Inflation Adjusted Financial Reporting

Concepts, Rules, and Examples

Historical Review of Inflation Accounting

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 GAAP requires 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 shortlived 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 twenty-five years ago. 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.

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 $1,000 machine purchased today is about the same as a $1,000 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 IASC 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.

Actual and would-be investors and creditors, as well as entity managers and others, desire accounting information to support their decision-making needs. Financial statements that ignore the effects of general price level changes as well as changes in specific prices are inadequate for several reasons.

1. Reported profits often exceed the earnings that could be distributed to shareholders without impairing the entity's ability to maintain the present level of operations, because inventory profits are included in earnings and because depreciation charges are not adequate to provide for asset replacements.

2. Balance sheets fail to reflect the economic value of the business, because plant assets and inventories, especially, are recorded at historical values which may be lower than current fair values or replacement costs.

3. Future earnings prospects are not easily projected from historical cost based earnings reports.

4. The impact of changes in the general price level on monetary assets and liabilities is not revealed, yet can be severe.

5. Because of the foregoing deficiencies, future capital needs are difficult to forecast, and in fact may contribute to the growing leveraging (borrowing) by many enterprises, which adds to their riskiness.

6. Distortions of real economic performance leads to social and political consequences ranging from suboptimal capital allocations to ill-conceived tax policies and public perceptions of corporate behavior.

Example

A business starts with one unit of inventory, which cost $2 and which at the end of the period is sold for $10 at a time when it would cost $7 to replace that very same unit on the display shelf. Traditional accounting would measure the earnings of the entity at $10 - $2 = $8, although clearly the business is only $3 "better off" at the end of the period than at the beginning, since real economic resources have only grown by $3 (after replacing the unit sold there is only that amount of extra resource available). The illusion that there was profit of $8 could readily destroy the entity if, for example, dividends of more than $3 were withdrawn or if fiscal policy led to taxes of more than $3 on the $8 profit.

On the other hand, if the financial report showed only $3 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.

The failure of the historical cost balance sheet 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 balance sheet, statement of financial position 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 balance sheet could be made more useful while remaining true to its traditions.

Evolving Use of the Financial statements.

The traditional balance sheet was the primary, even the only, financial statement presented during much of accounting's history. However, beginning during the 1960s, the income statement achieved greater importance, partly because users came to realize that the balance sheet had become the repository for unmatched 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 income statement. During this era, the matching concept became the key underlying postulate that drove new accounting rules.

As a result of a series of unpleasant economic events, including numerous credit crunches and recessions in the 1970s and 1980s, the focus substantially shifted back to the balance sheet. Partly in response, the major accounting standard-setting bodies developed conceptual standards that urged the elimination of some of the items previously found on balance sheets that were not really either assets or liabilities. Some of these were the leftovers from double entry bookkeeping, which was oriented toward achieving income statement goals; 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 balance sheet and an accurate income statement is inherent in the 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 nonmonetary 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.

Experiments and proposals for inflation 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 requirements of IAS 15 in context, a number of its more prominent predecessors will be reviewed in brief.

Price level accounting concepts and proposals.

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 2002 dollars as 2002 Swiss francs have to 2002 dollars. 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).

Consider a simple example. Assume that the index of general prices was as follows:

January 1, 1982	65
January 1, 1994	100
January 1, 2003	182
December 31, 2003	188

Also assume the following items selected from the December 31, 2003 balance sheet:

	Historical Cost	Price level adjusted cost
Cash	$ 50,000	$ 50.000
Inventories (purchased 1/1/03)	350,000
x 188/182		361.538
Land (acquired 1/1/82)	500,000
x 188/65		1,446.154
Machinery (purchased 1/1/94)	300,000
x 188/100		564,000
Accumulated depreciation	(200,000)
x 188/100		(376,000)
Book value of assets	$1,000,000	$2,045,692
Less monetary liabilities	(500,000)	(500,000)
Net assets	$ 500,000	$1,545,692

In the foregoing, all nonmonetary items were adjusted to "current dollars" using the same index of general prices. This is not based on the notion that items such as inventory and machinery actually experienced price changes of that magnitude, but on the idea that converting these to current dollars is a process akin to converting foreign currency denominated financial statements. The implication is that the historical cost balance sheet, showing net assets of $500,000, is equivalent to a balance sheet that reports some items in German marks, some in French francs, some in Italian lira, and so on. The price level adjusted balance sheet, by contrast, is deemed to be equivalent to a balance sheet in which all items have been translated into dollars.

