appendix CIP Accounting for Changes in Prices objectives 1 Understand the difference between current value and general price level adjustments.

Transcription

1 appendix CIP Accounting for Changes in Prices 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. 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.

2 Current Value and the General Price Level CIP3 In Chapter 18, we focused on asset valuation and revenue recognition issues using historical cost accounting. However, different methods of asset valuation provide different information to users if the prices of individual assets owned by companies change with time. Suppose a company purchases a parcel of land for $100,000. A year later the value of the land is $120,000, but there has been inflation of 5%. Theoretically, the company could value the land on its balance sheet either at its current value of $120,000 or at $105,000 the historical cost of $100,000 adjusted for the 5% inflation. However, under generally accepted accounting principles, the company values the land on its balance sheet at $100,000. In other words, the change in the value of the land is ignored, as is the change in the value of the dollar due to inflation. Furthermore, under historical cost accounting the effect of a change in value is generally recognized only when a transaction takes place, such as when the land is sold. Suppose that the company sells the land for $120,000. At this time, it recognizes a gain of $20,000 (the $120,000 selling price less the $100,000 original cost). However, should it recognize a gain of zero ($120,000 less the $120,000 current value) or of $15,000 ($120,000 less the $105,000 historical cost adjusted for the 5% inflation rate) instead? Which information is more useful to users of financial statements? This Appendix briefly explains the concepts and procedures underlying the alternative methods of accounting for changing prices. We also discuss the voluntary supplementary disclosures encouraged by FASB Statement No. 89. CURRENT VALUE AND THE GENERAL PRICE LEVEL Two types of price changes are relevant for accounting purposes. First, the price of an individual asset or liability, such as inventory, buildings, or bonds payable, changes in response to the dynamics of the market for that particular item. This is known as a specific price change or a current value change. Second, there may be a change in the value, or purchasing power, of the dollar. Such a change is caused by the overall change in the prices of all goods and services in the economy and is known as a general pricelevel change. Changes in the general purchasing power of money are known as inflation or deflation. During inflation (deflation), the general purchasing power of money declines (increases) as the general level of prices of goods and services rises (falls). The general purchasing power of money and the general price level are reciprocals. For a company s specific assets and liabilities, the price changes may be very different from the change in the general price level. For example, if the general price level rises, the specific price of an inventory item (its current value) may increase faster or slower, or even decline, in comparison with the general price level. So the two types of price changes are related, but it is important to understand that accounting for the current value of assets and accounting for changes in the general price level are not alternatives or substitutes for each other. Each method represents the use of a different concept and, therefore, has a different purpose. Although neither method is required under generally accepted accounting principles, selected current cost and general price-level adjusted supplementary disclosures are encouraged (but not required) under FASB Statement No. 89, as we discuss later in this Appendix. Understand the 1 difference between current value and general price level adjustments. Current Value Current value adjustments account for changes in the values of individual assets and liabilities and not for the change in the value of the dollar. As the specific current values change, they are recognized in the financial statements by recording assets and liabilities on the balance sheet at their current values. In the income statement, expenses are matched against revenues at the current value of the assets used up or the liabilities created. Therefore, this method significantly changes the basic concepts of asset valuation and income measurement. Current value is a general concept and may be measured in several ways, including (1) an exit value, such as net realizable value (the net amount that can be realized from sale), (2) the present value of future cash flows, and (3) an input value, such as current cost. Our discussion concentrates

3 CIP4 Appendix CIP Accounting for Changes in Prices on current cost as the measure of current value because this method is the basis for the current value disclosures encouraged by FASB Statement No. 89. Current cost is the cost in the current period of replacing (i.e., acquiring or producing) the items concerned, as we discuss later. Generally accepted accounting principles do allow occasional uses of current value, such as when there is a decline in the price of inventory and the lower of cost or market rule is used, and for certain investments and financial instruments. General Price Level General price-level adjustments account for the change in the value of the dollar and not for changes in the values of individual assets and liabilities. As the general price level increases, the goods and services that can be purchased with a given number of dollars decreases. Therefore, financial statements that include dollars measured at different times are potentially misleading, because the dollars vary in purchasing power. The adjustments for changes in the general price level convert these dollars of different purchasing power into dollars of constant purchasing power. In essence, the adjustments account for changes in the size of the measuring unit used in accounting. In contrast to a physical measuring unit such as a foot or a meter which remains constant, the dollar is not a constant measure because its purchasing power changes. Just as no one advocates adding and subtracting U.S. and Canadian dollars, for example, it can be argued that it is equally inappropriate to add and subtract dollars of different purchasing power, even though they are always called U.S. dollars. Four Alternative Concepts Just as with historical costs, current costs may be measured in different time periods. Since the general price-level adjustments account only for the change in the value of the dollar over time, these adjustments are equally applicable to historical cost and current cost financial statements. In both cases, amounts are included in the adjusted financial statements (or selected supplemental disclosures) that are measured in dollars of different dates, and so of different values. Thus, there are four alternative accounting methods to be considered (the common terminology used to differentiate the alternatives is in parentheses): 1. Historical cost 2. Historical cost adjusted for changes in the general price level (historical cost/ constant purchasing power) 3. Current value (current cost) 4. Current value adjusted for changes in the general price level (current cost/ constant purchasing power) Constant purchasing power amounts also are known as constant dollar amounts. The historical cost concept, which is the basis of generally accepted accounting principles, is covered throughout this book. We discuss the other three alternatives in the following section. Explain the 2 three alternatives to historical cost. THREE ALTERNATIVES TO HISTORICAL COST To briefly illustrate the differences between constant purchasing power and current cost financial statements, consider the following sequence of events for the Hallas Company: 1. The company begins operations with $3,000 cash from issuing capital stock. 2. The company purchases one unit of inventory for $1,000 cash. 3. The current (replacement) cost of the inventory increases to $1,250 and the general price-level index increases from 100 to 110, an increase of 10%. 4. The company sells the inventory for $2,000 cash. 5. The company purchases another unit of inventory for $1,250.

