International Accounting, 6/e
Frederick D.S. Choi
Gary K. Meek
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
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
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
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
Types of Adjustments for
Changing Prices
Objective of conventional historical cost accounting:
maintain a firm’s 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
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 firm’s 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 period’s 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 -
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
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
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 firm’s 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
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
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 firm’s 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
General Price Level Adjusted
Current Costs (contin)
The increase in the inventory’s cost due to general
inflation was $210 (= $1,000 x 121/100).
The real change in the inventory’s 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
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
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
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 < equity adjustment
produces a purchasing power loss.
A permanent asset adjustment > equity adjustment
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
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
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 period’s
translation gain or loss from the inflation adjustment.