This analogy is a weak one, however. Not only are such statements essentially meaningless, they can also be misleading from a policy viewpoint. For example, during a period of rising prices, an entity holding more monetary assets than monetary liabilities will report an economic loss due to the decline in the purchasing power of its net monetary assets. Nonmonetary assets, of course, are adjusted for price changes and thus appear to be immune from purchasing power gains or losses. The implication is that holding nonmonetary assets is somehow preferable to holding monetary assets.

In the foregoing example, the net monetary liabilities at year-end are $500,000 - $50,000 = $450,000. Assuming the same net monetary liability position at the beginning of 2003, the gain experienced by the entity (due to owning monetary debt during a period of depreciating currency) would be given as

($450,000 x 188/182) - $450,000 = $14,835

This suggests that the entity has experienced a gain, at the obvious expense of its creditors, which have incurred a corresponding loss, in the amount of $14,835. This fails entirely to recognize that creditors may have demanded an inflation adjusted rate of return based on actual past and anticipated future inflationary behavior of the economy; if this were addressed in tandem with the computed purchasing power gain, a truer picture would be given of the real wisdom of the entity's financial strategy.

Furthermore, the actual price level protection afforded by holding investments in non-monetary assets is a function of the changes in their specific values. If the replacement value of the inventory had declined, for example, during 1998, having held this inventory during the year would have been an economically unwise maneuver. Land that cost $500,000 might, due to its strategic location, now be worth $2.5 million, not the indicated $1.4 million, and the machinery might be obsolete due to technological changes, and not worth the approximately $190,000 suggested by the price level adjusted book value. In fairness, of course, the advocates of price level accounting do not claim that these adjusted amounts represent values. However, the utility of these adjusted balance sheet captions for decision makers is difficult to fathom and the potential for misunderstanding is great.

US and UK proposals.

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 "balance sheet 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 income statement (as realized and unrealized gains and losses) or even whether some of these changes even belong in the income statement (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 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.

As a very basic example, consider a machine with a cost of $40,000 that can produce 100 widgets per hour. The current price of the replacement machine is $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 balance sheet 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

$40,000 x (50,000/40,000) x 100/110 = $45,454

That is, the service potential represented by the asset in use has a current replacement cost of $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 $40,000 and $45,000, respectively. However, management plans to acquire a new type of machine, C, which at a cost of $78,000 will replace both machines A and B and will produce the same output as its predecessors. The combined reproduction cost of $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.

Limitations on replacement cost.

While entry value is clearly the most logical of the alternative measures discussed thus far, under certain circumstances one of the other candidates would be preferable as a measure to use in current cost financial reporting. For example, consider a situation in which the value in use (economic value or net present value of future cash flows) is lower than replacement cost, due to changing market conditions affecting pricing of the entity's output. In such a circumstance, although the enterprise may continue to use the machines on hand and to sell the output profitably, it would not contemplate replacement of the asset, instead viewing it as a cash cow. If current cost financial statements were to be developed that incorporated depreciation based on the replacement cost of the machine, earnings would be understated, since actual replacement is not to be provided for. A number of other hypothetical circumstances could also be presented; the end result is that a series of decision rules can be developed to guide the selection of the best measure of current cost. These are summarized in the following table, where NRC stands for net replacement cost, which is synonymous with current cost; NRV is net realizable value or exit value; and EV is the same as net present value.