4 Three Alternatives to Historical Cost CIP5 The events are reflected in the historical cost financial statements in Example CIP-1 (ignoring operating expenses and income taxes). The company prepares a set of financial statements after each event, labeled Steps 1 through 5. It recognizes income only in Step 4, when it sells the inventory; consequently, it recognizes the increase in asset values at the same time. EXAMPLE CIP-1 Historical Cost Financial Statements Step Income Statements Revenue $2,000 Cost of goods sold (1,000) Net income $1,000 Balance Sheets Cash $3,000 $2,000 $2,000 $4,000 $2,750 Inventory 1,000 1,000 1,250 Total Assets $3,000 $3,000 $3,000 $4,000 $4,000 Capital $3,000 $3,000 $3,000 $4,000 $4,000 Current Cost Financial Statements Example CIP-2 illustrates the current cost financial statements for the Hallas Company. The financial statements at Steps 1 and 2 are the same as the historical cost statements because no changes in current costs have occurred. However, in Step 3, when the current cost of the inventory rises to $1,250, the company recognizes the $250 increase. Since this gain results from holding the asset and is not realized through a sale, it is known as an unrealized holding gain. In Step 4, when the inventory is sold for $2,000, the company recognizes the cost of goods sold at the current cost of the inventory, or $1,250. Therefore, operating income is $750 as compared with the historical cost income of $1,000. The unrealized holding gain is now realized through a sale, so it recognizes a realized holding gain and removes the unrealized holding gain. The basic argument in favor of current cost financial statements can be seen by comparing the balance sheets in Steps 2 and 5. At both steps, the company has only two assets cash and one unit of inventory. Since the inventory is identical at both steps in terms of its physical characteristics, the company is better off at Step 5 by the increase in its cash balance, or $750. The current cost financial statements recognize an operating income of only $750. Therefore, this measure of income is consistent with the increase in the wealth of the company (the amount the company can distribute to the owners and remain as well off). In contrast, the historical cost financial statements recognize an operating income of $1,000. However, this income includes $250 that is not really income, because the company is required to replace the inventory to remain in business. For example, suppose that after Step 4 the company decides to distribute the historical cost income of $1,000 as dividends. This would leave the company with $3,000 cash. After purchasing a unit of inventory of $1,250, the company would have $1,750 cash left, and thus would have suffered a decrease in wealth of $250 since Step 2, when it held $2,000 cash and one unit of inventory.

5 CIP6 Appendix CIP Accounting for Changes in Prices EXAMPLE CIP-2 Current Cost Financial Statements Step Income Statements Revenue $2,000 Cost of goods sold (1,250) Operating income $ 750 Unrealized holding gain $ 250 (250) Realized holding gain 250 Net income $ 250 $ 750 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 Note that the company includes the unrealized and realized holding gains in income in this example. Many accountants, however, argue that these gains are not really income, as we illustrated in the previous paragraph. Therefore, they argue, the gains should be excluded from the income statement and reported directly in stockholders equity, or in other comprehensive income. Whichever way the gains (or losses) are classified, it is very important to understand the nature of these gains in contrast to income that represents real profit obtained through a sale. Historical Cost/Constant Purchasing Power Financial Statements Example CIP-3 illustrates the historical cost/constant purchasing power financial statements of the Hallas Company. Remember that this adjustment process is completely separate from the current cost financial statements we just discussed. The only change in the general price level is in Step 3, when the price-level index rises from 100 to 110, an increase of 10%. When the company originally prepared the financial statements for Steps 1 and 2, they were identical to the historical cost financial statements in Example CIP-1 because no change in the general price level had occurred. However, all the financial statements in Example CIP-3 are presented in terms of the value of the dollar after the 10% increase in the price level (that is, in Step 3 prices). Therefore, the cash and capital in Step 1, and the cash, inventory, and capital in Step 2 are all increased by 10% to reflect the increase in the general price level that has occurred since these amounts were measured originally. For example, the $3,000 in the historical cost balance sheet in Step 1 of Example CIP-1 is measured in dollars before the rise in the general price level. This amount has a purchasing power that is equivalent to $3,300 after the price rise (an increase of 10%). The $3,000 measured in dollars before the price rise is adjusted to $3,300 measured in dollars after the price rise, so that the statements in Steps 1 and 3 reflect dollars of the same purchasing power. The rise in the general price level takes place in Step 3. Thus, the $2,000 cash in the historical cost balance sheet is measured in dollars after the price-level increase. As a result, the company has lost $200 ($2,200 $2,000) of purchasing power because it held the cash while the price level rose. This $200 loss is included in income, and it also reduces the purchasing power of the capital to $3,100. The inventory is measured at the historical cost of $1,000 adjusted for the 10% increase in the general price level.

