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Theses and Dissertations 1. Thesis and Dissertation Collection, all items

1992-06

Inflation accounting methods and their effectiveness

Sulucay, Ismail Hakki

Monterey, California. Naval Postgraduate School

http://hdl.handle.net/10945/23927

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Inflation Accounting Methods and Their Effectiveness

1 2. PERSONAL AUTHOR(S) Ismail Hakki Sulucay

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Master's Thesis From To 1992,June,2 83
16 SUPPLEMENTARY NOTATION
The views expressed in this thesis are those of the author and do not reflect the official policy or position of the Department of Defense or the U.S.
Government.
17. COSATI CODES 18 SUBJECT TERMS (continue on reverse if necessary and identify by block number)
FIELD GROUP SUBGROUP Inflation, inflation accounting, constant purchasing power accounting, constant dollar
accounting, current cost accounting, current value.

19. ABSTRACT (continue on reverse if necessary and identify by block number)

This thesis provides an overview of the inflation accounting methods and their applications as accounting standards. Constant purchasing
power accounting and current cost accounting are explained as the major inflation accounting methods. Inflation accounting standards
announced in the United States, Britain, and Canada are presented in a comparative manner. Several empirical studies which examined the
usefulness of the inflation disclosures required by the U.S. Financial Accounting Standards Board Statement No.33 are reviewed to provide
information on the effectiveness of inflation accounting methods. These studies produced mixed results. While some showed enhanced
information value in inflation disclosures, others showed none.

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INFLATION ACCOUNTING METHODS

AND THEIR EFFECTIVENESS

by

Ismail Hakki Sulucay

First Lieutenant Turkish
, Army
B.S., Turkish Army Academy, Ankara, 1986

Submitted in partial fulfillment

of the requirements for the degree of

MASTER OF SCIENCE IN MANAGEMENT

from the

NAVAL POSTGRADUATE SCHOOL

June^992
 ABSTRACT

This thesis provides an overview of inflation accounting

methods and their applications as accounting standards.

Constant purchasing power accounting and current cost

accounting are explained as the major inflation accounting

methods. Inflation accounting standards announced in the

United States, Britain, and Canada are presented in a

comparative manner. Several empirical studies which examined

the usefulness of the inflation disclosures required by the

U.S. Financial Accounting Standards Board Statement No. 33 are

reviewed to provide information on the effectiveness of

inflation accounting methods. These studies produced mixed

results . While some showed enhanced information value in

inflation disclosures, others showed none.

111
 . .

TABLE OF CONTENTS

I INTRODUCTION 1

A. BACKGROUND 1

B. RESEARCH QUESTION 3

C. RESEARCH METHODOLOGY 3

D. ORGANIZATION OF THE STUDY 4

II. NATURE OF INFLATION 5

A. DEFINITION AND MEASUREMENT 5

B. CAUSES OF INFLATION 7

C. EFFECTS OF INFLATION ON A BUSINESS 9

D. SUMMARY 12

III. METHODS OF INFLATION ACCOUNTING 14

A. INTRODUCTION 14

B. CONSTANT PURCHASING POWER ACCOUNTING .... 15

1 . Definition 15

2. Methodology 16

3. Advantages of Constant Purchasing Power

Accounting 21

4 Disadvantages of Constant Purchasing

Power Accounting 22

C. CURRENT COST ACCOUNTING 23

1 Definition 23

2 Valuation Methods To Determine the Current

Values 24

3. Holding Gains and Losses 29

4 Advantages and Disadvantages of Current

Cost Accounting 31

iv
 .

D. SUMMARY 32

IV. INFLATION ACCOUNTING IN PRACTICE 34

A. INTRODUCTION 34

B. FASB STATEMENT NO. 33 35

1 . Origins 35

2. Objectives of Statement No. 33 37

3. Required Disclosures 38

4. Aftermath of Statement No. 33 41

C. INFLATION ACCOUNTING IN BRITAIN 43

D. INFLATION ACCOUNTING IN CANADA 46

E. SUMMARY 47

V. EMPIRICAL STUDIES ON INFLATION ACCOUNTING ... 50

A. INTRODUCTION 50

B. INFLATION DISCLOSURES AND STOCK PRICES ... 51

1 . Beaver and Landsman 52

2. Bublitz, Frecka, and McKeown 55

3 Bildersee and Ronen 55

4. Schaefer 56

5. Swanson, Shearon, and Thomas 57

6. Morris and McDonald 57

7. DeBerg, Hansen, and Boatsman 58

C. INFLATION DISCLOSURES AND PROFITABILITY

RANKINGS 59

D. COST-BENEFIT ANALYSIS OF INFLATION

ACCOUNTING METHODS 61

E. SUMMARY 63

VI. CONCLUSIONS 66
LIST OF REFERENCES 72

INITIAL DISTRIBUTION LIST 75

VI
 I . INTRODUCTION

A. BACKGROUND
The main objective of financial reporting is to provide

a fair presentation of a business' operations and current

position. Reliability of financial statements is very

important, because many decisions by investors, government and

management are based on the information provided in these

reports . Financial statements report business performance in

terms of money as a common measuring unit. The conventional

method of financial reporting (i.e, historical cost

accounting) is based on the business accounts which record all

business transactions at their nominal amount at the unique

times of transactions. A basic assumption is that money as a

common measuring unit is stable in value and represents a

constant amount of goods and services at any point in time.

Inflation has become a major problem in many countries,

especially after the 1970s. During inflation, the purchasing

power of money declines as the prices of goods and services

increase . A constant amount of money can buy lower and lower

amounts of goods and services through time. This situation

decreases the reliability of money as a measuring unit.

Financial statements based on money amounts with different

purchasing power fail to measure business performance

correctly. In market economies, prices of goods and services

 .

may change in different directions and at different rates over

time. Inflation represents the upward movement of the average

of all these specific price changes. Changes in the prices of

specific goods and services used by a business also decrease

the reliability of financial statements, since the book values

of these items do not reflect the current costs incurred by

the business.

Inflation accounting attempts to develop accounting

methods which can neutralize the distortional effects of

inflation or, in more general terms, the distortional effects

of changing prices. In the accounting literature, two main

inflation accounting methods have been developed: constant

purchasing power accounting and current cost accounting. These

two methods will be explained in the second chapter. On the

application side, the U.S. Financial Accounting Standards

Board Statement No. 33 was the first inflation accounting

standard and required the disclosure of inflation information

by using both inflation accounting methods. This statement

initiated a great deal of discussion and provided invaluable

data for researchers to evaluate the inflation accounting

methods

This thesis examines the evolution of the inflation

accounting methods and their applications. Also, some key

issues of inflation accounting are explored , and results of

several empirical studies on the usefulness of inflation

accounting methods are presented to provide a comprehensive

 .

approach to inflation accounting. Only such a comprehensive

approach would help to improve the reliability of financial

statements and lead to more efficient decisions both by

investors and business management.

B. RESEARCH QUESTION
The ultimate issue for this research is whether the

disclosure of inflation information improves the usefulness of

the financial statements for the users. Subsidiary questions

underlying this issue include these:

1. What is the nature of inflation? How does it affect the
measurement of business performance?

2 What methods are developed to account for inflation?

3. What are the advantages and disadvantages of these

methods?
4 . What accounting standards have called for the disclosure
of inflation information? In what manner have these
standards employed inflation accounting methods?

5. What evidence is there regarding the usefulness of the

disclosure of inflation information in financial
statements?

C. RESEARCH METHODOLOGY
This study is based on a review of the recent accounting

literature on inflation accounting and the FASB regulations.

Empirical studies which were conducted after the release of

FASB Statement No. 33 are reviewed, since they are based on the

real world data provided by the disclosures required by this

statement. The study presents a comparative analysis of

different approaches to inflation accounting.

 . ,

D. ORGANIZATION OF THE STUDY

The thesis consists of six chapters. After the

introduction, the second chapter explains the nature of

inflation and its effects on the measurement of business

performance. The deficiencies of historical cost accounting

during inflationary periods are presented to highlight the

motivation behind inflation accounting. In the third chapter

two main methods of inflation accounting are presented along

with their advantages and disadvantages with respect to each

other and to the historical cost accounting model . The fourth

chapter includes a comparative review of the inflation

accounting standards issued in the United States, Britain, and

Canada. In the fifth chapter, several empirical studies which

evaluate the usefulness of inflation disclosures provided in

compliance with the FASB Statement No. 33 are presented. The

last chapter includes some conclusions about inflation

accounting, based on the review of accounting literature and

empirical studies
 II. NATURE OF INFLATION

A. DEFINITION AND MEASUREMENT

Inflation is usually defined as a decline in the general

purchasing power of money due to an increase in the general

level of prices [Ref .1] . In essence, a certain amount of money

can purchase lower amounts of goods and services over time

during inflation. Deflation, which is the opposite of

inflation, can be defined as an increase in the general

purchasing power of money due to a decrease in the general

price level. In fact, prices of goods and services in an

economy may change in different directions and at different

rates through time, and the general price level represents the

average of all these specific price changes.

Inflation is easier to define than to measure [Ref. 2].

One commonly used measure of the U.S. price level is the

Consumer Price Index (CPI) . In preparing the index, a bundle

of goods and services in a certain weighted combination is

determined; the total price of the bundle is calculated every

month and an annual average is also determined. Then, these

totals are expressed as percentages of a predetermined year's

total, namely the base year. Although the logic seems

straightforward, some very important assumptions affect the

accuracy of the measurement. First, not all goods and services

in the economy are included, and relative weights assigned to

the items included are arbitrary. Second, goods and services

which are available in a year may not be available in other

years, and consumption patterns reflected by the relative

weights of items in the bundle may change over time. Finally,

quality improvements may cause price increases that are not

part of the inflation.

Another common measure of price level is the Gross

National Product (GNP) price deflator. The preparation

methodology is the same as with the Consumer Price Index, but
the bundle includes all final goods and services produced in

the economy in a certain year. For example, items like

airplanes, industrial machines, computers, and office space

are also included.

