Accounting for Changes in Prices ppendix Accounting for Changes in Prices 1 1 1 1

Objectives 1. Understand the difference between current value and general price level adjustments. 2. Explain the three alternatives to historical cost. 3. Understand issues related to the measurement of current cost, the adjustment of historical dollars for general price-level changes, and the purchasing power gain or loss on net monetary items. Continued 2 2 2 4

Objectives 4. Explain the conceptual issues relating to the alternatives to historical cost. 5. Be aware of the disclosure requirements that have existed for alternative disclosures, including the reasons for the elimination of the required disclosures.

Current Value Current value adjustments account for changes in the value of individual assets and liabilities…

…and not for the change in the value of the dollar. Current Value …and not for the change in the value of the dollar.

Current Value Current value is a general concept and may be measured in several ways, including— (1) An exit value, such as net realizable value. (2) The present value of future cash flows. (3) An input value, such as current cost.

Current Value We will use current cost as a measure of current value because it is encouraged by FASB Statement No. 89.

Four Alternative Concepts Historical cost Historical cost adjusted for changes in the general price level (historical cost ÷ constant purchasing power) Current value (current cost) Current value adjusted for changes in the general price level (current cost ÷ constant purchasing power)

Current Cost Financial Statements Step 1 2 3 4 5 Income Statements The increase in recognized in the period of sale. Revenue — — — $2,000 — Cost of goods sold — — — (1,250 ) — Net income — — — $ 750 — Unreal. holding gain — — $ 250 (250 ) — Real. holding gain — — — 250 — Net income — — $ 250 $ 750 A $250 increase due to current cost increasing. Continued

Current Cost Financial Statements Step 1 2 3 4 5 Balance Sheets Cash $3,000 $2,000 $2,000 $4,000 $2,750 Inventory — 1,000 1,250 — 1,250 Total Assets $3,000 $3,000 $3,250 $4,000 $4,000 Capital $3,000 $3,000 $3,250 $4,000 $4,000

Historical Cost/Constant PP Financial Statements Step 1 2 3 4 5 Income Statements Index increased 10% Revenue — — — $2,000 — Cost of goods sold — — — (1,100 ) — Purchasing power loss — — $(200 ) — — Net income — — $(200 ) $ 900 — $2,200 – $2,000 Continued

Historical Cost/Constant PP Financial Statements Step 1 2 3 4 5 Balance Sheets Cash $3,300 $2,200 $2,000 $4,000 $2,750 Inventory — 1,100 1,100 — 1,250 Total Assets $3,300 $3,300 $3,300 $4,000 $4,000 Capital $3,300 $3,300 $3,300 $4,000 $4,000

Current Cost/Constant PP Financial Statements Step 1 2 3 4 5 Income Statements The increase in recognized in the period of sale. Revenue — — — $2,000 — Cost of goods sold — — — (1250 ) — Operating income — — — $ 750 — Unreal. Holding gain — — $150 (150 ) — Realized hold. Gain — — — 150 — Purch. power loss — — (200 ) — — Net income — — $ (50 ) $ 750 — $1,250 – $1,100 Continued

Current Cost/Constant PP Financial Statements Step 1 2 3 4 5 Balance Sheets Cash $3,300 $2,200 $2,000 $4,000 $2,750 Inventory — 1,100 1,100 — 1,250 Total Assets $3,300 $3,300 $3,300 $4,000 $4,000 Capital $3,300 $3,300 $3,300 $4,000 $4,000

Measurement of Current Cost Three alternative methods of measuring the current costs of inventory and property, plant, and equipment are: Direct pricing. Current invoice prices, vendors’ price lists, other quotations or estimates, or standard manufacturing cost.

Measurement of Current Cost Three alternative methods of measuring the current costs of inventory and property, plant, and equipment are: Functional or Unit pricing. The estimation of construction (or acquisition) costs per unit and multiplication by the number of units in the asset being measured.

Measurement of Current Cost Three alternative methods of measuring the current costs of inventory and property, plant, and equipment are: Revision of Historical Acquisition Cost (Indexation). Using (a) externally generated specific price indexes for the class of goods or service being measured, or (b) internally generated indexes of cost changes for the class of goods or services being measured.

Adjustment of Historical Dollars Current Period Price-Level Index Constant Purchasing Power Dollars Historical Dollars x = Historical Price-Level Index

Adjustment of Historical Dollars A company purchased land for $24,000 when the price index was 120 and that the index now is 150.

Adjustment of Historical Dollars 150 Current Period Price-Level Index $30,000 $24,000 Constant Purchasing Power Dollars Historical Dollars x = Historical Price-Level Index 120

What is Income? A common definition is that income for a year is “the amount the corporation can distribute to the owners of the company and be as well off at the end of the year as at the beginning.”

What is Income? This is a useful definition of income, but what is meant by being “as well off”?

Capital Maintenance Concepts Historical Cost Historical dollars of capital at the beginning of the year.

Capital Maintenance Concepts Historical Cost/Constant Purchasing Power Purchasing power of the capital at the beginning of the year.

Capital Maintenance Concepts Current Cost Operating capacity (the ability to provide goods and services) at the beginning of the year, measured in dollars.

Capital Maintenance Concepts Current Cost/Constant Purchasing Power Operating capacity (the ability to provide goods and services) measured in units of constant purchasing power.

Reliability Current cost financial statements are considered less reliable than historical cost financial statements.

Reliability Financial statements prepared using historical cost are more understandable than those prepared using other concepts.

Reliability Many argue that historical cost financial statements should be continued, with the new data supplied in supplementary form.

Exit Value Financial Statements Step 1 2 3 4 5 Income Statements $1,800 – $1,000 Purchasing margin — $800 — — $950 Holding gain — — — $200 — Net income — $800 — $200 $950 $2,200 – $2,000 Continued

Exit Value Financial Statements Step 1 2 3 4 5 Income Statements Cash $3,000 $2,000 $2,000 $4,000 $2,750 Inventory — 1,800 1,800 — 2,200 Total Assets $3,000 $3,800 $3,800 $4,000 $4,950 Capital $3,000 $3,800 $3,800 $4,000 $4,950

Disclosures In 1986 FASB Statement No. 89 rescinded the requirements that qualifying companies disclose the effects of changing prices. However, the Statement encourages continued disclosure of information about the effects of changing prices.

International Accounting International accounting standards require that the primary financial statements of a company that reports in the currency of a hyperinflationary economy are prepared in terms of the currency at the balance sheet date.

A E ppendix The End