6 Three Alternatives to Historical Cost CIP7 EXAMPLE CIP-3 Historical Cost/Constant Purchasing Power Financial Statements Step Income Statements Revenue $2,000 Cost of goods sold (1,100) Purchasing power loss $ (200) Net income $ (200) $ 900 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 $3,100 $4,000 $4,000 Capital $3,300 $3,300 $3,100 $4,000 $4,000 General price-level index: Step 1, 100; Step 2, 100; Step 3, 110; Step 4, 110; and Step 5, 110. The $1,100 is the current purchasing-power equivalent of the original $1,000. No purchasing-power gain or loss results from holding a nonmonetary asset such as inventory, as we discuss later in the appendix. In Step 4 the inventory is sold for $2,000. The cost of goods sold is recorded at the constant purchasing power of the inventory, $1,100, and therefore the net income is $900. The major argument in favor of historical cost/constant purchasing power financial statements can be illustrated by considering the income statement in Step 4 and the balance sheets in Steps 1 and 4. In the historical cost income statement in Example CIP-1, dollars of one price level (the cost of goods sold) are subtracted from dollars of another price level (the revenue). Since these dollars do not have the same purchasing power, subtracting one from the other may not be very relevant. In contrast, the constant purchasing power income is measured by comparing two amounts measured in dollars of the same purchasing power. Comparing Steps 1 and 4 in the historical cost balance sheets in Example CIP-1 raises similar issues. The capital in Step 4 includes $3,000 original capital (and $1,000 retained earnings). However, Step 1 also shows original capital of $3,000. Does this reflect reality? If it is agreed that the purpose of dollars is to purchase goods and services, then to show the contributed capital as $3,000 in both balance sheets may be misleading. The owners of the company contributed $3,000 of purchasing power in Step 1 when the company was formed. However, in Step 4 an appropriate measure of the capital contributed is in terms of the dollars existing at the time the financial statements are prepared. In these terms, the owners have contributed $3,300 of purchasing power. The same argument may be applied to inventory. Although the inventory cost $1,000, that $1,000 is equivalent to $1,100 of purchasing power after the price-level increase. Thus, the historical cost/constant purchasing power financial statements do not reflect current value. They simply adjust the historical costs for changes in the purchasing power, or value, of the dollar that have occurred since the historical cost was recorded. Current Cost/Constant Purchasing Power Financial Statements The arguments in favor of current cost financial statements and of historical cost/constant purchasing power statements are entirely separate. Current cost financial statements do

7 CIP8 Appendix CIP Accounting for Changes in Prices not reflect the changing value of the dollar, and historical cost/constant purchasing power statements do not recognize the current cost of assets. However, the two concepts may be combined so that financial statements prepared on the current cost basis are adjusted for changes in the general price level. Example CIP-4 illustrates financial statements prepared on this basis. EXAMPLE CIP-4 Current Cost/Constant Purchasing Power Financial Statements Step Income Statements Revenue $2,000 Cost of goods sold (1,250) Operating income $ 750 Unrealized holding gain $ 150 (150) Realized holding gain 150 Purchasing-power loss (200) Net income $ (50) $ 750 Balance Sheets Cash $3,300 $2,200 $2,000 $4,000 $2,750 Inventory 1,100 1,250 1,250 Total Assets $3,300 $3,300 $3,250 $4,000 $4,000 Capital $3,300 $3,300 $3,250 $4,000 $4,000 The financial statements in Steps 1 and 2 are prepared on a current cost/constant purchasing power basis in terms of the price level existing after the rise in the general price level. That is, they are adjusted to reflect the 10% rise in the price level in the same manner as the historical cost/constant purchasing power statements in Example CIP-3. In Step 3 the rise in the general price level is recognized through the purchasing-power loss from holding cash. In addition, the unrealized holding gain on the inventory is recognized, but in this situation it is $150. This is the difference between the current cost of the inventory ($1,250) and the constant purchasing power cost of the inventory ($1,100). In Step 4 the inventory is sold and the cost of goods sold is recorded at the current cost of $1,250. The advantages of this method may be understood by considering the income statement in Step 4 and by comparing the balance sheets in Steps 2 and 5. The $750 operating income recognized in Step 4 is the real increase in value for the company, for exactly the same reasons as we discussed earlier for the unadjusted current cost financial statements in Example CIP-2. A comparison of the balance sheets in Steps 2 and 5 shows an increase in value of $550 since the cash has increased by $550 and one unit of inventory is held in each case. The $550 increase is the operating income of $750 in Step 4 less the purchasing power loss of $200 in Step 3. The relationship between the increase in wealth and the income statement is clearer if the holding gains are omitted from the income statement, which lends support to those accountants who advocate such exclusion.