From a statistical perspective, GNP deflator is preferred

since it covers a broader base. Economists, however, prefer

CPI on the grounds that purchasing power should be limited to

items which are used by an average consumer. Economists tend

to perceive the general price level as the cost of living of

an average consumer. Ideally, an individual cost of living

index would be superior to both indexing methods, if it were

practicable [Ref .3] . Price levels determined by price indices

are averages of all specific price changes, which are not

necessarily at the same rate or even in the same direction.

They don't explain whether and how much a specific person or

entity is better off or worse off during inflation. But they

 . .

do provide a reasonably reliable measure of overall price

changes [Ref.2].

B. CAUSES OF INFLATION

Economic theory tells us that inflation is caused by too

much money chasing too few goods. This statement implies that

either a substantial increase in the amount of money or a

substantial decrease in the amount of goods available in the

economy results in inflation. These two factors are named

demand stimulus and supply shocks, respectively. On the demand

side, expansionary monetary policies of governments to reduce

unemployment seem to play the greatest part . On the supply

side, food and energy shortages and inadequate increases in

productivity are stated as important factors

Although high inflation periods were experienced by many

countries in the past, inflation in the 1970s had the

remarkable feature of spreading simultaneously across the

world. Prices of internationally traded goods rose by 24% in

1973 and by 39% in 1974. Domestic inflation rates in the

industrial countries rose from an average of 4.5% in 1967 - 72

to 7.5% in 1973 and to 12.6% in 1974. In the following years,

high inflation rates became a common feature of developing

countries [Ref .4] . Inflation rates for different groupings of

countries are illustrated in Table 1

 TABLE 1. INFLATION RATES IN INDUSTRIAL AND DEVELOPING
COUNTRIES
GROUP 1967- 1973 1974 1975 1976 1977
72

Industrial 4.5 7.5 12.6 10.7 7.7 7.8

Countries
Oil-exporting 8.0 11.3 17.0 19.0 16.2 15.0
Countries
Non-oil -exp- 10.1 22.1 33.0 32.9 32.3 31.5
orting Devel-
oping Coun-
tries
Africa 4.8 9.3 18.6 16.4 18.8 25.0
Asia 5.4 14 . 9 27.8 11.5 1.5 8.8
Latin America 15.9 30.8 40.9 54.6 62.7 51.6
Middle East 4.3 12.7 21.8 20.3 17.4 24.2

The 1970s was a decade of inflation in the United States.

The average inflation rate for the decade was double the long-

run historical average. Alan S. Blinder states four major

reasons for the 1970s' inflation: rising food prices, rising

energy prices, the end of the Nixon wage-price control

programs, 1
and rising mortgage interest rates 2 [Ref.5]. In

1980, it reached the highest level since 1947, at 13.5%.

President Nixon announced a three-month freeze of wages and

prices on 15 August 1971. Evolving through several phases, it ended
at the and of April 1974.
2
Actually, high mortgage interest rates are an effect of
inflation. However, when mortgage payments are included in the
price index with a relatively higher weight, increases in mortgage
interest rates dramatically affect annual inflation rates.

8
 . .

Inflation levels in the United States between 1950 and 1990

are presented in the Figure 1

Figure 1: The U.S. Inflation Levels, Historical Consumer

Price Index for All Urban Customers

C. EFFECTS OF INFLATION ON A BUSINESS

Inflation implies that money, as a fundamental measuring

unit, fluctuates in value through time and that comparisons of

financial data over time may be misleading. In the accounting

world, all transactions, liabilities, and assets of a business

are recorded at their nominal value at the time of transac-

tions. Obviously, two basic functions of accounts are to keep

track of transactions and to determine performance through

time. If money amounts recorded at different times do not

reflect the same purchasing power, real performance may not be

determined correctly through conventional accounting.

Two common measures of business performance are income

and rate of return on capital . Since depreciation charges for

long-lived assets do not reflect the current costs, accounts

kept in historical dollars overstate income. If the inflation

rate is high enough, even the costs which are incurred in the

same year when they are expensed do not reflect the current

costs. On the other hand, revenue increases as prices rise.

Thus, an overstated income results. In addition to the over-

statement of income, understated book values of assets

compound the effect upon the rate of return on capital

In parallel to the overstatement of income, the effective

tax rate also increases. Since income tax is determined as a

percentage, it goes up with reported income. However, real

income may not have increased at all. As a result, the

effective tax rate, tax as a percentage of real income,

becomes larger.

Another issue is the maintenance of business capital

represented by stockholders'" equity. Basically, income is

divided among tax, dividends and retained earnings. As

illustrated above, the effective tax rate increases under

inflation and takes a greater portion of income. On the other

hand, stockholders expect to receive enough dividends to make

10
 .

up for inflation. However, if sufficient earnings to maintain

the physical capital are not retained, dividend policies based

on overstated income figures may erode the capital base

[Ref.7]. Physical capital represents the resources necessary

to maintain the existing level of productive capacity.

The effects of inflation on a business enterprise and on

its financial statements depend on the change in the general

price level and the composition of its assets and liabilities

[Ref.8]. Since money loses its purchasing power during

inflation, assets which are held as monetary amounts, like

cash and accounts receivable, decline in real value. On the

other hand, non-monetary assets like plant, equipment, and

inventory appreciate in nominal terms. The same effects are

valid for monetary and non-monetary liabilities. The

distinction between monetary and non-monetary items is stated

by FASB Statement No. 33 as follows:

A monetary asset is either money or a claim held by an

enterprise for the future receipt of money whose amount is
either fixed or is determinable without reference to the
future price of a specific good or service. A monetary
liability is just the converse. It is an obligation to pay
an amount of money whose amount is either fixed or is
determinable without reference to the future price of a
specific good or service. Non-monetary assets and
liabilities are defined as any assets or liabilities which
is not monetary. [Ref.l]

If a business has more monetary liabilities than monetary

assets during inflation, a purchasing power gain results.

Thus, a business prefers to have more monetary liabilities

than monetary assets, which might not be desirable without

inflation

11
 .

An important feature of inflation which largely

determines its impact is the level of anticipation. If

perfectly anticipated, inflation can be reflected in nominal

interest rates and capital budgeting decisions to eliminate

its anticipated effects. If it comes as a surprise, its impact

will be larger. Also, higher inflation rates are likely to be

associated with a wider range of variability of actual

inflation rates [Ref.9].

Another problem is the uncertainty about future prices

during inflation. R. J. Chambers states that specific prices

and general price levels reacts upon each other. If the

average level of nominal income rises faster than some prices

and slower than some other prices, the result is a change in

spending patterns and consequently in relative prices. Now, we

know that prices have changed, but we cannot know what portion

of this change is due to demand and supply conditions and what

portion is due to general price level changes [Ref .10]

D. SUMMARY
The objective of publishing financial statements is to

render a fair presentation of a business' activities and

current position. Financial statements based on historical

costs does not achieve this objective during periods of

inflation due to the effects stated above. The basic problem

stems from the fact that money is an elastic measuring device;

it is not stable as is assumed in historical financial

12
 .

statements [Ref.ll]. Since investment decisions are largely

based on financial statements as an indicator of business

performance, distortions introduced by inflation may lead to

inefficient or wrong decisions both by management and

stockholders. Following chapters will explore the methods

which are designed to neutralize the distortional effects of

inflation so far and their effectiveness in achieving this

objective

13
 III. METHODS OF INFLATION ACCOUNTING

A. INTRODUCTION
Interest in inflation accounting has changed through time

in direct relation to the inflation rate [Ref.12], and the

debate on the issue has intensified during periods of high

inflation. However, low annual inflation rates can also exert

significant impact on accounting if compounded over a long

period of time [Ref.12]. Moreover, effects of inflation on

business performance lingers long after inflation subsides

[Ref .13] . This situation extends the need for inflation

accounting over periods longer than the duration of high

inflation. Although there is no agreement among accounting

professionals upon a single accounting method to neutralize
the effects of inflation, inflation accounting has developed

along two main streams of thought; constant purchasing power

accounting and current cost accounting.

In the constant purchasing power accounting method,

historical cost financial statements are restated to reflect

the changes in the general purchasing power of money by using

publicly provided general price indices . On the other hand,

the current cost accounting method replaces historical costs

with current costs and departs from the conventional income

determination technique of historical cost accounting. Current

cost accounting is really an alternative to historical cost

14
 . .

accounting, whereas constant purchasing power accounting is an

adjustment to historical cost for the decline in the general

purchasing power of the money. Constant purchasing power

accounting focuses on general price level changes, but current

cost accounting deals with the changes in the prices of

specific assets. General price level is the average of the

prices of all goods and services in an economy, and specific

price changes in opposite directions may balance out to zero.

In such a case, the constant purchasing power accounting

method does not require any adjustment to historical cost

financial statements. However, current cost accounting does

require the consideration of each specific price change

separately in the preparation of current cost financial

statements

B. CONSTANT PURCHASING POWER ACCOUNTING

1 . Definition
Historical cost statements are based on accounts

measured in dollars which have different levels of purchasing

power. Constant purchasing power accounting converts these

into money amounts with the same purchasing power. Purchasing

power of money is determined at a certain point in time

through the use of price indices. The overall objective of the

method is to determine the real changes in the well-being of

the business and to exclude all effects resulting from the

fluctuations in the value of money which do not represent real

changes in financial position of a business [Ref .2]

15
 2 . Methodology

a. Use of Price-Level Index Numbers:

To adjust the historical cost statement balances,

index numbers for all relevant periods should be obtained. All

index numbers must be based on the same year. Price indices

published at different times may use different base years.

Index numbers are published for each month-end and an average

for the year is also included. Different account balances may

require the use of different index numbers. For example, some

transactions occur evenly throughout the year, such as sales

and wages, and the balances that include these transactions

are assumed to reflect the average index number for that year.

