International Accounting, 6/eFrederick D.S. ChoiGary K. MeekChapter 7: Financial Reporting and Changing PricesChoi/Meek, 6/e1Learning ObjectiveslWhat do we mean by the term, changing prices?lWhy are financial statements misleading during periods of changing prices?lWhat are the various ways of adjusting financial statements for changing prices?Choi/Meek, 6/e2lDo adjustments for changing prices vary internationally?lWhat does IAS 21 have to say about inflation adjustments in hyperinflationary countries?lWhat is the restate-translate controversy all about?lIs it possible to double-count for the effects of foreign inflation?Choi/Meek, 6/e3What Does “Changing Prices” Mean and How are Price Changes Measured?lGeneral price level change: refers to a movement in the prices of all goods and services in an economy on average.lPositive price movement is termed inflation.lA negative price movement is called deflation.Choi/Meek, 6/e4lGeneral price level changes are measured by use of a general price level index (GPL).lGPL 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.lThe reciprocal of the GPL is a measure of the general purchasing power of the monetary unit. Choi/Meek, 6/e5lSpecific 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.lSpecific price changes are measured by a specific price index (SPL).lSPL is a cost ratio that compares the cost of a specific item with its cost in a prior or base period.Choi/Meek, 6/e6Why are Financial Statement Potentially Misleading During Periods of Changing Prices?lDuring periods of inflation, revenues are based on the general purchasing power of the current period.lExpenses, 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. Choi/Meek, 6/e7lDeducting expenses based on historical purchasing power from revenues that expressed in currency of current purchasing power yields a nonsensical index of performance. Choi/Meek, 6/e8Why are Financial Statements Potentially Misleading During Periods of Changing Prices? (contin)lDuring 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:lHigher taxeslHigher dividendslHigher wagesChoi/Meek, 6/e9lFrom a managerial perspective, accounting numbers unadjusted for changing prices distort:lFinancial projectionslBudget comparisonslPerformance dataChoi/Meek, 6/e10Types of Adjustments for Changing PriceslObjective of conventional historical cost accounting: maintain a firms original investment. lAssume 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. Choi/Meek, 6/e11lRevenues would be $1,500 received uniformly over the period, expenses would be $1,000, and net income would be $500.lNet income of $500 represents the amount that could be withdrawn from the firm and leave the owners with their original investment intact.Choi/Meek, 6/e12General Price Level Adjustments lObjective: to measure income such that it represents an amount that could be withdrawn from the business while preserving the general purchasing power of the firms original investment.lAssume the same facts as previously except that the GPL advances from a level of 100 at the beginning of the period to 121 at periods end and averaged 110 during the year.Choi/Meek, 6/e13lTo 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.lTo 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).Choi/Meek, 6/e14lExpenses (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. lThis produces an adjusted operating income of $440 (=$1.650 - $1,210).Choi/Meek, 6/e15General Price Level AdjustmentslDuring inflation, an additional consideration must be accounted for. These are the gains and/or losses attributed to holding monetary items. lMonetary asset = cash or a claim to a fixed number of currency in the future; e.g. cash or accounts receivable.Choi/Meek, 6/e16lMonetary liability = obligations to pay a fixed number of currency in the future; e.g., most payables excluding customer advances. lDuring inflation, a firm holding monetary assets experiences a purchasing power loss as cash or receivables are not adjusted for inflation; a firm holding monetary liabilities experiences a purchasing power gain, as monetary liabilities are not adjusted for inflation.Choi/Meek, 6/e17lIn 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.lPrice level adjusted net income would be $290 (= $440 - $150).Choi/Meek, 6/e18lWithdrawing $290 from the business would leave the firm with $1,210, the amount necessary to keep up with inflation. lFor balance sheet purposes, all non-monetary assets and liabilities would be adjusted to their end of period purchasing power equivalents by multiplying them by the end of period index over the index that prevailed when these items were acquired.Choi/Meek, 6/e19Choi/Meek, 6/e20Adjustments for Specific Price Changes lObjective: to measure income such that it represents an amount that could be withdrawn from the business while preserving the firms productive capacity; i.e., ability to replace specific assets whose prices have risen during the period.lContinuing the previous example, assume that in addition to general inflation, specific prices of inventory have increased by 30%. Choi/Meek, 6/e21lAs 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.lTo accomplish this, assets and their related expenses are restated to their current cost equivalents. Choi/Meek, 6/e22Adjustments for Specific Price Changes lInventory and hence cost of sales (all inventory was