8 Additional Measurement Issues CIP9 ADDITIONAL MEASUREMENT ISSUES The previous section dealt with a simple example involving current cost and constant purchasing power financial statements. We discuss several additional issues related to measuring current costs and constant purchasing power amounts in this section. Measurement of Current Cost In the previous examples we focused on a few simple transactions. The two most significant differences between current cost and historical cost usually occur for inventory and property, plant, and equipment. The FASB defines the current cost of inventory as the current cost of purchasing or producing the goods concerned. It defines the current cost of property, plant, or equipment as the current cost of acquiring the same service potential (indicated by operating costs and physical output capacity) provided by the asset owned. 1 Three alternative methods of measuring the current costs of inventory and property, plant, and equipment are: 1. Direct Pricing. Current invoice prices, vendors price lists, other quotations or estimates (e.g., appraisals), or standard manufacturing costs. 2. Functional or Unit Pricing. The estimation of construction (or acquisition) costs per unit (such as per square foot of building space) and multiplication by the number of units in the asset being measured. 3. Revision of Historical Acquisition Cost (Indexation). Using (a) externally (independently) generated specific price indexes 2 for the class of goods or services being measured, or (b) internally generated indexes of cost changes for the class of goods or services being measured. 3 A company might choose any one of the methods for any asset or liability. Generally direct pricing would be used for inventory and readily available property, plant, and equipment such as office equipment. Functional, or unit, pricing would be used to estimate the current cost of a complete productive asset such as a building or a chemical plant. A specific price index could be used for any asset, and often it is the simplest to use because once the index for the asset is selected, the adjustment process is arithmetically simple. Because technology changes, the property, plant, and equipment (and perhaps some inventory) that would be purchased today do not have the same service potential as the assets the company owns. Therefore, the current cost of property, plant, and equipment may be determined by either (1) the current cost of a used asset of the same age and in the same condition as the asset owned, (2) the current cost of a new asset with the same service potential as the used asset had when new, less a deduction for depreciation, or (3) the current cost of a new asset with a different service potential, less a deduction for depreciation, and adjusted for the cost of the difference in service potential due to differences in life, output capacity, and nature of service, including any operating cost savings. Inventory is valued on the balance sheet at its current cost at the end of the period. The cost of goods sold is valued on the income statement at the average current cost, which is measured as the units sold [(beginning current cost per unit ending current cost per unit) 2]. Alternatively, the actual current costs incurred during the period could be used if the company recorded the current cost when each sale was made. Understand 3 issues related to the measurement of current cost, the adjustment of historical dollars for general pricelevel changes, and the purchasing power gain or loss on net monetary items. 1. Financial Reporting and Changing Prices, FASB Statement of Financial Accounting Standards No. 89 (Stamford, Conn.: FASB, 1986), par The federal government publishes numerous specific price indexes. 3. These are examples of a reproduction cost, which is the current cost of acquiring an asset identical to that currently owned. An alternative concept is a replacement cost, which is the current cost of acquiring the best asset available to undertake the function of the asset owned.

9 CIP10 Appendix CIP Accounting for Changes in Prices Property, plant, and equipment are valued on the balance sheet at their current costs at the end of the period, less a proportional amount of accumulated depreciation. The depreciation expense on the income statement is based on the average current cost of the depreciable assets, which is measured as [(beginning current cost ending current cost) 2] estimated life. For both costs of goods sold and depreciation expense, an average is used because sales are made at prices current throughout the period, and it is appropriate to match the average current cost of the assets used during the period against those sales. Adjustment of Historical Dollars The conversion of historical dollars to the purchasing power of the current period by means of a price-level index is a simple mathematical procedure. Dividing the index of the current period by the index of the period in which the historical dollar was originally recorded provides a measure of the relative price change. Multiplying the historical dollar amount by this relative price change gives the constant purchasing power dollar amount. This computation is as follows: Constant Purchasing Current Period Price-Level Index Historical Dollars Power Dollars Historical Price-Level Index For example, suppose a company purchased land for $24,000 when the price index was 120 and that the index is now 150. The cost of the land in constant purchasing power dollars is $30,000 [$24,000 ( )]. The current period index depends on the financial statement. The use of the average index for the year is the most appropriate for the income statement and the cash flow statement, which measure flows over a period of time. The use of the index at the end of the year is the most appropriate for the balance sheet, which measures amounts at the end of the year. The average Consumer Price Index for All Urban Consumers (CPI-U) is used for the disclosures encouraged by FASB Statement No. 89. Purchasing-Power Gain or Loss on Net Monetary Items Holding cash during periods of inflation results in a purchasing-power loss. If $100 can buy a certain quantity of goods and services, and prices later rise, the $100 can then buy fewer goods and services, and purchasing power has been lost. The same principle applies to all monetary assets. A monetary asset is defined as money or a claim to receive a sum of money, the amount of which is fixed or determinable without reference to future prices of specific goods or services. 4 In addition to cash, principal monetary assets are accounts receivable and notes receivable. The reverse effect occurs with monetary liabilities. Since an obligation exists to repay a fixed amount of dollars in the future, inflation reduces the purchasing power of the dollars necessary to repay these liabilities, thus resulting in a purchasing-power gain. Principal monetary liabilities include accounts payable, notes payable, and bonds payable. 5 Suppose Peter Cameron borrows $1,000 from a bank when the price index is 120. He has a monetary liability of $1,000 and the bank has a monetary asset of $1,000. Disregarding interest, if the money is repaid when the price index is 150, Peter Cameron has a general purchasing-power gain. The equivalent purchasing power of the $1,000 when it is repaid is $1,250 [$1,000 ( )], and since he only has to repay the $1,000, he has a gain of $250. Conversely, the bank has a general purchasing-power loss because it has received $1,000 in full payment of a historical debt that now has a current purchasing-power equivalent of $1,250. Since the bank knows that inflation will occur, it includes the expected level of inflation when it sets the interest rate. 4. FASB Statement No. 89, op. cit., par For a classification of items as monetary or nonmonetary, see FASB Statement of Financial Accounting Standards No. 89, par. 96.