Assume that sales for 1990 will be restated in 1990 year-end

dollars. The restated amount is calculated as follows:

Restated sales = (1990' s sales) * (1990 year-end index)

(1990 average index)

Some transactions, however, reflect the price

levels at the unique times of transactions, such as money

borrowed or equipment purchased. If equipment is purchased on

30 May 1990, the original cost of the equipment is restated in

1990 year-end dollars as follows:

Restated Cost = (Original Cost) * (1990 year-end index)

(1990 May's index)

With this introduction, a more detailed

explanation of the constant purchasing power method can be

presented. Adjusted amounts for a specific date can be found

16
 .

that date's index number in the numerator in the above

equations and this number is the same for every item. In the

following discussion, only the index number which is the

denominator in these equations is specified because that

number may be different for different items

b. Adjustment of Income and Retained Earnings Statements: [Ref.14]

(1) . Sales and Expenses Other Than Cost of Goods

Sold and Depreciation. These balances can be assumed to be

taking place evenly throughout the year and they are restated

by using the average index number for the year.

(2) . Cost of Goods Sold. For this account, the

adjustment method depends upon the beginning and ending

inventory levels and the inventory pricing method used.

In last-in, first-out inventory pricing, if

the beginning and ending inventory levels are the same or the

ending inventory level is higher, the balance is adjusted by

using the average index number for the year. If the ending

inventory is lower, the difference is adjusted by using the

index number at the beginning of the year, since the

difference comes from the beginning inventory. The remainder

is adjusted by use of the average index for the year.

In f irst-in, first-out inventory pricing, the

portion of the balance which is equal to the beginning

inventory level is adjusted by using the index number at
beginning of the year. The rest of the balance is adjusted by
using the average index for the year. However, if the amount

17
 . .

of goods sold is less than the beginning inventory level, this

means that all of the cost of goods sold comes from the

beginning inventory and the total balance should be adjusted

by using the index number at the beginning of the year.

If the average cost inventory pricing method

is used, the total balance can be adjusted by using the

average index number for the year

(3) . Depreciation. Historical cost of a

depreciable asset is restated from the date of purchase and

then an adjusted depreciation charge is determined by applying

the rate required by the depreciation schedule to the restated

cost

(4) . Dividends. They are adjusted by using the

index number at the time of payment to the stockholders.

(5) . Gain or Loss on Monetary Items. A business

incurs a purchasing power loss if it holds a monetary asset

during inflationary periods. However, monetary liabilities

give rise to a gain. The net monetary position determines the

magnitude of the gain or loss. The difference between the

nominal net monetary position and the adjusted net monetary

position at the year-end is disclosed as the gain or loss on

monetary items . Assume that the following information about a

business is available for the current year and a purchasing

power gain or loss on monetary items will be determined. Net

monetary position (monetary assets minus monetary liabilities)

at the beginning of the year is $1000. Accounts receivable

18
increased by $3000 during the current year. Expenses also

increased by $3000 and $500 worth of merchandise has been

purchased on credit at the year— end. The beginning, average

and ending index numbers for the year are 100, 150 and 200,

respectively. There has been no other change in monetary

items. Purchasing power gain or loss calculations are shown in

Table 2.

TABLE 2. PURCHASING POWER GAIN OR LOSS CALCULATIONS

MONETARY ITEMS NOMINAL INDEX ADJUSTED
AMOUNT RATIO AMOUNT
Net Monetary Position $1000 200/100 $2000
At Beginning of Year
Account Receivables $3000 200/150 $4000
Expenses ($3000) 200/150 ($4000)
Purchase of Merchandise ($500) 200/200 ($500)
Net Monetary Assets $500 $1500
At Year-end

Purchasing Power Loss = Adjusted Amount - Nominal Amount

= $1500 - $500 = $1000

c. Adjustment of The Balance Sheet: [Ref 14 ].

(1) . Monetary Assets and Liabilities. These

amounts are not adjusted.

(2) . Inventories. The inventory pricing method

affects the calculations. The adjustments for three inventory

pricing methods are explained below.

In the last-in, first-out method, if the

ending inventory level is lower than or equal to the beginning

inventory, total inventory balance is adjusted by using the

19
 .

index number at the beginning of the year. If the ending

inventory level is higher than the beginning inventory level,

the increase should be adjusted by using the average index

number for the year, since this amount is assumed to be

purchased at the average price level of the year. The

remainder is adjusted by using the index number at the

beginning of the year.

In the first-in, first-out method, if the

cost of goods sold is higher than or equal to the beginning

inventory level, the total inventory balance is adjusted by

using the average index number for the year. If the cost of

goods sold is lower than the beginning inventory level, the

amount which is equal to the difference between cost of goods

sold and the beginning inventory should be adjusted by using

the index number at the beginning of the year, since this

portion comes from the beginning inventory. The rest of the

inventory balance is adjusted by using the average index

number for the year, since it is purchased throughout the

year .

If the average cost inventory pricing method

is used, the total amount of cost of goods sold can be

restated by using average index number for the year.

(3) . Plant and Equipment. Historical costs of

plant and equipment are adjusted by using the index number at

the date of purchase. Adjusted amounts of accumulated

depreciation are derived from these adjusted costs

20
 (4) . Capital Stock. The adjustment is made by

using the index number at the date when stocks were issued.

(5) . Retained Earnings. The adjusted amount of

the change in retained earnings for the year is obtained by

subtracting the adjusted dividends from net profit in the

adjusted income statement . The beginning balance is adjusted

by use of the index number at the beginning of the year.

By using this methodology, historical cost

financial statement balances can be restated in terms of any

desired date's purchasing power. If financial statements are

restated in terms of year-end purchasing power every year,
restatement of these adjusted statements with respect to a new

point in time will be one step easier, since all adjusted

balances reflect the same purchasing power. Preparation of

comparative financial statements will also be easier.

3. Advantages of Constant Purchasing Power

Accounting:

First of all, constant purchasing power accounting is

the most readily available method for coping with the effects

of inflation on accounting practices . Price indices are

prepared and published every month and computations are fairly

simple. Also, the Consumer Price Index is an objective basis,

since it is prepared by an unbiased government agency.

Moreover, it is argued that adjustment based on the Consumer

Price Index makes the most sense for the stockholders, who are

also consumers. Stockholders can more easily relate these

adjusted figures to their personal expectations and needs

21
 .

[Ref .11] . As a result, they can make more informed decisions

by understanding the real return on their investments.

Another important use of financial data is trend

analysis which requires the comparison of performance through

successive years. Such an analysis has more meaning if the

compared amounts not reflect the same purchasing power.

Constant purchasing power accounting facilitates trend

analysis by restating all balances in terms of money units

which have the same purchasing power.

4 . Disadvantages of Constant Purchasing Power

Accounting:

Disadvantages of this method originate from the use

of general price indices. The central argument is that not

everyone is affected by inflation in the same manner, and

general price indices, which are averages, may not apply to

any individual in reality. From this perspective, two

conclusions are drawn. First, these adjustments do not yield

relevant data for some businesses, such as steel and oil

companies which mainly own long-lived assets. Secondly, the

cost of assets restated in current purchasing power reflects

neither what it would cost to buy the asset today nor what it
could be sold for. Thus, interpretation of these adjusted

figures in the real world is very difficult [Ref .11]

22
 .

C. CURRENT COST ACCOUNTING

1 . Definition
As previously mentioned, chapter, current cost

accounting constitutes a departure from historical cost,

whereas constant purchasing power accounting merely restates

the historical balances in terms of current purchasing power

of money. Current cost financial statements replace the

historical costs with current costs. These current costs are

determined by using various valuation methods, and changes in

the prices of all specific assets are accounted for

separately

"Proponents of current cost accounting argue that the

decision usefulness of historical cost data declines, even if

there is no general inflation, when prices change in the

specific goods and services purchased by a company" [Ref.15].

They advocate the use of current costs for all assets and

expenses instead of historical costs. However, determination

of some current costs cannot be done accurately due to

technological changes and incomplete markets for certain

assets. Moreover, it is impossible for a single and neutral

agency, such as government, to provide current prices of

numerous different items in an economy. Thus, the objectivity

of current cost accounting is considerably lower than that of

constant purchasing power adjustments, which are based on

general price indices published by the government.

23
 As an integral feature of all market economies,

prices of specific goods and services fluctuate due to changes

in demand and supply as well as due to technological

innovations [Ref.16]. These conditions affect investor's

judgement about the present worth of a business and its

viability through time. Current cost proponents feel that the

real problem is not the decline of the purchasing power of

money, but the deficiencies in the historical cost model.

An understanding of current cost accounting requires

the exploration of various valuation methods which are

employed to determine current costs. Once the current costs

are obtained, financial statements can be produced by

replacing historical costs with these values . Financial

statement format stays the same.

2 . Valuation Methods To Determine the Current

Values :

In this section, four major valuation methods which

provide a measure of current values will be discussed. These

methods are replacement cost, exit value, present value and
value to the owner. In general, all methods utilize market

prices, if available, to determine current values.

a. Replacement Cost

As the name implies, replacement cost is based on

the current buying prices of the assets of a business which

were acquired in the past . It is the basis for current cost

accounting. In 1976, the Securities and Exchange Commission of

24
 .

the United States issued ASR 190, which required large

corporations to disclose supplemental replacement cost data in

their financial statements for cost of goods sold,

inventories, depreciation and productive capacity. In this

statement, replacement cost is defined as "how much it would

cost to replace existing productive facilities and inventories

in the manner in which they would actually be replaced"

[Ref .17] . In this definition, replacement costs may be

overstated since companies generally replace their productive

facilities with more expensive and technologically superior

ones, so as to reduce labor and other operating costs.

However, a replacement cost within the above definition

ignores this important dimension of the replacement

Laurence A. Friedman proposes another definition to

eliminate this deficiency. He defines replacement cost as the

current cost to acquire the productive capacity which would

provide the current level of economic services [Ref .17] . Here,

the basis for replacement cost is not the existing

facilities, but the level of economic services provided by

them.
3
b. Exit Value

Exit value is the money amount that could be

received by selling an asset in the current market. To

determine such a value objectively, a complete market for the

3
Another common term for this valuation method is net
realizable value which equals the selling price less selling costs.

