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Questions and Answers
What is one potential consequence of not adjusting financial statements for changing prices?
What is one potential consequence of not adjusting financial statements for changing prices?
What is the objective of general price level adjustments in accounting?
What is the objective of general price level adjustments in accounting?
During periods of specific price changes, what effect can the overstatement of reported income have on a firm?
During periods of specific price changes, what effect can the overstatement of reported income have on a firm?
What is a key reason for adjustments made to financial projections during changing prices?
What is a key reason for adjustments made to financial projections during changing prices?
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What does a positive price movement indicate?
What does a positive price movement indicate?
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How is the general price level change characterized?
How is the general price level change characterized?
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Which index measures specific price changes?
Which index measures specific price changes?
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Why can financial statements be misleading during inflationary periods?
Why can financial statements be misleading during inflationary periods?
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What is the reciprocal of the General Price Level index indicative of?
What is the reciprocal of the General Price Level index indicative of?
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What happens to a firm holding monetary assets during inflation?
What happens to a firm holding monetary assets during inflation?
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What is the objective of adjustments for specific price changes?
What is the objective of adjustments for specific price changes?
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Study Notes
International Accounting, Chapter 7: Financial Reporting and Changing Prices
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Learning Objectives:
- Define changing prices
- Explain how changing prices mislead financial statements
- Detail various adjustments for changing prices
- Discuss international variations in adjustments
- Explain IAS 21's stance on inflation adjustments
- Describe the restatement-translation controversy
- Examine the potential for double-counting of foreign inflation
What Does "Changing Prices" Mean and How are Price Changes Measured?
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General price level change: Refers to average price movements for all goods and services in an economy.
- Positive movement is inflation
- Negative movement is deflation
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Specific price change: Refers to the price movement of a particular asset (e.g., inventory, equipment)
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General Price Level Index (GPL): Measures general price level changes.
- Compares the cost of a basket of goods in the current period to the cost in a base period.
- Reciprocals indicate general purchasing power.
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Specific Price Index (SPL): Measures specific price changes.
- Compares the cost of a specific item in the current period to its cost in a base period.
Why are Financial Statements Potentially Misleading During Periods of Changing Prices?
- Inflation: Revenues are based on the current general purchasing power, while expenses often reflect older lower purchasing power, creating a distorted picture of profitability.
- Historical purchasing power: Using historical purchasing power when comparing revenues and expenses during times of changing prices results in inaccurate performance indexes.
Types of Adjustments for Changing Prices
- Objective of historical cost accounting: Maintain a firm's original investment.
- Example: A firm begins with $1000
- All inventory is sold at 50% markup ($1500), no price changes
- Revenues are $1500 (uniformly throughout the year)
- Expenses are 1000,netincome=1000, net income = 1000,netincome=500
General Price Level Adjustments
- Objective: Measure income to represent an amount that can be withdrawn, preserving the general purchasing power of the original investment.
- Example using a GPL that increased from 100 to 121:
- Revenues: 1500∗(121/110)=1500 * (121/110) = 1500∗(121/110)=1650
- Expenses: 1000∗(121/100)=1000 *(121/100) = 1000∗(121/100)=1210
- Adjusted operating income: $440
General Price Level Adjustments (Continued)
- Monetary items: Cash, receivables, and payables.
- Nonmonetary items: Inventory, equipment, etc.
- During inflation, gains/losses based on holding monetary items need accounting.
- Monetary assets: Loss in purchasing power
- Monetary liabilities: Gain in purchasing power
General Price Level Adjustments (Continued)
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Example (continued):
- Cash from sales 1500,adjustedforinflationto1500, adjusted for inflation to 1500,adjustedforinflationto1,650
- Real cash balance is 1500,resultinginalossof1500, resulting in a loss of 1500,resultinginalossof150
- Final adjusted net income: 290(=290 (= 290(=440 - 150),leavethefirmwith150), leave the firm with 150),leavethefirmwith1,210
- Non-monetary assets/liabilities are adjusted to their purchasing power equivalents
Adjustments for Specific Price Changes
- Objective: Measure income to maintain the firm's productive capacity
- Example: Inventory price rises 30%
- Increased equity 300,endingequity=300, ending equity = 300,endingequity=1,300
- Restructured inventory & expenses reflect current cost equivalents
Adjustments for Specific Price Changes (Continued)
- Restated inventory costs to $1,300
- Inventory & cost of sales = $1,300
- Adjusted operating income: 200(200 (200(1,500 - $1300)
- $1300 is the actual amount that can stay in the business, in order to maintain capacity as seen by the increased prices
National Variations - US
- U.S. SFAS 89: encourages but does not mandate specific disclosures.
- Income from continuing operations (current costs)
- Net monetary items (gains/losses)
- Adjusted changes in inventory, plant, equipment (net of inflation)
- Aggregate foreign currency adjustments
- Specific figures for each of 5 years to be reported
National Variations - United Kingdom
- SSAP 16: offers three reporting options relating to current costs and historical costs:
- Current cost accounts as the sole accounts, or with supplementary historical cost accounts
- Historical cost accounts, with supplementary current cost accounts
- Current cost accounts only with adequate historical cost information
- Monetary gains/losses, and gearing adjustments required
National Variations - Brazil
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Permanent assets, equity adjustments, and monetary items that consider general price level changes as well
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Asset/equity adjustments are offset (power losses/gains)
IAS 21
- Restatement of primary financial statements in hyperinflationary environments using constant purchasing power (balance sheet date)
- Include gains/losses on net monetary items, and disclose what methods were used to meet this accounting
Restate/Translate Controversy
- Issue: Consolidating subsidiary accounts in inflationary environments during restatement/translation
- Solution: Restate to consolidate for specific price changes, translate to parent currency using the current rate.
- Use specific price indexes to calculate monetary gains/losses
Double-counting for Inflation
- Local inflation affects exchange rates impacting translation to parent currency
- Solution: Back out the translation gain/loss during the inflation adjustment
Other Chapter Exhibits
- Includes other terms (attributes, monetary assets/liabilities, etc.) and examples for understanding the specific concepts and calculations needed for adjusting financial statements during changing price levels, and specific price adjustments for subsidiaries.
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Description
Explore the complexities of financial reporting in relation to changing prices in International Accounting. This quiz covers definitions, implications on financial statements, and international standards like IAS 21 regarding inflation adjustments. Test your understanding of these critical concepts and the controversies involved.