10 Conceptual Issues Relating to Alternatives to Historical Cost CIP11 Monetary assets and liabilities are combined to derive net monetary items on which gains or losses from inflation are computed. The FASB calls these gains and losses purchasing-power gains and losses. (They are also known as monetary gains and losses, or general price-level gains and losses.) Purchasing-power gains result from holding negative net monetary items (liabilities exceed assets) and purchasing-power losses result from holding positive net monetary items (assets exceed liabilities) during periods of rising general prices. In contrast to monetary items, holders of nonmonetary assets and liabilities do not gain or lose general purchasing power simply as a result of general price-level changes. If the price of a nonmonetary item changes at the same rate as the general price level, no gain or loss of general purchasing power results. Holders of nonmonetary assets and liabilities gain or lose general purchasing power if the specific price of the item owned or owed rises or falls faster or slower than the change in the general price level. 6 Historical cost financial statements usually report gains and losses on nonmonetary items only when the items are sold. Gains and losses from holding nonmonetary items are recognized in the period of the sale by inclusion in the profit or loss from the sale. 7 CONCEPTUAL ISSUES RELATING TO ALTERNATIVES TO HISTORICAL COST The simple examples of the current cost, historical cost/constant purchasing power, and current cost/constant purchasing power concepts discussed in this Appendix focus on the logic underlying the adjustment processes and deliberately avoid the many complexities that would be involved in preparing comprehensive financial statements for a company. 8 In this section we evaluate the three methods in greater detail with respect to selected criteria and compare them with historical cost financial statements. Also, we discuss the concept of using an exit value as a measure of current value. Explain the 4 conceptual issues relating to the alternatives to historical cost. Capital Maintenance Concept (Income Statement) One of the major purposes of financial accounting is to measure a company s income. But what is income? A common definition is that income for a year is the amount the corporation can distribute to the owners of equity in the corporation and be as well off at the end of the year as at the beginning. 9 This is a useful definition of income, but it does raise the question of what is meant by being as well off. In other words, what is the capital that is to be maintained during the year so that income may be measured as the excess above the capital maintained? Another way of looking at this issue is to consider the distinction between the maintenance of capital and the return on capital. During each period, a company first should earn enough to maintain the capital invested in the business. Then, any excess, or return on capital, is considered income. 6. Financial Statements Restated for General Price-Level Changes, APB Statement No. 3 (New York: AICPA, 1969), par Current cost financial statements report (holding) gains and losses on nonmonetary items in the period in which the gain or loss occurs. When current cost financial statements are adjusted for general price-level changes, the holding gain or loss is adjusted for the purchasing-power gain or loss from holding the nonmonetary items. For example, in Example CIP-4, the unrealized holding gain on the inventory in Step 3 is $150. This is the increase in the current cost of $250, less the increase that results from inflation of $100 (10% $1,000). 8. See APB Statement No. 3, op. cit., Appendix C, for an example of general price-level adjustments, and Conceptual Framework for Financial Accounting and Reporting: Elements of Financial Statements and Their Measurement, FASB Discussion Memorandum (Stamford, Conn.: FASB, 1976), Appendix B, for examples of general price-level, replacement cost, and general price-level adjusted replacement cost financial statements. 9. Sydney S. Alexander, Income Measurement in a Dynamic Economy, Five Monographs on Business Income (New York: Study Group on Business Income, AICPA, 1950), p. 15.

11 CIP12 Appendix CIP Accounting for Changes in Prices The capital maintenance concepts underlying each type of financial statement that we illustrated in Examples CIP-1 through CIP-4 are as follows: Financial Statements Historical cost Historical cost/constant purchasing power Current cost Current cost/constant purchasing power Capital Maintenance Concept Historical dollars of capital at the beginning of the year Purchasing power of the capital at the beginning of the year Operating capacity (the ability to provide goods and services) at the beginning of the year, measured in dollars Operating capacity (the ability to provide goods and services), measured in units of constant purchasing power Although it may not be reasonable to make a categorical statement that one of the alternative capital maintenance concepts is the best, it should be clear that they are different, and that each has advantages and disadvantages. The historical cost concept has the advantage of being the most verifiable and widely understood of the different methods, but it may not be the most relevant to the needs of the user of financial statements. The user has no assurance that the purchasing power of a company s capital is maintained, or that the company can continue to operate at the same level. In other words, income may be overstated since it is likely to include a return of some of the capital as well as a return on the capital. To ensure that the company maintains the purchasing power of its capital probably would be considered desirable by most stockholders. They did contribute a certain number of dollars to the company, but they are more concerned about the purchasing power of those dollars than about the number of their dollars originally contributed. Stockholders would not be satisfied to get back the same number of dollars as they contributed if these dollars represent less purchasing power. Therefore, the stockholders are likely to be interested in knowing that the purchasing power represented by the capital of the company is maintained before income is reported as a return on capital. Historical cost/constant purchasing power income statements disclose this information. A company needs specific assets to conduct its operations, and it is possible that the company could be maintaining the general purchasing power of its capital but not its ability to replace the assets. Use of the current cost concept ensures that the operating capability of the company is maintained before it reports earnings as a return on capital. However, when these results are reported in unadjusted dollars, a flexible measuring unit is being used. For example, cost of goods sold at its current cost is subtracted from sales. Both measures are in terms of current dollars, so no problem exists. But any holding gain or loss is computed as the difference between the current cost and the historical cost of the inventory, and these two values are measured in terms of different dollar values. Consequently, it is difficult to evaluate the meaning of the holding gain, and also to compare the holding gain with operating income; in each case the two amounts being compared are measured in different dollar values. Use of current cost/constant purchasing power income statements resolves these issues. In summary, the historical dollar/constant purchasing power income statements resolve one issue with the historical dollar measurement concept, and current cost income statements resolve a different issue. Only current cost/constant purchasing power income statements resolve both issues and ensure that income is the excess after the capital is maintained in terms of operating capacity measured in units of constant purchasing power. The primary conceptual argument against the use of current costs is that those costs are not relevant if the intent of the company is to hold and use the asset rather than to sell it. For example, a company purchases property, plant, and equipment to use it