25
asset should exist, as is required for replacement cost. In

reality, complete markets which can provide both selling and

buying prices for assets may not exist, especially in case of

assets which have very specific uses. Moreover, many assets

are held to be used in operations rather than to be resold. As

a result, valuation has to be based on hypothetical

transactions and subjectivity may inevitably be injected.

c. Present Value (Discounted Cash Flows)

In this method, the current value of an asset is

calculated by discounting the future net cash receipts

expected from its use. For this calculation, two essential

pieces of information are needed; the amounts of expected

future receipts and the appropriate discount rate. Obviously,

these data cannot be determined accurately and require

assumptions about the future. In practice, present value

calculations are regarded as too subjective by

accountants to provide a reliable basis for the valuation of

non-monetary assets for external reporting purposes [Ref .17]

Geoffrey Whittington refers to the three preceding
valuation methods as "pure valuation basis" and he states that
"each method is of potential relevance in particular
circumstances, and in some cases a comparison might be

desirable among the values derived from alternative valuation

basis" [Ref. 3]. George Staubus tried to identify the

appropriate valuation for particular assets in particular

situations . He suggests that net realizable value is

26
 . . .

appropriate for inventory valuation since inventory is held

for resale. For the valuation of assets which are held for use

in operations, he suggests the use of replacement cost

[Ref .17]

None of these valuation methods is regarded as a

complete solution to the valuation problem by itself. As a

result, another method which utilizes all three "pure"

valuation methods has evolved in British inflation accounting

literature under the name of "value to the owner" . It has

become part of accounting practice and received considerable

attention, especially in Great Britain [Ref .3]

d. Value To the Owner

Value to the owner is the minimum loss which a

business would incur if it were deprived of an asset [Ref .3]

The first step in the application of this method is to

determine three possible current values by using the preceding

three pure valuation bases. In the next step, these values are

compared to determine the minimum loss by assuming that the

business is deprived of an asset and, normally, that it is

trying to maximize its profits. Solomons first stated the

"value to the owner" rules in the familiar inequality form

which later became popular [Ref. 3]. These rules determine the

appropriate current value for all possible combinations of

replacement cost (RC) , net realizable value (NRV) , and present

value (PV) under the assumptions of deprival and profit

maximization. Table . 3 illustrates these rules.

27
 .

TABLE. 3 VALUE TO THE OWNER RULES

CASE NUMBER INTERRELATIONSHIP VALUE TO THE OWNER
1 PV > RC > NRV RC
2 PV > NRV > RC RC
3 RC > PV > NRV PV
4 NRV > PV > RC RC
5 NRV > RC > PV RC
6 RC > NRV > PV NRV

In cases 1 and 2, the business prefers to replace

the lost asset since its present value is greater than

replacement cost. Thus, replacement cost is the current value

of the asset since it represents the minimum loss to be

incurred by the business in case of deprival . In case 3,

because the replacement cost is greater than the present

value, the rational choice is not to replace the lost asset.

If the asset is not replaced, the loss will be equal to the

present value. Cases 4 and 5 represent a situation where an

asset can be sold at an amount higher than what it would cost

to buy it. Thus, replacement is the appropriate choice and the

cost of replacement equals the current value. In the last

case, the lost asset should not be replaced, since its present

value is less than replacement cost and the asset could be

sold at an amount higher than its present value if it were not

lost. As a result, net realizable value equals the current

value which represents the minimum loss to be incurred by the

business

28
 .

Reliance on present values, which are perceived as

too subjective by accountants for external reporting purposes,

constitutes the main weakness of the value to the owner

method. R. J. Chambers states that "present values cannot be

compared to net realizable values and current costs since they

are not in the same domain" [Ref .18] . Present values are

expectations whereas the others are facts, that is, accessible

amounts of money at a certain date. Another problem is the

extra effort required for calculations separately for each

valuation basis. However, the value to the owner method avoids

abnormal valuations that may result from using a single

valuation method.

3 . Holding Gains and Losses

Current cost proponents believe that gains and losses

which result from possessing assets during a period of

changing prices should not be included in the income from

operations. They suggest that these gains and losses should be

disclosed separately in current cost financial statements

[Ref .19]

An illustration may be useful to further the

understanding of holding gains and losses. Assume that

original cost of an asset is $100 and its current cost at the

financial statement date is $110. If the asset is sold for

$120, current cost income will be $10. However, historical

cost income would be $20. The $10 difference between the

incomes results from holding the asset while prices change and

29
it should be disclosed separately if income is determined on

a current cost basis.

In fact, there is no agreement in the literature on

whether or not to recognize holding gain as part of income.

There are two lines of thought on this issue. According to the

financial capital maintenance concept (a proprietary view of

the business) , which is advocated by proponents of constant
purchasing power accounting, the real value of the business
capital should be maintained before any income is recognized.

After the decline in the general purchasing power of the

business capital is compensated for, the remainder of the

historical cost income can be recognized as real income.

Since any remaining holding gains or losses do not necessarily

result from the changes in the general purchasing power of the

monetary unit, they should be included in business income. On

the other hand, the physical capital (or productive capacity)

maintenance concept, which is favored by current cost

proponents, suggests that the major concern should be the

maintenance of the business' ability to provide the same level

of economic goods and services in the future before

recognizing any income. It is assumed that this would not

happen if the business does not accumulate enough resources to

replace its productive capacity. As a result, holding gains

should be a direct adjustment to stockholder's equity.

30
 . .

4 . Advantages And Disadvantages of Current Cost

Accounting
Advantages and disadvantages associated with various

current valuation methods have been stated along with the

discussion of these methods . Subjectivity involved can be

stated as the common weakness of all current valuation bases.

Subjectivity arises from the fact that not all assets owned by

a business have complete markets to indicate selling and

buying prices
Another main objection is that current cost

accounting fails to capture the effect of general price level

increases while dealing with specific price changes. R. J.

Chambers states that " there is a rate of inflation which

affects every holder of money or things worth money" [Ref .10]

He suggests purchasing power gains or losses be incorporated

in the current cost accounting method. A. Friedman also

concurs with Sterling's and others' suggestion that general

purchasing power adjustments should be added to any current

valuation method [Ref. 18].

Lastly, determination of current costs requires the

preparation of specific price indices for numerous assets

owned by a business, and this may prove to be unmanageable in

practice. Costs incurred for the implementation of such a

system may never be justified by the benefits received from

the information provided. This is a general observation at

this point, and this issue will be addressed in more depth in

the following chapters.

31
D. SUMMARY

In this chapter, constant purchasing power accounting and

current cost accounting are presented as methods employed to

report the effects of inflation on financial reporting. In the

literature, other methods are proposed which can be regarded

as variations of these two basic methods. Deficiencies of

historical cost accounting are well recognized, especially
during inflationary periods, and many accountants argue that
the historical cost method should be replaced with a more

competent accounting method which can deal with the effects of

changing prices. However, some others argue that the

historical cost method is based on arms-length transactions

and this objectivity should not be sacrificed by using

subjective methods. As a position of compromise, these methods

are used to provide supplementary information within

historical cost financial statements. In reality, financial

statements cannot be perfectly objective, since they are

prepared by the firm whose financial position is being

reported. Moreover, some unavoidable uncertainties and

estimates are part of all financial statements, and inflation

adds to these uncertainties. The rational objective should be

to reduce this uncertainty to a level which is reasonable.

With this point in mind, inflation accounting methods can be

utilized to increase the quality of financial data.

In the next chapter, some inflation accounting methods

which have been put into practice by standard setting bodies

32
in different countries will be presented. The United States

Financial Accounting Standards Board Statement No. 33, which is

the most important step in United States inflation accounting

practice, will be the focus of the discussion.

33
 IV. INFLATION ACCOUNTING IN PRACTICE

A. INTRODUCTION

Effects of general and specific price changes on

financial reporting have been known in the accounting world

for a long time. In 1922, Professor William Paton stated that

"the value of the dollar - its general purchasing power - is

subject to serious change over a period of years...

Accountants... deal with an unstable, variable unit; and

comparison of unadjusted accounting statements prepared at

intervals are accordingly always more or less unsatisfactory

and are often misleading" [Ref .8] . Despite its early

recognition, no official standard-making body had required a

disclosure of the effects of price changes until the United

States Financial Accounting Standards Board (FASB) published

Statement No. 33 in September 1979. A British standard was

announced in 1980. Two years later, Canada published a

standard which only recommended certain disclosures. These

three standards will be introduced in the following sections

and the differences in their requirements and approaches will

be highlighted.

34
B. FASB STATEMENT NO. 33

1 . Origins

The Accounting Research Bulletins published in 1947,

1948 and 1953 by the Committee on Accounting Procedure first

officially indicated the need for some form of recognition of

the effects of price level changes in financial statements.

These bulletins dealt with possible changes in acceptable

depreciation methods to cover changes in replacement costs.

In 1963, the American Institute of Certified Public

Accountants issued Accounting Research Study (ARS) No. 6,

"Reporting the Financial Effects of Price-Level Changes",

which was primarily designed to stimulate the discussion on

the topic. ARS No . 6 achieved its objective by initiating the

Accounting Principles Board (APB) , the successor of the

Committee on Accounting Procedure, to issue APB Statement No . 3

in 1969. The disclosure of general price-level information

announced with this statement was voluntary and it found

little or no application.

The FASB, which replaced the Accounting Principles

Board, issued an Exposure Draft, entitled "Financial Reporting

in Units of General Purchasing Power", in 1974. This draft was

issued in conjunction with a field test of 100 companies, to

gather feedback on the reception to and applicability of

general price-level financial statements. This Exposure Draft

was the same as APB Statement No. 3, from a procedural point of

view, and the Board pointed out the usefulness of APB

35
 .

Statement No . 3 in the preparation of the recommended financial

statements . Due to the overwhelming negative comments and

desire for further analysis of field test results, the FASB

was never able to convert this draft to a mandatory standard.

Meanwhile, inflation continued to rise and reached

11% during 1974. Complaints about the deficiencies of

historical cost statements were also increasing. The

Securities and Exchange Commission, frustrated with slow and

hesitant actions of the FASB, established its own requirement

by issuing Accounting Series Release (ASR) 190. This statement

required certain publicly held corporations to disclose

replacement cost information in their yearly reports to the

Commission.