Conditions	Value to the business
EV > NRC > NRV	NRC
NRC > EV > NRV	EV
NRC > NRV > EV	NRV
EV > NRV > NRC	NRC
NRV > EV > NRC	NRC
NRV > NRC > EV	NRC

Measuring Income under the Replacement Cost Approach

There are two reasons to employ replacement cost accounting: (1) to compute a measure of earnings that can probably be replicated on an ongoing basis by the enterprise and approximates real economic wealth creation, and (2) to present a balance sheet that presents the economic condition of the entity at a point in time. Of these, the first is by far the more important objective, since decision makers' use of financial statements is largely oriented toward the future operations of the business, in which they are lenders, owners, managers, or employees.

Given the foregoing, the principal use of replacement cost information will be to assist in computing current period earnings on a true economic basis. The income statement items which on the historical cost basis are most distortive, in most cases, are depreciation and cost of sales. Historical cost depreciation can be based on asset prices that are ten to forty years old, during which time even modest price changes can compound to very sizable misrepresentations. Cost of sales will not typically suffer from compounding over such a long period, since turnover for most businesses will be in a matter of months (although this can be greatly distorted if low LIFO inventory costs are released into cost of sales), but since cost of sales will account for a much larger part of the entity's total costs than does depreciation, it can still have a major impact.

Thus, current cost/replacement cost/current value earnings are typically computed by adjusting historical cost income by an allowance for replacement cost depreciation and cost of sales. Typically, these two adjustments will effectively derive a modified earnings amount that closely approximates economic earnings. This modified amount can be paid out as dividends or otherwise disbursed, while leaving the enterprise with the ability to replace its productive capacity and continue to operate at the same level as it had been. (This does not, however, address the matter of purchasing power that may have been gained or lost by holding net monetary assets or liabilities during the period, which requires yet another computation.)

Determining current costs.

In practice, replacement costs are developed by applying one or more of four principal techniques: indexation, direct pricing, unit pricing, and functional pricing. Each has advantages and disadvantages, and no single technique will be applicable to all fact situations and all types of assets. The following are useful in determining current costs of plant assets.

Indexation is accomplished by applying appropriate indices to the historical cost of the assets. Assuming that the assets in use were acquired in the usual manner (bargain purchases and other such means of acquisition will thwart this effort, since any index when applied to a nonstandard base will result in a meaningless adjusted number) and that an appropriate index can be obtained or developed (which incorporates productivity changes as well as price variations), this will be the most efficient approach to employ. For many categories of manufactured goods, such as machinery and equipment, this technique has been widely used with excellent results. One concern is that many published indices actually address only reproduction costs, and if not adjusted further, the likely outcome will be that costs are overstated and adjusted earnings will be artificially depressed.

Direct pricing, as the name suggests, relies on information provided by vendors and others having data about the selling prices of replacement assets. To the extent that these are list prices that do not reflect actual market transactions, these must be adjusted, and the same concern with productivity enhancements mentioned with reference to indexation must also be addressed. Since many enterprises are in constant, close contact with their vendors, obtaining such information is often straightforward, particularly with regard to machinery and other equipment.

Unit pricing is the least commonly employed method but can be useful when estimating the replacement cost of buildings. This is the bricks-and-mortar approach, which relies on statistical data about the per unit cost of constructing various types of buildings and other assets. For example, construction cost data may suggest that single-story light industrial buildings in cold climates (e.g., Europe) with certain other defined attributes may have a current cost of $47 per square foot, or that a first-class high-rise urban hotel in England has a construction cost of $125,000 per room. By expanding these per unit costs to the scale of the enterprise's facilities, a fairly accurate replacement cost can be derived. There are complications; for example, costs are not linearly related to size of facility due to the presence of fixed costs, but these are widely understood and readily dealt with. Unit pricing is typically not meaningful for machinery or equipment, however.

