• As the replacement cost of inventories have
  increased by 30, owners equity should grow by
  at least 300 i.e., beginning equity 1,000 x
  130/100 1,300. Failing this, the company will
  not be able to maintain its productive capacity
  replace all of its inventory.
• To accomplish this, assets and their related
  expenses are restated to their current cost
  equivalents.

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Adjustments for Specific Price Changes (contin)

• Inventory and hence cost of sales (all inventory
  was sold) would be restated to 1,300 ( 1,000 x
  130/100).
• This produces a replacement cost based adjusted
  operating income of 200 ( 1.500 - 1,300).
• Withdrawing 200 from the business would leave
  the firm with 1,300, the amount necessary to
  enable it to preserve its productive capacity.
• See pp. 143-144 of Infosys annual report at
  www.infosys.com/investor/reports-filings and
  select annual report for 2007.

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General Price Level Adjusted Current Costs

• Objective to measure income such that it
  represents an amount that could be withdrawn from
  the business while preserving the firms general
  purchasing power and allowing it to maintain its
  productive capacity in real terms.
• Same facts as before. General price levels have
  advanced by 21 and specific prices have
  increased by 30.
• A distinctive feature of this measurement
  framework is that it reports changes in the
  current costs of a firms nonmonetary assets, net
  of inflation.

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General Price Level Adjusted Current Costs
(contin)

• The increase in the inventorys cost due to
  general inflation was 210 ( 1,000 x 121/100).
• The real change in the inventorys current cost
  was 90 (1,000 x 121/100) (1,000 x
  130/100).
• Net income is 200 ( 1,650 revenues - 1,300
  cost of sales - 150 monetary loss). It
  represents the amount that could be paid out as a
  dividend and yet allow the firm to keep up with
  general inflation and allow it to replace
  specific assets (inventory) whose prices have
  advanced by 90 in real terms.

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National Variations U.S.

• U.S. SFAS 89 encourages but does not mandate the
  following disclosures for each of the five most
  recent years
• Net sales
• Income from continuing operations on a
  current-cost basis.
• Monetary gains or losses on net monetary items.
• Increases or decreases in the current cost or
  lower recoverable amount of inventory or plant,
  property and equipment, net of inflation.
• Aggregate foreign currency translation
  adjustment, on a current cost basis.
• Net assets at year-end on a current cost basis.
• Earnings per share on a current cost basis.
• Dividends per share of common stock.
• Level of the Consumer Price Index used to measure
  income from continuing operations.
• For foreign operations included in the
  consolidated statements
• Translate foreign accounts to dollars, then
  restate for U.S. inflation, if the dollar is the
  functional currency.
• Restate for foreign inflation, then translate to
  U.S. dollars if the local currency is functional.
  

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National Variations United Kingdom

• In the U.K., SSAP 16 recommends one of three
  reporting options
• Present current-cost accounts as the basic
  financial statements with supplementary
  historical cost accounts.
• Present historical-cost accounts as the basic
  statements with supplementary current-cost
  accounts.
• Present current-cost accounts as the only
  accounts accompanied by adequate historical-cost
  information.
• The foregoing options must include a monetary
  working capital adjustment that captures the
  monetary gains or losses from holding net
  monetary assets. This adjustment, however,
  employs specific price indexes as opposed to
  general price level indexes.
• Also required is a gearing adjustment that
  offsets inflation-adjusted cost of sales,
  depreciation, and the monetary working capital
  adjustment for monetary gains resulting from the
  use of debt.

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National Variations Brazil

• Permanent assets (i.e., fixed assets, buildings,
  investments, deferred charges, and their
  respective depreciation, as well as their
  amortization or depletion accounts) are adjusted
  for general price level changes.
• Stockholders equity accounts (i.e., capital,
  revenue reserves, retained earnings, and capital
  reserve accounts) are also adjusted by GPL
  changes.
• Permanent asset adjustments are offset against
  stockholders equity adjustments.
• A permanent asset adjustment lt equity adjustment
  produces a purchasing power loss.
• A permanent asset adjustment gt equity adjustment
  produces a purchasing power gain.

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IAS 21

• Requires the restatement of primary financial
  statement information for operations located in
  hyperinflationary environments.
• Historical cost or current cost statements must
  be expressed in constant purchasing power as of
  the balance sheet date.
• Purchasing power gains or losses on net monetary
  items must be included in current income.
• Firms must disclose
• that restatement for inflation has been made.
• which asset valuation framework is being used in
  the primary statements.
• which price index is used and its level at the
  balance sheet date and movement during the period.

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Restate/Translate Controversy

• When consolidating the accounts of subsidiaries
  located in inflationary environments, should
  management first restate these accounts for
  foreign inflation, then translate to parent
  currency?
• Or, should they first translate unadjusted
  accounts to parent currency, then restate for
  parent country inflation?
• Our solution, based on a dividend discount
  valuation framework
• Restate statements to be consolidated for
  specific price changes.
• Translate to parent currency using the current
  rate.
• Use specific price indexes to calculate monetary
  gains and losses.

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Double-counting for Inflation

• Local inflation affects exchange rates used to
  translate inflation-adjusted foreign currency
  balances to parent currency.
• Result Inflation is accounted for twice.
• To eliminate the double-dip, back out the
  periods translation gain or loss from the
  inflation adjustment.
• See example for inventory on page 268 of text.
• See Appendix 7-1 for cost of sales example.

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Other Chapter Exhibits