12 Conceptual Issues Relating to Alternatives to Historical Cost CIP13 in its operations and not for sale. Therefore it may be argued that the current cost is not relevant. Also the use of current costs would substantially change the revenue recognition and matching principles. Balance Sheet The values attached to items on the balance sheet are closely related to the capital maintenance concept and the resulting rules of valuation and income realization. Historical cost balance sheets disclose items at the historical dollars exchanged (except for securities reported at fair value). The difficulty of interpreting the information on the balance sheet arises because the dollar figures represent different purchasing powers, and adding and subtracting them is as inappropriate as relating U.S. and Canadian dollars, as we discussed earlier. Use of historical cost/constant purchasing power amounts does ensure that all the values on the balance sheet represent equivalent purchasing power. Current cost balance sheets present assets and liabilities at their current replacement cost or, in other words, at a measure of their current value at the balance sheet date. It is difficult to compare them over time (for example, on the balance sheets for two years), however, because of the changing value of the dollar. Only current cost/constant purchasing power balance sheets value the assets at their current cost and also enhance comparability over time by measuring current costs in dollars of constant purchasing power. Reliability Historical cost financial statements clearly are the most reliable, and adjusting historical dollars for changes in the general price level affects that reliability very little, if at all. Under FASB Statement No. 89, the historical dollars are adjusted by an index published by the federal government, and all companies would use the same index and follow established procedures. Current cost financial statements are considerably less reliable than historical cost financial statements. Several general approaches (discussed earlier in this Appendix) to the determination of current cost are available. Although each approach is more suitable for certain types of assets, there are no requirements that a particular method be used in any given situation. For example, Shell Oil Company tested four indexes for estimating the current cost of refineries and found that the current cost varied by 25%. Understandability An argument frequently made in favor of historical cost financial statements is that they are more understandable than financial statements prepared under other concepts. This is difficult to disagree with, because historical costs have been used for so many years. This argument suggests, however, that no change should ever take place, because initially users would be less familiar with the new method than with the old. There also is a trend toward giving greater consideration to the needs of sophisticated users of financial statements who presumably have, or would soon develop, the ability to understand financial statements prepared on a different basis. Many supporters of the use of a changed concept have argued that the historical cost financial statements should be continued and the new data supplied in supplementary form. This would enable users to gain experience with the new methods and concepts and limit the potential for misunderstandings from the adoption of alternative concepts. This is the approach used by the FASB, as we discuss later. Costs and Benefits The implementation of each of the different concepts discussed in this appendix would involve additional costs for the company in preparing the data, and for audit fees if the financial statements are to be audited. For example, in a survey of companies, 62% of

13 CIP14 Appendix CIP Accounting for Changes in Prices the respondents estimated that up to 800 hours of employee time would be necessary to compute the supplementary disclosure requirements of FASB Statement No Although it may be expected that such costs would decline as experience increased, it was still a significant cost, and the FASB requirements did not involve complete implementation of current costs. Historical cost/constant purchasing power financial statements would also involve additional costs, but these would be much less than with current cost financial statements. Since the adjustment process involves the use of generally accepted accounting principles and a publicly available price-level index, the costs mainly result from modifying accounting systems. Current Cost and Operating Savings Current cost net income includes depreciation expense based on the current cost of the property, plant, and equipment. If the current cost were based on the current productive capacity of the assets, which incorporates technological changes, it is argued that the savings, as well as the higher depreciation charges, that would result from the technological changes should be included. For example, suppose a company owns a fleet of trucks. The current cost depreciation expense would be based on the higher purchase price of trucks. But if new trucks get better gas mileage and have lower repair and maintenance costs, other operating expenses would be lower. Since the new trucks have not been acquired, the operating savings have not been realized and would have to be estimated. Complete implementation of this current cost framework would require that these lower costs, as well as the higher depreciation, be reflected in the income statement. However, it is difficult to estimate operating savings objectively. The SEC s rescinded requirements (which we discuss later) allowed estimation of such operating savings. Bethlehem Steel reported that its estimated cost savings were 167% of the excess of current cost depreciation over historical cost depreciation. Sears reported savings of 86% and the Ford Motor Company savings of 72%. You should also note that the operating savings might be offset to some extent by the increased interest costs on the money that would have to be borrowed to finance the acquisition of the new property, plant, and equipment. The FASB avoided this issue by requiring that a company measure current cost in terms of the reproduction cost of currently owned assets, thereby ignoring any changes in technology and the operating savings that might result. This advantage is offset by the fact that the current cost is measuring replacements that the company may not make. Current Cost versus Partial Adjustments Generally accepted accounting principles require several current cost methods that tend to modify the historical dollar concept, so that historical cost financial statements achieve some of the objectives of current cost accounting. The LIFO inventory costing method matches approximately the current cost of the inventory (or a value close to the current cost) as cost of goods sold against revenue. Accelerated depreciation methods expense a high percentage of the historical cost of the asset against revenue early in the life of the asset, thus partially offsetting the effects of price changes on those assets. However, the extra amount of the expense may not be related in any rational way to the change in the asset s current cost. Also, the total depreciation expense over the life of the asset is limited by the historical dollars paid for it. Furthermore, neither LIFO nor accelerated depreciation methods reflect current costs in the balance sheet. The use of LIFO and accelerated depreciation do reduce income, so that it is likely to be closer numerically to current cost income, but they should not be considered as substitutes for current cost financial statements. 10. K. Evans and R. Freeman, Statement 33 Disclosures Confirm Profit Illusion in Primary Statements, FASB Viewpoints (Stamford, Conn.: June 24, 1983), p. 13. FASB Statement No. 33 required certain supplementary disclosures, but was rescinded by FASB Statement No. 89, as discussed later.