Functional pricing is the most difficult of the four principal techniques and is best reserved for highly integrated production processes, such as refineries and chemical plants, where attempts to price individual components would be exceptionally difficult. For example, a plant capable of producing 400,000 tons of polyethylene annually could be priced as a unit by having an engineering estimate made of the cost to construct similar capacity in the current environment. Clearly, this is not a merely mechanical effort, as indexation in particular is likely to be, but demands the services of a skilled estimator. Technological issues are neatly avoided since the focus is on creating a new plant with defined output capacity, using whatever mix of components would be most cost-effective. This technique has been widely employed in actual practice.

Inventory costing problems.

For a merchandising concern, direct pricing is likely to be an effective technique to assist in developing cost of sales on a current cost basis. Manufacturing firms, on the other hand, will need to build up replacement cost basis cost of goods manufactured and sold by separately analyzing the cost behavior of each major cost element (e.g., labor contracts, overhead expenses, and raw materials prices). It is unlikely that these will have experienced the same price movements, and therefore an averaging approach would not be sufficiently accurate. Also, as product mix changes over time, the entity may be subject to varying influences from one period to the next. Finally, the inventory costing method used (e.g., LIFO vs. FIFO) will affect the extent of adjustment to be made, with (assuming that costs trend upward over time) relatively greater adjustments made to cost of sales determined on the FIFO basis, since relatively older costs are included in the GAAP income statement.

Whatever assortment of methods is used, the end product is a restated inventory of plant assets, depreciation on which must then be computed. For the current cost earnings data to be comparable with the historical cost financial statements, it is usually recommended that no other decisions be superimposed. For example, no changes in asset useful lives should be made, for to do so would exacerbate or ameliorate the impact of the replacement cost depreciation and make interpretation very difficult for anyone not intimately familiar with the company. Some ancillary costs may need to be adjusted in computing cost of sales and depreciation on the revised basis. For example, if the only replacement machines available will reduce the need for skilled labor, the (higher) replacement cost depreciation should be reduced by related cost savings, if accurately predictable. There are literally scores of similar issues to be addressed, and indeed entire volumes have been written providing detailed guidance on how to apply current cost measures.

Examples of current costing adjustments to depreciation and cost of sales

Example 1

Hapsburg Corp. is a wholesale distributor for a single product. For 2003, the company reports sales of $35,000,000, representing sales of 600,000 units of its single product. The traditional income statement reports cost of sales as follows:

	($000 omitted)
Beginning inventory	$ 8.8
Purchases, net	25.7
Ending inventory	(6.5)
Cost of goods sold	$28.0

Reference to purchase orders reveals the fact that product cost early in 2003 was $42 per unit and was $55 per unit late in December of that year. The company employs FIFO accounting.

Since there is no evidence presented to the effect that net realizable value of the product is below current replacement cost, current cost can be used without modification.

Beginning current cost	$42.0
Ending current cost	$55.0
Average	$48.5

Total cost of sales for the period, on a replacement cost basis, is therefore $48.5 x 600,000 units = $29,100,000.

Example 2

In the following example, deprival value is, for one product line, better measured by net realizable value than by replacement cost. The company, St. Ignatz Mfg. Co., manufactures and sells two products, A and B. Product A has been a declining item for several years, and management now believes that it must close this line due to the shrinking market share, which will not support higher costs. St. Ignatz will continue to produce Product B and may possibly expand into new products in the future.

Company records show the following results in 2003:

	($000,000 omitted)
	Product A	Product B	Total
Sales	$19.5	$40.5	$60.0
Cost of sales
Beginning inventory	12.5	6.8
Purchases	8.7	20.0
Ending inventory	(3.0)	(5.4)
Cost of sales	18.2	21.4	39.6
Gross profit	$ 1.3	$19.1	20.4
All other expenses			(18.8)
Net income			$ 1.6

The company's manufacturing records show the following data:

Current costs, beginning of year	$52.0	$75.0
Current costs, ending of year	$63.0	$79.0
Current costs, average	$57.5	$77.0

Sales in 2003 comprised 390,000 units of Product A and 540,000 units of Product B. Management believes that the market for Product A cannot support further price increases, and thus the remaining inventory will probably be sold at a loss. Selling expenses are estimated at $6 per unit.