In December 1978, the FASB issued another exposure

draft entitled "Financial Reporting and Changing Prices",

which proposed the disclosure of both general price-level and

current cost information. In May 1979, the Board finally

recognized the problems in its approach and it sponsored a

"Conference on Financial reporting and Changing Prices" in New

York City on May 31, 1979. This conference allowed a thorough

discussion of the issues and prepared a favorable atmosphere

for FASB to introduce its requirements for the disclosure of

inflation information in financial statements

In September 1979, Statement No. 33, entitled

"Financial Reporting and Changing Prices", was issued. As will

be explained later in this chapter, this statement required

36
 .

certain publicly held companies to disclose both constant

purchasing power and current cost information in their

financial statements. The FASB also declared that disclosure

requirements were experimental and the statement would be

reviewed comprehensively after no more than five years.

[Ref .20]

2. Objectives of Statement No. 33

The third paragraph of Statement No. 33 states that

"the users of financial reports need to understand the effects

of changing prices on a business to help their decisions"

[Ref .1] . The ways in which this statement may help the users

of financial reports are explained as follows:

a. Assessment of future cash flows. Present financial

statements include measurements of expenses and assets at
historical prices. When prices are changing, measurements
that reflect current prices are likely to provide useful
information for the assessment of future cash flows.

b. Assessment of enterprise performance. The worth of an

enterprise can be increased as a result of prudent timing
of asset purchases when prices are changing. That increase
is one aspect of performance even though it may be
distinguished from operating performance. Measurements
that reflect current prices can provide a basis for
assessing the extent to which past decisions on the
acquisition of assets have created opportunities for
earning future cash flows
c. Assessment of the erosion of operating capability. An
enterprise typically must hold minimum quantities of
inventory, property, plant, and equipment and other assets
to maintain its ability to provide goods and services.
When the prices of those assets are increasing, larger
amounts of money investment are needed to maintain the
previous levels of output. Information on the current
prices of resources that are used to generate revenues can
help users to asses the extent to which and the manner in
which operating capability has been maintained.

37
 :

d. Assessment of the erosion of general purchasing power.

When general price levels are increasing, larger amounts
of money are required to maintain a fixed amount of
purchasing power. Investors typically are concerned with
assessing whether an enterprise has maintained the
purchasing power of its capital. Financial information
that reflects changes in general purchasing power can help
with that assessment. [Ref.l]

Three reasons are stated as to why the effects of

changing prices should be measured and disclosed in financial

statements
a. The effects depend on the transactions and
circumstances of an enterprise and users do not have
detailed information about those factors;

b. Effective financial decisions can take place only in an

environment in which there is an understanding by the
general public of the problem caused by changing
prices; that understanding is unlikely to develop until
business performance is discussed in terms of measures
that allow for the impact of changing prices;

c. Statements by business managers about the problems

caused by changing prices will not have credibility
until specific quantitative information is published
about those problems. [Ref.l]

The need for experimentation in this area is pointed

out in paragraph 13 and it is further stated that "preparers

and users of financial reports have not yet reached a

consensus on general practical usefulness of constant dollar

information and current cost information". [Ref.l] This

statement's requirements are perceived as an opportunity for

systematic applications that can accumulate experience and

real-world data for further study of the problem.

3 . Required Disclosures
Public enterprises which own inventories and

property, plant, and equipment more than $125 million or total

38
assets more than $1 billion were required to present certain

financial data based on both constant purchasing power

(referred to as constant dollar in the statement) and current

cost accounting methods. Statement No. 33 states that

recoverable amounts should be used instead of constant dollar

and current cost amounts if they are materially or permanently

lower. "Recoverable amount" is defined as "the current worth

of the net amount of cash expected to be recoverable from the

use or sale of an asset". If an asset is held for sale,

recoverable amount equals net realizable value. If it is held

to be used in operations, then recoverable amount equals the

present value of the future cash flows expected from the use

of the asset.

a. Constant Dollar Information

The minimum requirement included the restatement of

inventory, property, plant, and equipment, cost of goods sold,

and depreciation, depletion, and amortization expense by using

the average CPI number for the current year. Business income

should be recomputed and disclosed based on these restated

amounts. Also, the purchasing power gain or loss on net

monetary items must be calculated "by restating in constant

dollars the opening and closing balances of, and transactions

in, monetary assets and liabilities" . However, if a business

prefers to prepare comprehensive constant dollar statements,

year-end index number can also be used. [Ref.l]

39
 .
. .

b. Current Cost Information

The current costs of inventory, property, plant,

and equipment, cost of goods sold, and depreciation and

amortization expenses had to be measured and disclosed along

with the current cost income based on these amounts

Externally or internally generated price indices, current

invoice prices, vendors' price lists or other quotations or

estimates, and standard manufacturing costs that reflect

current costs are recommended as the types of information that

may be used to determine current costs . Companies were also

given the discretion to choose any other type of information

which was appropriate to their particular circumstances. In

addition to this information, increases or decreases in the

current cost amounts of inventory and property, plant, and

equipment (holding gains or losses) , should be reported both

before and after eliminating the effects of inflation.

c. Information For The Most Recent Five Years

The following financial data should be presented in

terms of the current year's or CPI's base year's dollars, and

relevant index numbers should also be disclosed:

1 Net sales and other operating revenues

2 On a constant dollar basis;

a. Income from continuing operations
b. Income per common share from continuing
operations
c. Net assets at fiscal year-end

3 On a current cost basis;

a. Income from continuing operations

40
 s

b. Income per common share from continuing

operations
c. Net assets at fiscal year-end
d. Holding gains or losses net of inflation

4 . Other information
a. Purchasing power gains or losses on net
monetary items
b. Cash dividend declared per common share at
fiscal year-end. [Ref.l]

4. Aftermath of Statement No. 33

The discussion and research on the effects of

changing prices continued while over 1300 companies prepared

the required disclosures for six years until 1986. Meanwhile,

inflation had decreased considerably and the cost

effectiveness of the disclosures came under question. As a

response to growing criticism of mandatory disclosures, the

FASB eliminated the requirement for the disclosure of constant

dollar information in 1984. The Board stated that the use of

two competing bases was confusing and current cost disclosures

were more useful [Ref .13] . The FASB was trying to satisfy both

the proponents and the opponents of inflation disclosures.

Maintaining the current cost disclosure requirements

can be attributed to pressure from the SEC, which long

advocated some form of accounting for the effects of changing

prices [Ref .21] . However, in 1986, the FASB issued an exposure

draft which proposed the current cost requirements be

voluntary rather than mandatory, and a majority of the

respondents preferred voluntary disclosure [Ref. 13].

Consequently, Statement No. 89, which made the current cost

disclosures voluntary, has been the final step of the FASB'

41
venture to incorporate some form of inflation accounting in

financial accounting standards [Ref.27].

Three main weaknesses are associated with the Board's

approach and the requirements of the Statement No. 33. From the
very beginning, the Board was not able to make a choice

between constant dollar and current cost methods. As a result,

both kinds of information were required to be disclosed.

Parallel use of two conceptually different methods was

confusing for the users of financial reports. Secondly,

disclosures were described as experimental . Although this was

a useful tool for political maneuvering, it discouraged the

use of both kinds of information, instead of promoting

competition between methods as intended by FASB . Financial

analysts, as primary users of financial statements, handled

the information with caution and suspicion due to the label

"experimental". [Ref.21] Lastly, interpretation of current

costs varied among companies due to the generous discretion

allowed by the statement and this resulted in noncomparable

performance measures under current cost method. Inflation

disclosures failed to provide a bottom line measure like

historical cost net income, since purchasing power or holding

gains or losses weren't included in income figures. All these

factors fostered a feeling of confusion and distrust among the

users of financial reports who were already familiar with

historical cost statements . User indifference to the Statement

No. 33 disclosures was the dominant behavior. In 1982, Arthur

42
Young & Company conducted a survey among 500 financial

analysts to determine the degree to which inflation

information was used. One hundred and ninety useful responses

were received and only half of them indicated some use of the

disclosures. Less than 19 respondents described their use as

frequent. However, these results should not be interpreted as

a user indifference to inflation information in general, since

inflationary distortions on financial reporting are widely

recognized. [Ref .21]

Allowing a real- world experiment may be considered

the main contribution of the Statement No. 33. The invaluable

data accumulated during six years of implementation provided

a reliable basis for further research in the United States.

Some of these studies will be presented in the next chapter.

C. INFLATION ACCOUNTING IN BRITAIN [Ref. 12]

In 1980, the British Accounting Standards Committee

issued its Statement of Accounting Practice (SSAP) No. 16,

entitled Current Cost Accounting. With this statement, most

listed companies and other large entities were required to

present current cost income statements and balance sheets

along with historical cost financial statements . Either of the

current cost or historical cost statements could be presented

as the primary financial statements. No provision was made

concerning general price-level adjustments. The main objective

of this standard is:

43
 To provide more useful information than that available
from historical cost accounts alone for the guidance of
the management, shareholders, and others on such matters
as;
(a) the financial viability of the business
(b) return on investment
(c) pricing policy, cost control and
distribution decisions; and
(d) gearing (or financing) [Ref .12]
.

SSAP Statement No. 16 requires a two-step procedure to

compute operating income on a current cost basis . In the first

step, current cost adjustments for the cost of goods sold,

depreciation and monetary working capital are deducted from

the historical cost income to obtain "current cost operating

income" . Monetary working capital can be defined the amount of

cash, receivables and other similar current assets which are

required to carry out daily business operations . In the second

step, gearing adjustment is added to "current cost operating

income" to determine the "current cost profit attributable to

shareholders". "The gearing adjustment is a measure of the

benefit (or cost) accruing to the shareholders for having

financed part of the operating assets through debt." [Ref .12]

Debt represents a fixed money amount and the prices of the

assets purchased by using debt may increase or decrease

through time. The difference between the current cost of the

asset and fixed amount of debt used to purchase the asset

constitutes the gearing adjustment. The rationale behind the

gearing adjustment is stated in paragraph 16 as follows:

The net operating assets shown in the balance sheet have

usually been financed partly by borrowing and the effect
of this is reflected by means of a gearing adjustment in
arriving at current cost profit attributable to

44
 .

shareholders No gearing adjustment arises where a company

.

is wholly financed by shareholders' capital. While

repayment rights on borrowing are normally fixed in
monetary amount the proportion of net operating assets so
financed increases or decreases in value to the
business. . [Ref .12]
. .