14 Conceptual Issues Relating to Alternatives to Historical Cost CIP15 Generally accepted accounting principles also require the use of the lower of cost or market method for inventory (as we discussed in Chapter 9), fair value for impaired noncurrent assets (as we discussed in Chapters 11 and 12), fair value for investments in trading and available-for-sale securities (as we discussed in Chapter 15), and for some financial instruments and derivatives (as we discussed in Chapters 7 and 15). Both the market value and fair value typically approximate current costs. A company is required to report the gains and losses on these items in its comprehensive income (either in net income or other comprehensive income). So a company's comprehensive income has a few similarities to current cost income. Current Exit Values The three alternative measurement methods that we have discussed use entry, or input, values. An historical cost is, of course, the cost measured at the time of the acquisition of the item. A constant purchasing power amount is an adjusted historical cost amount. A current cost is the amount that would have to be paid to purchase an item. In contrast, some users of financial statements argue that it would be more appropriate to use exit values. A current exit value is the net cash amount that a company would receive if it sold the item. An exit value often is referred to as the net realizable value because it is the net amount to be received from the sale after deducting any costs associated with the sale, such as transportation costs and sales commissions. The basic argument in favor of the use of exit values in a company s financial statements is that the company will have to dispose of each item at some point in the future, and therefore the current measure of the cash to be received from such sales is relevant to users of financial statements. It is argued that exit values provide a better measure of the return on investment, liquidity, and financial flexibility. Example CIP-5 illustrates the use of exit values using the facts for the Hallas Company earlier in the Appendix. In addition, it is assumed that at Steps 2 and 5, the exit values of the inventory are $1,800 and $2,200, respectively. There are two components of income. The first is the purchasing margin, which is the difference between the exit value and the acquisition cost of the assets on the date of acquisition. The second is the holding gain or loss, which is the change in the exit values of the assets. In the Hallas Company example, inventory is acquired at Step 2 for $1,000 when its exit value is $1,800, so that the company recognizes a purchasing margin of $800 and includes it in net income. At Step 4, when the inventory is sold, the exit value is $2,000 and the EXAMPLE CIP-5 Exit Value Financial Statements Step Income Statements Purchasing margin $ 800 $ 950 Holding gain $ 200 Net Income $ 800 $ 200 $ 950 Balance Sheets Cash $3,000 $2,000 $2,000 $4,000 $2,750 Inventory 1,800 1,800 2,200 $3,000 $3,800 $3,800 $4,000 $4,950 Capital $3,000 $3,800 $3,800 $4,000 $4,950

15 CIP16 Appendix CIP Accounting for Changes in Prices company recognizes the holding gain of $200 (the increase in the exit value from $1,800). At Step 5 the company acquires inventory for $1,250 when its exit value is $2,200, so that it recognizes a purchasing margin of $950 and includes it in net income. At all times, the company includes the exit value of the inventory in its balance sheet. Generally accepted accounting principles require the use of exit values in the financial statements of a company for reporting certain investments (as we discussed in Chapter 15) because the securities are readily saleable. In this case, the exit value and the current cost are the same, except for transaction costs. Many people argue that the use of exit values for other items would not provide relevant information, however. Consider two examples. If a company used an exit value for its inventory, it would record that inventory at its selling price (less costs of disposal) before any sale transaction occurred and therefore would recognize income simply by acquiring inventory. Second, suppose that a company acquired a specialized machine for use in its activities. If the machine has no value to another company, its value would immediately be recorded as zero and its entire purchase price expensed in the period of acquisition, even though the company intends to use the machine for several years. Alternatively, it can be argued that in certain situations (in addition to certain investments) exit values have more relevance than input values. For example, if a company is to be liquidated, then exit values are more relevant. Of course, in this case the going concern (continuity) assumption is no longer valid. Furthermore, when a company is being sold in its entirety, many purchasers are interested in exit values because they may intend to sell some of the assets. Regardless of their position on the relevance of exit values, few accountants argue that exit values should be the basis of the accounting principles for financial statements used in most investment and lending decisions. Be aware of the 5 disclosure requirements that have existed for alternative disclosures, including the reasons for the elimination of the required disclosures. DISCLOSURES The APB, FASB, and SEC have recommended or required various disclosures of the effects of changing prices. In 1969 the APB issued APB Statement No. 3, which stated that general price-level adjusted historical cost financial statements present useful information not available from historical cost financial statements and concluded that: General price-level information may be presented in addition to the basic historical dollar financial statements, but general price-level financial statements should not be presented as the basic statements. 11 In 1977 the Securities and Exchange Commission adopted a requirement for supplementary disclosure on the annual 10-K report of the current replacement cost of the inventories, cost of goods sold, net productive assets, and depreciation. Companies with inventories and gross property, plant, and equipment of more than $100 million that represented more than 10% of their total assets were required to make these disclosures. These requirements were rescinded when FASB Statement No. 33 was issued. In 1979 the FASB issued FASB Statement No. 33, Financial Reporting and Changing Prices, which required disclosure of the effects of changing prices as a supplement to the basic historical cost financial statements. 12 Public companies having $1 billion of assets (after deducting accumulated depreciation) or $125 million of inventories and property, plant, and equipment (before deducting accumulated depreciation) were required to make such disclosures, although all companies were encouraged to do so. Then, in 1986 FASB Statement No. 89 rescinded the requirement that qualifying companies disclose the information specified in FASB Statement No. 33 as amended. However, FASB Statement No. 89 encourages the continued disclosure of information about the effects of changing prices and includes guidelines for measurement and disclosure. We discuss the reasons for making the disclosures voluntary in the next section. 11. APB Statement No. 3, op. cit., par Financial Reporting and Changing Prices, FASB Statement of Financial Accounting Standards No. 33 (Stamford, Conn.: FASB, 1979).