Product A has a recoverable value lower than current manufacturing costs. The net recoverable amount is given by the selling price per unit less selling expenses: $50 - $6 = $44 per unit. Current cost of sales is $44 x $390,000 = $17,160,000. Note that recoverable amount, not replacement cost, is used.

Product B has an average current cost of $77 per unit, so 2003 cost of sales on a current cost basis is $77 x $540,000 = $41,580,000.

Total cost of sales on the current cost basis is therefore $17,160,000 + $41,580,000 = $58,740,000.

Example 3

Jacquet Corp. reports depreciation of $16,510 for 2003 in its historical cost based financial statements prepared on the basis of GAAP. A summary of plant assets reveals the following:

Asset class	Total depreciable cost[a]	Useful life (yr.)	Depreciation rate (%)[b]
A	$24,000	8	12 1/2
B	50,000	10	10
C	45,000	12	8 1/3
D	60,000	15	6 2/3
E	19,000	25	4
[a]Depreciable cost is historical cost less salvage value. [b]Depreciation rate is I/useful life.

Management employs appraisals and other methods, including information from vendors and indices, to develop current cost data as shown below.

Asset class	Current costs
	1/1/03	12/31/03	Average
A	$28,000	$31,000	$29,500
B	56,000	60,000	58,000
C	55,000	60,000	57,500
D	62,000	68,000	65,000
E	30,000	33,000	31,500

From this information the current cost depreciation for the year 2003 can be computed as follows:

Asset class	Depreciation rate (%)	Average current cost	Depreciation
A	12 1/2	$29,500	$ 3,687.5
B	10	58,000	5,800.0
C	8 1/3	57,500	4,792.0
D	6 2/3	65,000	4,333.0
E	4	31,500	1,260.0
			$19,872.5

Note that the replacement cost basis depreciation for the year is $3,362.50 greater than was the historical cost depreciation.

Purchasing power gains or losses in the context of current cost accounting.

Thus far, general price level (or purchasing power or constant dollar) accounting has been viewed as a reporting concept totally separate from current value (or current cost or replacement cost) accounting. As noted, advocates of price level adjustments have argued that these are not attempts to measure value, as current cost accounting is, but merely to "translate" old dollars into current dollars. For their part, advocates of current value accounting have generally been more focused on deriving a measure of the "replicatable" economic earnings of the enterprise, usually with no mention of the fact that changing specific prices of productive assets exist against a backdrop of changing general price levels.

In fact, the FASB requirements imposed in the late 1970s (and dropped in the 1980s for lack of interest) attempted to measure both general and specific price changes. That standard included a requirement for reporting purchasing power gains or losses, as well as for stating the amount of adjustment for current cost depreciation and cost of sales. The IASC has imposed a somewhat similar requirement in IAS 15 (compliance with which is now wholly voluntary, and which may be withdrawn by IASB), albeit with less specificity. The guidance in the now dormant FASB standard can be used by those attempting to report under IAS 15 without limitation, as there are no conflicts between these sets of rules.

Requirements under IAS 15

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 demanding the supplementary information (IAS 15 was imposed in 1981), the IASC announced in 1989 that due to lack of worldwide support for this noble experiment, it would no longer be required to comply with the standard, although still encouraged. In the event that inflation again becomes a concern, which eventually it will as such cycles are almost inevitable, this standard can be reactivated.

Alternative approaches permitted.

The standard was intended to require certain supplementary current value and constant dollar information. A great deal of latitude was given to entities, which could choose from among a range of supportable methods to accomplish this directive. As the standard notes, the two main methods are intended to (1) recognize income after the general purchasing power of shareholders' equity has been maintained (price level accounting), and (2) recognize income after the operating capacity of the enterprise is maintained (current value accounting, which may or may not also include adjustments related to the general price level).

General purchasing power approach.

IAS 15 does not stipulate what index should be used to measure the change in the general level of prices but does identify depreciation and cost of sales as being subject to adjustment, as well as a need to measure the effect of changing prices on net monetary items held.