In the current cost balance sheet required by the British

standard, assets are presented "at their value to the business

based on current prices" . Value to the business is defined as

the net current replacement cost, or recoverable amount, if a

permanent decrease to below net replacement is recognized.

SSAP No. 16 is based on the physical capital maintenance

concept and, consistent with this approach, it requires a

monetary working-capital adjustment . As stated in paragraph

11, "this adjustment should represent the amount of additional

(or) reduced finance needed for monetary working-capital as a

result of changes in the input prices of goods and services

used and financed by the business". [Ref. 12]

The British standard has been criticized in two aspects

which eventually prevented it from gaining general acceptance.

It didn't require the disclosure of purchasing power gains and

losses on holding monetary items, and also it didn't address

the measurement unit problem which deals with the erosion in

the value of the monetary unit due to inflation. In 1985, the

requirements were downgraded to a nonmandatory status . The

British Accounting Committee continues research for a more

acceptable standard to report the effects of changing prices

45
D. INFLATION ACCOUNTING IN CANADA [Ref .12]

The Canadian Institute of Chartered Accountants released

a standard entitled "Reporting the Effects of Changing Prices"

in October 1982. This standard only recommended certain

disclosures and compliance was voluntary.

The Canadian standard identified five objectives that

could be achieved by recommended disclosures:

1 . Maintenance of the operating capability of the

enterprise,
2 . Maintenance of the operating capability financed by the
common shareholders,
3. Evaluating performance,
4. Maintenance of general purchasing power of capital,
5. Assessment of future prospects. [Ref. 12]
Consistent with these objectives, disclosure of both

general price-level and current cost information was

recommended. Inventory, property, plant, and equipment would

be reported at their current values and reductions from

current value to lower recoverable amounts would also be

disclosed. Additionally, a current cost income would be

calculated by the use of current costs or lower recoverable

amounts of cost of goods sold, depreciation, depletion and

amortization expense. Other informative disclosures are stated

as follows

1. Changes in the current cost values of the inventory,

plant and equipment during the reporting period, together
with information as to any reduction from current costs to
lower recoverable amounts

2 The amount of changes in the current cost amounts of

inventory, property, plant and equipment that is
attributable to the effects of general inflation.

46
 . .

3. The amount of the gain or loss in general purchasing

power that results from holding net monetary items during
the reporting period. This amount is to be disclosed
separately and not included in computing the income for
the period.

4. The financing adjustment based on the current cost

adjustments to income for the period. [Ref.12]

This financing adjustment which is the same as "gearing

adjustment" in the British standard. However, there is no

provision for a working-capital adjustment, and this impedes

the measurement of a comprehensive current cost income. Except

for the financing adjustment and voluntary compliance, the

Canadian standard is quite similar to FASB Statement No 33 .

For comparison purposes, the same information from the

preceding year' s financial reports stated in constant dollars

is to be presented with current year's data.

E. SUMMARY

Inflation accounting standards which were adopted in the

United States, Britain and Canada were briefly presented in

this chapter. It should be noted that all three countries are

highly industrialized and they all have well-organized capital

and stock markets. Moreover, inflation rates experienced in

these countries have been considerably lower than the

inflation rates in other countries with less-developed

economies. However, these standards and accompanying research

and discussion have addressed the fundamental issues of

reporting the effects of changing prices in financial

statements

47
 .

The United States and the Canadian standards seem to have

a more comprehensive approach, since they address both general

and specific price changes. The British standard, on the other

hand, deals only with specific price changes and ignores the

decrease in the general purchasing power of the monetary unit.

Such an approach may prove to be quite insufficient during

periods of high inflation.

Both FASB No. 33 and the Canadian standard have reflected

the need for a disclosure of financial data from different

years stated in the same purchasing power, to facilitate trend

analysis over a period of years. The British announcement

disregards such a need. However, SSAP No. 16 allows the

measurement of a more comprehensive current cost income by

requiring a monetary working-capital adjustment . Failure of

the British standard to gain general acceptance "has been

attributed to its neglect of the measurement unit problem and

to its failure to account properly for purchasing power gain

on debt in an inflationary period" [Ref .12]

Both before and after inflation information disclosures

were required by standard-setting bodies, many studies have

been conducted to evaluate the usefulness of inflation

disclosures in practice. Of course, the studies which are

based on real-world data provided by as a result of announced

standards have provided a more valuable evaluation of the

disclosures. In the next chapter, some of these studies will

48
be presented to present a more realistic view of inflation

accounting methods.

49
 V. EMPIRICAL STUDIES ON INFLATION ACCOUNTING

A. INTRODUCTION

The FASB Concepts Statement No.l, Objectives of Financial

Reporting by Business Enterprises, states that "financial

reporting should provide information to help investors,

creditors, and others assess the amounts, timing, and

uncertainty of prospective net cash flows into the enterprise"

[Ref .28] . Inflation accounting methods are designed to remedy

the deficiencies of conventional financial statements during

periods of changing prices . The contribution of these methods

to the purpose of financial reporting should be verified

through empirical studies if inflation accounting methods are

to be accepted as accounting principles.

Although persuasive arguments are made for the relevance

of inflation data on theoretical grounds, surveys of managers,

auditors, and professional analysts show that inflation

disclosures required by FASB Statement No. 33 did not find much

use in practice [Ref .22] . Such a result casts doubt on the

usefulness of the inflation data and also constitutes a major

obstacle for empirical research. How can the contributions of

the inflation disclosures be observed in the real world if

they are hardly ever used? Even if they are used, it is

practically impossible to distinguish the contribution of

inflation information from that of historical cost data, since

50
 .

they become available to the user at the same time. These

factors, combined with all the others which affect individual

economic decisions, prevent the researchers from designing

perfectly reliable research methodologies and from providing

conclusive results.

In the following sections, some of the studies which

examined the usefulness of Statement No. 33 in practice are

summarized. These studies can be classified into three general

types . The first and largest group of studies tried to find

relationships between inflation information and stock prices

The studies which examined the changes in the relative

profitability of different industries and companies under

alternative accounting methods, such as constant purchasing

power and current cost, can be considered the second type. The

third category includes the studies which attempted a cost-

benefit analysis from a economic efficiency perspective.

B. INFLATION DISCLOSURES AND STOCK PRICES

Most researchers tried to determine a relationship

between inflation-adjusted accounting data provided by the
Statement No. 33 disclosures and stock prices. These studies

assume that investors understand the disclosures, accept them

as relevant, and have confidence in their consistency and

quality [Ref .24] . Beaver and Landsman explain the relevance of

studying stock prices as follows:

There are several reasons why the security price-earnings

approach is relevant. First, stock prices are commonly
viewed by the investment community and academic

51
 .

researchers as being determined by users' perception of

the magnitude, timing, and uncertainty of future cash
flows. Second, because stock prices reflect users' beliefs
about prospective cash flows, the relationship between
stock prices and earnings can be investigated now without
waiting for the passage of time. Third, because stock
prices are conceptually linked to prospective cash flows,
the difficulty of disentangling actual cash flows from
expected cash flows does not exist. Fourth, the stock
price-earnings relationship has been the subject of many
empirical studies over several years. [Ref.25]

However, lack of a complete theory which links stock prices

and accounting information is stated as a major limitation of

this kind of study. Further, inflation information may be

relevant for other purposes even though it may be irrelevant

in relation to stock prices [Ref .22]

1 . Beaver and Landsman

Beaver and Landsman investigated the ability of the

Statement No. 33 disclosures to explain stock prices and the

changes in stock prices in their FASB-sponsored research in

1983. The data included the disclosures of 731 companies for

the years 1979 through 1981. By using these data, they

constructed six "Statement No. 33 earnings variables" which

were defined as follows: "income from continuing operations

under current cost, income from continuing operations under

current cost plus purchasing power gains, income from

continuing operations under current cost plus gross holding

gains, income from continuing operations under current cost

plus purchasing power gains plus net holding gains, income

from continuing operations under constant dollar, and income

52
from continuing operations under constant dollar plus

purchasing power gains" [Ref.25].

In their preliminary analysis, they examined the

correlation between security returns and historical cost

earnings and also between security returns and the Statement

No. 33 earnings variables. They found that percentage changes

in stock prices were more highly correlated with percentage

changes in historical cost earnings than with the percentage

changes in the Statement No. 33 variables. In the next step,

they tried to determine whether "Statement No. 33 data provide

information content (in this context, explanatory power) over

and above that provided by historical cost data" [Ref.25] . To

explore this, they designed a two-stage regression analysis.

In the first stage, they regressed the Statement No. 33

variables on historical cost earnings to obtain residual

variables. In the second stage, they regressed security

returns on these residual variables and on historical cost

earnings. Again, historical cost data showed a stronger

relationship to security returns than the Statement No. 33

variables did.

They repeated the same statistical test to determine

whether these variables could explain the level of stock

prices rather than the yearly changes in stock prices . They

thought that yearly changes in stock prices might not be large

enough to reflect an effect of inflation information and that

53
 . . . .

cumulative changes over time could be large enough to indicate

such an effect. The results didn't indicate any impact,

however
Beaver and Landsman concluded that "once historical

cost earnings are known, The Statement No. 33 earnings

variables provide no additional explanatory power with respect

to differences across firms both in yearly stock price changes

and in the level of stock prices, and even after any one of

the Statement No. 33 variables is known, knowledge of

historical cost earnings still provides explanatory power"

[Ref .25] After considering the user indifference to Statement

No. 33 disclosures and the availability of inflation

information from other sources, they stated three possible

interpretations consistent with their results:

1 An adjustment of stock prices for inflation was not

being made or was too small to detect empirically
because unanticipated price changes were not material
in 1979 through 1981.