16 Disclosures CIP17 If a company decides to voluntarily report supplementary information on the effects of changing prices, the FASB disclosure guidelines for the current year and for a 5-year summary are as follows: The selected disclosures for the current year are (1) income from continuing operations under the current cost basis, including disclosure of the current cost amounts of cost of goods sold, and depreciation, depletion, and amortization expense, (2) purchasing power gain or loss on net monetary items (excluded from income from continuing operations), (3) current cost (or lower recoverable) amount of inventory and of property, plant, and equipment at the end of the current year, (4) increase or decrease in the current cost (or lower recoverable) amount of inventory and of property, plant, and equipment, before and after eliminating the effects of inflation (excluded from income from continuing operations), and (5) aggregate foreign currency translation adjustment on a current cost basis, if applicable. The selected disclosures included in a 5-year summary, adjusted to average-for-theyear, end-of-year, or base-period constant purchasing power are (1) net sales and other operating revenues, (2) income from continuing operations (and related earnings per share) under the current cost basis, (3) purchasing power gain or loss on net monetary items, (4) increase or decrease in the current cost (or lower recoverable) amount of inventory and of property, plant, and equipment, net of inflation, (5) aggregate foreign currency translation adjustment on a current cost basis, if applicable, (6) net assets at year-end on a current cost basis, (7) cash dividends declared per common share, and (8) market price per common share at year-end. 13 Additional disclosures include (1) the principal types of information used to calculate the current costs, and (2) differences between the depreciation methods, estimates of useful lives, and residual values used for calculations of current cost depreciation and the methods and estimates used in the primary financial statements (there is a presumption that the methods and estimates should be the same). The FASB states that the objective of the calculations is to obtain a reasonable degree of accuracy and that preparers are encouraged to devise short-cut methods. 14 The Statement requires that the constant purchasing power adjustments use the average Consumer Price Index for All Urban Consumers (CPI-U) for the year. Conceptual Evaluation of the Elimination of the Required Disclosures When FASB Statement No. 33 was adopted in 1979, it was intended that its provisions would be reviewed after a period of not more than five years. Consequently, the FASB sponsored and monitored research to help assess the usefulness of information about the effects of changing prices. In 1983 the FASB issued an Invitation to Comment on the need for disclosures of information on the effects of changing prices and the best way to meet that need. In 1984 the FASB responded to the related comments and research results by issuing FASB Statement No. 82, which eliminated certain disclosure requirements. Then, in 1986 FASB Statement No. 89 eliminated the requirement for the remaining disclosures. This Statement was adopted by a 4-to-3 majority. There were several arguments in favor of eliminating the required disclosures. First, there was evidence that the disclosures were not widely used. Among the reasons for the lack of use were concerns that the information was not relevant. It was argued that the concept of current cost (the cost of replacing existing service potential) was not relevant because many companies intended to replace their assets with others that had a different service potential. It was also argued that applying a specific price index to the historical cost did not provide a relevant value because technological change may not be appropriately reflected in the index. The lack of use also resulted from concerns about the reliability of the information. For example, the determination of the current cost 13. FASB Statement No. 89, op. cit., par. 7, 8, Ibid., par. 48.

17 CIP18 Appendix CIP Accounting for Changes in Prices when an asset with equivalent service potential was not available required considerable judgment and therefore could be viewed as unreliable. Also, the determination of the recoverable amount required substantial judgment. Furthermore, since the disclosures were labeled unaudited and supplementary, they were considered to lack reliability. Second, responses to the Invitation to Comment expressed the concern that the costs of providing the information exceeded the benefits. Because neither the costs nor the benefits could be accurately measured, it was appropriate for the FASB to suspend disclosure requirements if preparers and users perceive an unfavorable cost/benefit relationship. Third, it was argued that the disclosures lacked comparability. This situation resulted from the degree of flexibility in methods of application, from differences in the quality of the raw data used to prepare the disclosures, and from failure to disclose the assumptions used. Fourth, concern was expressed that the disclosures lacked understandability because they were overly complex. Also, it was argued that the disclosures were difficult to understand because they were not adequately explained and did not include comprehensive financial statements. Fifth, many users of financial statements indicated that they used information about changing prices in their decisions but had developed their own methods for making the adjustments. Therefore, additional disclosures might not be useful because users had information that was better or different from that required by FASB Statement No. 33. The final argument against continuing the required disclosures was that the significance of the disclosures had decreased because prices were changing much less than in previous years. Therefore, other concerns were more important to users, such as the ability of the company to finance replacements of productive capacity or the effects of changing interest rates on monetary assets and liabilities. There were several arguments in favor of continuing the required disclosures. First, it was argued that the basic concept underlying FASB Statement No. 33 (inflation causes historical cost financial statements to show illusory profits and to mask the erosion of capital) is virtually undisputed. Second, although there was evidence of limited use of the disclosures, five years is an insufficient time to assess the usefulness of the information. Therefore, an effort should be made to improve any shortcomings of the information. Third, suspension of the required disclosures will encourage companies to remove the systems used to develop the information. Therefore, information will no longer be available for research on the relevance and reliability of the information. The final argument against the elimination of the required disclosures was that when inflation rates increase at some time in the future, the FASB will again be asked to require supplementary disclosures of the effects of changing prices. The effort required at that time will be as difficult, time-consuming, and costly as the implementation of FASB Statement No. 33 disclosures. International Accounting Differences 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; that is, the statements are adjusted in a way similar to the constant dollar process we discussed in this Appendix. The standards also require that the company include the purchasing power gain or loss on net monetary items in its net income. SUMMARY At the beginning of the appendix, we identified several objectives you would accomplish after reading the appendix. The objectives are listed below, each followed by a brief summary of the key points in the appendix discussion. 1. Understand the difference between current value and general price level adjustments. A current value (or specific price change) is the change in the price of an individual asset or liability caused by changes in the dynamics of the market for that particular item. A general price-level change is the change in the value, or purchasing power, of the dollar.