Current cost approach.

IAS 15 acknowledges the existence of various methods, with replacement cost being identified as the principal measurement strategy, subject to the caveat that if replacement cost is higher than both net realizable value and present value, replacement value is not to be used. Instead, the higher of net realizable value and present value would denote current value, as explained earlier in this chapter. Replacement costs are said to be found in information about current acquisitions of new or used assets of similar productive capacities or service potentials. Specific price indices are also favorably noted as sources of current cost data. Net realizable value is generally a representation of net current selling price (i.e., exit value), while present value is the discounted amount of future receipts attributable to the asset.

The standard discusses at some length the need to determine an adjustment for the effects of changing prices on net monetary items, including long-term debt, but suggests that some current cost methods (which it does not name) may not need to address this separately. In particular, the discussion in IAS 15 alludes to the argument (made explicitly in the British proposal of the 1970s but not otherwise enacted in any standards) that since depreciable assets in particular are often acquired at least in part in exchange for monetary debt, the gross replacement cost adjustment exaggerates the negative effect on earnings and that this is moderated to the extent leveraging is used.

In fact, one can make this argument, but as noted earlier in the chapter, to do so assumes that added borrowing in periods of rising prices is "costless" in the sense that no premium is added by lenders to compensate for either (1) the borrowers' greater riskiness as they become more leveraged, or (2) for the loss to be incurred on repayment of the debt in devalued currency. It is not likely that in the long run lenders will go uncompensated for either of these, and therefore to offset the higher charges for depreciation and cost of sales by the fraction to be borne by the lenders may be imprudent.

Minimum disclosures required by IAS 15.

The disclosures required (now made optional) include the following:

1. The amount of adjustment to, or the adjusted amount of, depreciation of property plant and equipment

2. The amount of adjustment to, or the adjusted amount of, cost of sales

3. The adjustments relating to monetary items, the effect of borrowing, or equity interests when such adjustments have been taken into account in determining income under the (inflation) accounting method adopted

4. The overall effect on results of the adjustments described above, as well as any other items reflecting the effects of changing prices

5. If a current cost method is used, the current cost of property, plant, and equipment and of inventories should be disclosed.

6. There should be a description of the methods used to compute the foregoing items.

Example of disclosure consistent with IAS 15

DeKalb Thermodynamics Inc. Statements of Income from Continuing Operations Year Ended December 31, 2002

	As reported in primary statements	Adjusted for general inflation	Adjusted for changes in specific prices (current costs)
Net sales and other revenue	$253,000	$253,000	$253,000
Cost of goods sold	$197,000	$204,384	$205,408
Depreciation and amortization	10,000	14,130	19,500
Other operating expense	20,835	20,835	20,835
Interest expense	7,165	7,165	7,165
Provision for income taxes	9,000	9,000	9,000
	$244,000	$255,514	$261,908
Income (loss) from continuing operations	$ 9,000	$ (2,514)	$ (8,908)
Gain from decline in purchasing power of net amounts owed		$ 7,729	$ 7,729
Increase in specific prices (current costs) of inventories and property, plant, and equipment held during the year			$ 24,608
Effect of general price level increase			18,959
Excess of increase in specific prices over increase in general price level			$ 5,649

Note

Current costs are determined by consulting current prices posted for plant assets, net of applicable discounts, and by reference to indexed or replacement costs adjusted for productivity increases. The gain on purchasing power change is determined by reference to the consumer price index for all urban consumers.

Proposed withdrawal of standing on accounting for changing prices.

The IASB's Improvements Project has addressed the requirements of IAS 15 and has found that very few reporting entities actually are reporting in conformity with the optional practices set forth by that standard. Accordingly, the IASB has proposed that IAS 15 be withdrawn.

There are no apparent intentions to address the matter of reporting on changing prices at the present time, a reflection, doubtlessly, of the fact that in most of the world's major nations the issue of rapid price escalations has been vastly reduced in importance from what existed in the 1980s, when IAS 15 was promulgated. The IASB has 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."