2. If an adjustment was being made, Statement No. 33

disclosures were unrelated to those adjustments,
possibly due to errors in the measurement of current
costs

3. An adjustment was not being made due to users' slow

learning. [Ref. 25]

They drew a distinction between anticipated and

unanticipated inflation and stated that a different result

could be possible if unanticipated inflation was high enough

to overcome the measurement errors or if these errors could be

reduced by modifying the Statement No. 33 disclosure

requirements. [Ref. 25]

54
 2. Bublitz, Frecka, and McKeown

Bublitz, Frecka, and McKeown conducted research in

the same direction as Beaver and Landsman in 1985. They added

1982 and 1983 Statement No. 33 disclosures to the previous

research data and employed additional variables to include the

effects of industry differences among the companies. They also

regressed security returns on the Statement No. 33 earnings

variables and historical cost earnings, but did not use a two-

stage approach like Beaver and Landsman . They reported that

these variables had significant explanatory power over

historical cost earnings. Inclusion of two additional years,

the use of new variables, and the changes in statistical

methods were stated as the possible causes of the different

result. [Ref.25]

3 . Bildersee and Ronen

Bildersee and Ronen argued that focusing on earnings

measures to determine the information content of inflation

disclosures was wrong. They claimed that current cost data

could be used to measure the real growth of a company and the

association between real growth and security returns could

provide a better assessment of current cost disclosures. They
examined the current cost disclosures of 136 companies for

1980 and 1981. By utilizing these current cost data, they

constructed two productive activity growth measures. The first

variable was related to continuing operations, whereas the

second was related to the potential future productive activity

55
growth associated with expenditures on capital assets . These

variables showed a slightly stronger relationship with

security returns than historical cost growth variables did.

The authors suggested that current cost data could reflect

real growth information that might not be contained in

historical cost statements. [Ref.23]

4 . Schaef er

In 1984, Schaef er examined the usefulness of the

Statement No. 33 current cost disclosures in forecasting

security returns. The study included 121 companies for 1979,

and 262 companies for 1980. By regressing the percentage
change in current cost income on the percentage change in

historical cost income, he determined the residual current

cost variables which represented the information content of

current cost disclosures. In the same manner, he also

determined the information content of dividends by annualizing

first-quarter dividends and comparing this forecast with the

actual dividends paid during the year. Statistical tests

showed that the information content of the current cost income

variable diminished as the information content of the

historical cost income and dividends were added in the

forecast model. Hence, current cost income changes didn't

prove to be more informative than historical cost income and

dividend changes in forecasting security returns. [Ref.23]

56
 .

5. Swans on, Shear on, and Thomas

In 1985, Swanson, Shearon, and Thomas employed four

different forecasting models to determine the most accurate

one in forecasting one year's future current cost earnings.

The study included 129 companies from nine industrial sectors.

The data consisted of the ASR 190 disclosures from years 1976

through 1978 and the Statement No. 33 disclosures from years

1979 through 1981. The model which used the analyst's forecast

for sales and current cost profit margin along with the

analyst's forecast of a proportional change in historical cost

profit margin provided the most accurate forecasts for eight

of nine industrial sectors. The results showed that the

inclusion of historical cost data increased the accuracy of

current cost income forecasts. [Ref.22]

6 Morris and McDonald

Morris and McDonald studied the relationship between

current cost disclosures and systematic risk in 1982.

Systematic risk is defined as the portion of a security' s risk

which cannot be avoided through diversification. The risk of

a security is measured by the standard deviation of its

returns in the past periods and is reflected in the security' s

market price. The Capital Asset Pricing Model (CAPM) is a

method which specifies the relationship between a company's

risk and the required rate of return on its stock when held in

a well-diversified portfolio . This relationship is represented

by beta in the calculations. The return on a stock must

57
increase as its risk increases. As an alternative to CAPM,

Arbitrage Pricing Theory (APT) includes some other factors in

addition to systematic risk to determine required rates of

return. These factors mainly include interest rates, gross

national product, and inflation. Morris and McDonald contended

that the effects of inflation could be included in the beta of

CAPM or as a separate factor in APT. They assumed that price

changes contributed to a company's risk and, therefore, could

not be avoided by diversification. By using current cost

disclosures of 172 companies from 1979 financial statements,

they constructed a variable which was equal to the ratio of

the difference between historical cost income and current cost

income to the historical cost of assets. They hypothesized

that higher values of this variable should correspond to

higher systematic risk, and in turn, to higher return on

stock. The tests showed that stock returns were highly

correlated with the constructed variable, and the authors

concluded that the Statement No. 33 current cost disclosures

were impounded in stock prices. However, when Morris and

McDonald repeated the same study by distinguishing between

anticipated and unanticipated inflation, they reported that

Statement No. 33 disclosures were irrelevant rather than being

impounded in stock prices. [Ref.23]

7. DeBerg, Hansen, and Boatsman

In 1986, DeBerg, Hansen and Boatsman tried to

demonstrate that specific and general price changes affect

58
 .

systematic risk. They hypothesized that input price changes

and their effects on output prices impact systematic risk and

company value through fluctuating cash flows. Their study

suggested that these factors might have a value in risk

assessment. Moreover, they concluded that "the specific price

information may be useful when there is little or no general

inflation, and general inflation may affect systematic value

and company value even when a company experiences

proportionate rates of price changes in inputs and outputs".

[Ref .22]

C. INFLATION DISCLOSURES AND PROFITABILITY RANKINGS

In 198 6, Smith and Anderson conducted a study to

determine whether the use of the Statement No. 33 current cost

and constant dollar income figures, instead of historical cost

income, had an effect on company and industry profitability

rankings. Their statistical tests used the 1980 inflation

disclosures of 328 companies which were further classified

into 32 industrial groups . They used four different bases to

determine the rate of return on common stockholders' equity:

historical cost, constant dollar, current cost, and combined

current cost and constant dollar. The rate of return on common

equity for each basis was calculated as follows:

1. Historical cost. Preferred dividends are deducted from

net income from continuing operations to give income
available to common equity which, in turn, is expressed
as a percentage of the book value of common equity.

2 Current cost Current cost income less preferred

.

dividends is stated as a percentage of the current cost

59
 .

net assets reduced by the book value of preferred

stock ....

3. Constant dollar. Constant dollar income less preferred

dividends is augmented by the purchasing power gain or
loss on net monetary assets on the premise that the
effects of such gains or losses accrue to providers of
equity capital The result is stated as a percentage of
.

the constant dollar net assets reduced by the book

value of preferred stock. . .

4. Current cost and constant dollar. Current cost net

income less preferred dividends is augmented by the
purchasing power gain or loss on net monetary assets
and also by the holding gain or loss on property, plant
and equipment, and inventories, net of general
inflation. The result is stated as a percentage of
current cost net assets reduced by the book value of
preferred stock.... [Ref.24]
Average rates of return for 32 industrial groups were
calculated under each basis and a new ranking was made

according to these rates of returns. The statistical tests

showed that the relative performances of industry groups were

significantly changed by the use of different bases. In the

second part of the study, the authors derived some ratios from

historical cost data to determine whether the changes in the

rankings could be explained by using the information readily

available in historical cost financial statements. They found

that these changes couldn't be substantially explained by

using the ratios derived from historical cost data. They

concluded that "additional dimensions of performance or

changes in corporate position are revealed by inflation

accounting, beyond those revealed by contemporaneous

historical cost information." [Ref.24] These findings also

imply that not all industrial sectors are affected by

60
 . ,

inflation in the same manner and the use of inflation

accounting methods instead of historical cost accounting may

affect the resource allocation in the economy as a result of

changes in relative profitability.

D. COST-BENEFIT ANALYSIS OF INFLATION ACCOUNTING METHODS

In 1984, Espahbodi and Hendrickson conducted a study to

asses the net social benefits associated with three

alternative inflation accounting models: general price-level

adjusted (i . e . , constant dollar) historical cost (GPLA)

current cost (CC) , and current cost-general price-level

adjusted (CC-GPLA) . CC-GPLA income was measured by adding

purchasing power and holding gains and losses to current cost

income. They also modified Statement No. 33 current cost income

to include holding gains or losses . The researchers used

financial reports of ten steel and eleven chemical companies

from 1964 through 1979. They explained that both steel and

chemical industries mainly used long-lived physical assets and

such industries were believed to be affected by inflation more

than the others

The study was conducted in six main steps. First,

historical cost financial statements were restated for

specific and general price level changes. In the second step,

they forecast the societal rate of return for each company

under each inflation accounting model for the years 1977,

1978, and 1979. The societal rate of return was described as

"income before deducting interest and income taxes divided by

61
total assets net of accumulated depreciation, depletion and

amortization" . In the third step, the companies were ranked

according to these rates of return for each of the three years

and those with lower rates of return were eliminated. "Lower

rates of return" were defined in four separate tests as the

lowest 10%, 20%, 30%, and 40%, successively. Then, total

resources available to the industry were allocated among the

surviving companies under each model. In the next step, the

average of the resources allocated to surviving companies over

three years was calculated and restated in terms of CC-GPLA.

Later, actual societal rates of return were determined for

years 1977, 1978, and 1979 on a CC-GPLA basis for each

company. The societal income (benefits accruing to society)

for each of the four alternative accounting models was

determined by multiplying the average societal rates of return

by the average resources allocated to surviving companies over

three years. The gross benefits of GPLA, CC, and CC-GPLA were

calculated by subtracting the societal income under the

historical cost model from the societal income under these

three inflation accounting models . In the fifth step, the cost

of applying each inflation accounting model was estimated from

a survey of company executives. In the last step, the net

benefits of each inflation accounting model was determined by

subtracting the estimated cost from the gross benefits.