sold) would be restated to $1,300 (= $1,000 x 130/100). lThis produces a replacement cost based adjusted operating income of $200 (= $1.500 - $1,300).Choi/Meek, 6/e23lWithdrawing $200 from the business would leave the firm with $1,300, the amount necessary to enable it to preserve its productive capacity. lSee pp. 143-144 of Infosys annual report at and select annual report for 2007. Choi/Meek, 6/e24General Price Level Adjusted Current CostslObjective: to measure income such that it represents an amount that could be withdrawn from the business while preserving the firms general purchasing power and allowing it to maintain its productive capacity in real terms. Choi/Meek, 6/e25lSame facts as before. General price levels have advanced by 21% and specific prices have increased by 30%.lA distinctive feature of this measurement framework is that it reports changes in the current costs of a firms nonmonetary assets, net of inflation.Choi/Meek, 6/e26lThe increase in the inventorys cost due to general inflation was $210 (= $1,000 x 121/100).lThe real change in the inventorys current cost was $90 = ($1,000 x 121/100) ($1,000 x 130/100). Choi/Meek, 6/e27lNet income is $200 (= $1,650 revenues - $1,300 cost of sales - $150 monetary loss). It represents the amount that could be paid out as a dividend and yet allow the firm to keep up with general inflation and allow it to replace specific assets (inventory) whose prices have advanced by $90 in real terms.Choi/Meek, 6/e28Choi/Meek, 6/e29Choi/Meek, 6/e30Choi/Meek, 6/e31National Variations U.S. lU.S. SFAS 89 encourages but does not mandate the following disclosures for each of the five most recent years:lNet sales lIncome from continuing operations on a current-cost basis.lMonetary gains or losses on net monetary items.Choi/Meek, 6/e32lIncreases or decreases in the current cost or lower recoverable amount of inventory or plant, property and equipment, net of inflation.lAggregate foreign currency translation adjustment, on a current cost basis.lNet assets at year-end on a current cost basis.Choi/Meek, 6/e33lEarnings per share on a current cost basis.lDividends per share of common stock.lLevel of the Consumer Price Index used to measure income from continuing operations.Choi/Meek, 6/e34lFor foreign operations included in the consolidated statements:lTranslate foreign accounts to dollars, then restate for U.S. inflation, if the dollar is the functional currency.lRestate for foreign inflation, then translate to U.S. dollars if the local currency is functional. Choi/Meek, 6/e35Choi/Meek, 6/e36National Variations United KingdomlIn the U.K., SSAP 16 recommends one of three reporting options:lPresent current-cost accounts as the basic financial statements with supplementary historical cost accounts.lPresent historical-cost accounts as the basic statements with supplementary current-cost accounts.lPresent current-cost accounts as the only accounts accompanied by adequate historical-cost information.Choi/Meek, 6/e37lThe 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. lAlso required is a gearing adjustment that offsets inflation-adjusted cost of sales, depreciation, and the monetary working capital adjustment for monetary gains resulting from the use of debt. Choi/Meek, 6/e38National Variations Brazil lPermanent 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.lStockholders equity accounts (i.e., capital, revenue reserves, retained earnings, and capital reserve accounts) are also adjusted by GPL changes.Choi/Meek, 6/e39lPermanent asset adjustments are offset against stockholders equity adjustments.lA permanent asset adjustment equity adjustment produces a purchasing power gain.Choi/Meek, 6/e40Choi/Meek, 6/e41IAS 21lRequires the restatement of primary financial statement information for operations located in hyperinflationary environments.lHistorical cost or current cost statements must be expressed in constant purchasing power as of the balance sheet date.Choi/Meek, 6/e42lPurchasing power gains or losses on net monetary items must be included in current income.lFirms must disclose: lthat restatement for inflation has been made.lwhich asset valuation framework is being used in the primary statements.lwhich price index is used and its level at the balance sheet date and movement during the period.Choi/Meek, 6/e43Restate/Translate ControversylWhen consolidating the accounts of subsidiaries located in inflationary environments, should management first restate these accounts for foreign inflation, then translate to parent currency?lOr, should they first translate unadjusted accounts to parent currency, then restate for parent country inflation?Choi/Meek, 6/e44lOur solution, based on a dividend discount valuation framework:lRestate statements to be consolidated for specific price changes.lTranslate to parent currency using the current rate.lUse specific price indexes to calculate monetary gains and losses.Choi/Meek, 6/e45Double-counting for Inflation lLocal inflation affects exchange rates used to translate inflation-adjusted foreign currency balances to parent currency.lResult: Inflation is accounted for twice.lTo eliminate the double-dip, back out the periods translation gain or loss from the inflation adjustment.lSee example for inventory on page 268 of text.lSee Appendix 7-1 for cost of sales example.Choi/Meek, 6/e46Other Chapter ExhibitsChoi/Meek, 6/e47