Inflation accounting

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In countries experiencing hyperinflation the International Accounting Standards Board requires
corporate financial statements to be adjusted for changes in purchasing power using a price
index.

Contents
[hide]
• 1 Historical cost basis in financial statements
○ 1.1 Measuring unit principle
○ 1.2 Misleading reporting under historical cost accounting
• 2 History of inflation accounting
• 3 Inflation accounting models
○ 3.1 Constant dollar accounting
• 4 International standard for hyperinflationary accounting
• 5 See also
• 6 Notes and references

[edit] Historical cost basis in financial statements

Fair value accounting (also called replacement cost accounting or current cost accounting) was
widely used in the 19th and early 20th centuries, but historical cost accounting became more
widespread after values overstated during the 1920s were reversed during the Great Depression
of the 1930s. Most principles of historical cost accounting were developed after the Wall Street
Crash of 1929, including the presumption of a stable currency [1] based on the international gold
standard. It has been argued that when using gold as the base currency the US$ is in
hyperinflation under IAS 29. [2]
[edit] Measuring unit principle
For thousands of years gold or silver functioned as monetary commodities and were the
measuring unit. Because turmoil resulting from the collapse of fiat currency in 1695 the United
Kingdom followed the advice of Isaac Newton, Master of the Mint, and adopted the gold
standard. He was subsequently knighted for his work in monetary science in 1705 by Queen
Anne. In the 20th century the Bretton Woods system established an international gold standard
with the dollar as the world reserve currency. President Richard Nixon, in the Nixon shock,
closed the convertibility of $35 for 1 ounce of gold on August 15, 1971. The current worldwide
monetary system is based on fiat currency and subject to payment risk [3].
Under a historical cost-based system of accounting, inflation leads to two basic problems. First,
many of the historical numbers appearing on financial statements are not economically relevant
because prices have changed since they were incurred.... Second, since the numbers on financial
statements represent dollars expended at different points of time and, in turn, embody different
amounts of purchasing power, they are simply not additive. Hence, adding cash of $10,000 held
on December 31, 2002, with $10,000 representing the cost of land acquired in 1955 (when the
price level was significantly lower) is a dubious operation because of the significantly different
amount of purchasing power represented by the two numbers.[4]
By adding dollar amounts that represent different amounts of purchasing power, the resulting
sum is misleading, as would be adding 10,000 dollars to 10,000 Euros to get a total of 20,000.
Likewise subtracting dollar amounts that represent different amounts of purchasing power may
result in an apparent capital gain which is actually a capital loss. If a building purchased in 1970
for $20,000 is sold in 2006 for $200,000 when its replacement cost is $300,000, the apparent
gain of $180,000 is illusory.
Accounting based on commodity money, like gold or silver, is never subject to these illusions
because the unit of account has intrinsic value (numismatics).
[edit] Misleading reporting under historical cost accounting
“In most countries, primary financial statements are prepared on the historical cost basis of
accounting without regard either to changes in the general level of prices or to increases in
specific prices of assets held, except to the extent that property, plant and equipment and
investments may be revalued.”[5]
Ignoring general price level changes in financial reporting creates distortions in financial
statements such as[6]
• reported profits may exceed the earnings that could be distributed to shareholders without
impairing the company's ongoing operations
• the asset values for inventory, equipment and plant do not reflect their economic value to
the business
• future earnings are not easily projected from historical earnings
• the impact of price changes on monetary assets and liabilities is not clear
• future capital needs are difficult to forecast and may lead to increased leverage, which
increases the business's risk
• when real economic performance is distorted, these distortions lead to social and political
consequenses that damage businesses (examples: poor tax policies and public
misconceptions regarding corporate behavior)
[edit] History of inflation accounting
Accountants in the United Kingdom and the United States have discussed the effect of inflation
on financial statements since the early 1900s, beginning with index number theory and
purchasing power. Irving Fisher's 1911 book The Purchasing Power of Money was used as a
source by Henry W. Sweeney in his 1936 book Stabilized Accounting, which was about constant
purchasing power accounting. This model by Sweeney was used by The American Institute of
Certified Public Accountants for their 1963 research study (ARS6) Reporting the Financial
Effects of Price-Level Changes, and later used by the Accounting Principles Board (USA), the
Financial Standards Board (USA), and the Accounting Standards Steering Committee (UK).
Sweeney advocated using a price index that covers everything in the gross national product. In
March 1979, the Financial Accounting Standards Board (FASB) wrote Constant Dollar
Accounting, which advocated using the Consumer Price Index for All Urban Consumers (CPI-U)
to adjust accounts because it is calculated every month.[7]
During the Great Depression, some corporations restated their financial statements to reflect
inflation. At times during the past 50 years standard-setting organizations have encouraged
companies to supplement cost-based financial statements with price-level adjusted statements.
During a period of high inflation in the 1970s, the FASB was reviewing a draft proposal for
price-level adjusted statements when the Securities and Exchange Commission (SEC) issued
ASR 190, which required approximately 1,000 of the largest US corporations to provide
supplemental information based on replacement cost. The FASB withdrew the draft proposal.[8]
[edit] Inflation accounting models
Inflation accounting is not fair value accounting. Inflation accounting, also called price level
accounting, is similar to converting financial statements into another currency using an
exchange rate. Under some (not all) inflation accounting models, historical costs are converted to
price-level adjusted costs using general or specific price indexes.[9]
Income statement general price-level adjustment example[10]
On the income statement, depreciation is adjusted for changes in general price levels
based on a general price index.
2001 2002 2003 Total
Revenue 33,000 36,302 39,931 109,233
Depreciation 30,000 31,500 (a) 33,000 (b) 94,500
Operating income 3,000 4,802 6,931 14,733
Purchasing power loss - 1,500 (c) 3,000 (d) 4,500
Net income 3,000 3,302 3,931 10,233
(a) 30,000 x 105/100 = 31,500
(b) 30,000 x 110/100 = 33,000
(c) (30,000 x 105/100) - 30,000 = 1,500
(d) (63,000 x 110/105) - 63,000 = 3,000
[edit] Constant dollar accounting
Constant dollar accounting is an accounting model that converts nonmonetary assets and equities
from historical dollars to current dollars using a general price index. This is similar to a currency
conversion from old dollars to new dollars. Monetary items are not adjusted, so they gain or lose
purchasing power. There are no holding gains or losses recognized in converting values.[11]
[edit] International standard for hyperinflationary
accounting
The International Accounting Standards Board defines hyperinflation in IAS 29 as:"the
cumulative inflation rate over three years is approaching, or exceeds, 100%." [12]
Companies are required to restate their historical cost financial reports in terms of the period end
hyperinflation rate in order to make these financial reports more meaningful.[13] [14] [15]

The restatement of historical cost financial statements in terms of IAS 29 does not signify the
abolishment of the historical cost model. This is confirmed by PricewaterhouseCoopers:
"Inflation-adjusted financial statements are an extension to, not a departure from, historical cost
accounting."