When compared according to these net benefits, the CC-

GPLA model was superior to GPLA and CC models. For the

62
chemical industry, the CC model was found to be inferior to

the GPLA model, but whether this was valid for the steel

industry depended on the assumptions made for the elimination

of companies in the third step of the study. [Ref.26]

A. W. Stark criticized Espahbodi and Hendrickson on the

grounds that their assumptions about the re-allocation of

resources and the determination of benefits under alternative

accounting models were unrealistic. However, he congratulated

the authors for attempting such an analysis, since such a

comprehensive cost-benefit analysis had not been attempted

before and it could stimulate the discussion "on the effects

of accounting measures on the social, as opposed to private,

value of the distribution and profitability of resources".

[Ref .27]

E. SUMMARY

Most of the studies here have failed to provide strong

evidence that security returns are affected by inflation

information [Ref. 22]. However, Bublitz, Frecka, and McKeown

stated that inflation information had significant explanatory

power over historical cost data. Bildersee and Ronen employed

an indirect approach to show the usefulness of current cost

data. DeBerg, Hansen and Boatsman pointed out the potential

value of inflation information in evaluating systematic risk.

It appears that research design has a significant effect on

the results of the studies. This situation highlights the need

for more robust research methodologies and further research

63
for exploring the usefulness of inflation information in

explaining stock prices

On the other hand, Smith and Anderson showed that

relative profitability of industries was significantly

affected by the use of alternative accounting methods. If some
inflation accounting method replaces historical cost method,

this will affect the allocation of resources in the economy.

From an economic efficiency perspective, Espahbodi and

Hendrickson conducted a cost-benefit analysis of alternative

accounting methods . Such an approach has the merit of

enlarging the perspective of the discussion on inflation

accounting
All of these studies relied on the FASB Statement No. 33

disclosures and the guidelines provided by this statement.

Negative conclusions about the usefulness of inflation

information can be attributed to the potential deficiencies in

the provisions of this specific standard. Beaver and Landsman

specifically pointed out the possible measurement errors due

to excessive discretion in determining current values

[Ref .25] . Another main issue is the manner in which the

inflation information is presented to the users, such as

primary, supplementary, or experimental. These factors largely

determine the level of use in practice, and in turn, the level

of the impact on economic decisions

The results of the studies on the usefulness of inflation

information do not provide a clear-cut conclusion. Since

64
deficiencies of historical cost accounting are well

recognized, the search for a more accurate accounting method

seems to continue and empirical studies constitute the main

tool in the evaluation of alternative accounting methods.

65
 .

VI. CONCLUSIONS

Inflation decreases the ability of historical cost

financial statements to provide a fair presentation of

business performance. While monetary assets lose their

purchasing power during inflation, the book values and

depreciation charges for non-monetary assets fail to reflect

the real value of the business and- the real costs incurred in

operations. Understated costs lead to overstated income, and

excessive income taxes and dividends may erode the productive

capacity of the business. However, holding net monetary

liabilities gives rise to a purchasing power gain, since

monetary liabilities represent a fixed amount of money. Thus,

companies prefer to have more monetary liabilities than

monetary assets, which might not be desirable without

inflation

Two important aspects of inflation are its magnitude and

the level of anticipation. If perfectly anticipated, inflation

can be incorporated in business decisions in advance, so as to

neutralize its effects. On the other hand, variability of

inflation rates increases with its magnitude; and

unanticipated inflation becomes more likely. The basic problem

stems from the fact that money becomes an elastic measuring

unit under inflation. As a result, business performance as

indicated by historical cost financial statements, which

66
assume that money is a stable measuring unit, may lead to

inefficient or wrong decisions by investors and management.

As a response to the distortional effects of inflation on

financial reporting, two main methods emerged in the

accounting literature. As the first method, constant

purchasing power accounting focuses on the decline in the

purchasing power of the monetary unit. It is assumed that the
magnitude of this decline can be determined through general

price indices, and the historical cost accounts can be

adjusted to neutralize the distortional effects of inflation.

The overall objective of this method is to determine the real

changes in the well-being of a business, and to exclude all

effects resulting from the decline in the value of money.

However, the prices of different assets may change at

different rates and in different directions, and businesses

which own different assets may not be affected by the

inflation in the same manner. This situation focuses on the

distinction between constant purchasing power accounting and

the second method, current cost accounting.

Current cost accounting attempts to account separately

for each specific price change. The current values of assets

are determined mainly through current market prices, and

historical costs are replaced with the current costs which are

derived from these current values to measure business

performance. However, determination of the current values may

involve a high degree of subjectivity due to incomplete

67
markets for some assets and technological changes. Thus,

potential subjectivity can be stated as the main weakness of

the current cost accounting method, which may cause

inconsistent valuation of assets across companies. If this

weakness can be eliminated, the current cost method can

provide a better valuation of non-monetary assets than the

constant purchasing power method. However, constant purchasing

power method measures the purchasing power gains or losses on

monetary assets and liabilities in an objective manner by

using publicly provided general price indices. Such gains or

losses are ignored by current cost accounting. A proper

combination of these two methods seems to render a better
measure of business performance.
In September 1979, the FASB published Statement No. 33,

which was the first inflation accounting standard put into

practice. This statement required certain publicly held

companies to disclose both constant dollar (i.e, constant

purchasing power) and current cost information as a supplement

to their historical cost financial statements. The board

stated the lack of consensus on a single method as the cause

of requiring both kinds of inflation information. It also

announced that the requirements were experimental. Later,

surveys showed that the users of financial statements were

indifferent to the disclosures. This result was attributed to

the experimental and supplementary nature of the disclosures.

68
 .

Compliance with the Statement No. 33 was made voluntary in 198 6

after inflation decreased to lower levels.

The British standard announced in 1980 required certain

large entities to present current cost financial statements

and balance sheets along with their historical cost financial

statements . This standard was downgraded to a non-mandatory

status in 1985. The British standard didn't include any

provision for purchasing power gains and losses, and this was
stated as the main cause of its failure to gain general

acceptance

The Canadian Institute of Chartered Accountants published

its inflation accounting standard, which was very similar to

the U.S. standard. Because compliance with the standard was

voluntary, it found little application. The U.S. and the

Canadian standards displayed a more comprehensive approach

than the British standard, which limited itself to the current

cost method.

After publishing Statement No. 33, FASB sponsored a study

by Beaver and Landsman which tried to determine the

information content of inflation disclosures in explaining

stock prices. In this comprehensive study based on the

Statement No. 33 disclosures for the years 1979 and 1980, the

authors concluded that these disclosures didn't have any

additional power to explain stock prices over and above the

data already available in historical cost financial

statements. However, Bublitz, Frecka, and McKeown conducted

69
another study in the same direction, and they stated that

inflation disclosures had significant power to explain stock

prices

Many other studies have been conducted to find a

relationship between stock prices and Statement No. 33

disclosures during 1980s, and most of them failed to show

strong evidence that stock prices were affected by the

disclosure of inflation information. User indifference,

potential errors in the preparation of the disclosures, and

the lack of a complete theory that linked stock prices and

financial reports were stated as possible explanations of

these results. Furthermore, research methodologies seem to

have a significant effect on the results . With a different

approach, Smith and Anderson showed that the relative

profitability of different industries changed significantly by

the use of inflation accounting models . This result implies

that not all businesses are affected by inflation in the same

manner, and the use of inflation accounting methods instead of

the historical cost method may affect resource allocation in

the economy.

Espahbodi and Hendrickson conducted a cost-benefit

analysis of alternative accounting models . They concluded that

the inflation accounting model, which included the purchasing

power gains or losses on monetary assets and the holding gains

or losses on non-monetary assets net of inflation in business

70
income, provided the most beneficial allocation of resources

in the economy for the society as a whole.

Interest in inflation accounting has fluctuated with

inflation rates . Such an attitude seems to neglect two

important dimensions of the inflationary effect on financial

reporting. First, studies showed that distortional effects

extend over longer periods than the duration of high

inflation. Second, even insignificant inflation rates can

decrease the reliability of financial statements if compounded

over years. Since business operations could normally cover

several decades in most cases, effects of inflation do not

appear to be negligible. Financial statements cannot be

perfectly objective since they are prepared by the company

whose financial position is being reported. Inflationary

distortions to the measurement of business performance may add

to the inherent uncertainty faced by investors and decision

makers. Thus, Inflation accounting methods have the potential

to improve the usefulness of the information provided by

financial statements. Inflation accounting techniques may need

further refinements, and users may need further education and

experience with them.

71
 ,

LIST OF REFERENCES

1. Financial Accounting Standards Board Statement No. 33,

FASB, Stamford, 1979.
Financial Accounting and Changing Prices,

2. Bierman, H., Financial Management and Inflation, The Free Press,

New York, 1981.

3. Whittington, G. Inflation
, Accounting , Cambridge University
Press, Cambridge, 1983.

4. Cline, W. R. and Associates, World Inflation and Developing

Countries, The Brookings Institutions, Washington, 1981.

5. Blinder, A. S., "The Anatomy of Double-Digit Inflation in

The 1970s", in Inflation: Causes and Effects edited by Hall, R. E.,
The University of Chicago Press, Chicago, 1982.

6 . Illustrationsand Analysis of Disclosure of Inflation Accounting Information

AICPA, Inc., New York, 1981.

7. Zieha, E. L. and Cheng, T. T., "Proposing A More

Appropriate Dividend Policy", Management Accounting,
September 1979.

8. Accounting Principles Board Statement No. 3, General Price-

APB 1969.
Level Financial Statements , ,

9. Gwartney, J. D. and Stroup, R. L Macroeconomics, Fifth

. ,

Edition, HBJ Publishers, U.S., 1990.

10. Chambers, R. J., "Accounting for Inflation - Part or

Whole", in Current Cost Accounting Identifying the Issues edited by
-

Dean, G. W. and Wells, M. C, England, 1977.

11. Baumann, Robert D., "Constant Dollar Accounting", in

edited by Robert W. McGee,
Accounting for Inflation
Prentice Hall, 1981.
12. Bloom, Robert and Ar ay a Debessay, "Comparative Analysis of
Recent Pronouncements on Accounting for Changing Prices",
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 Thesis
S8622 Sulucay
c.l Inflation accounting
methods and their effec-
tiveness.

Thesis
S8622 Sulucay
c.l Inflation accounting
methods and their effec-
tiveness.

10-93