A CRITICAL ANALYSIS AND F7ALUATI0N OF THE PROBLEMS ...

A CRITICAL ANALYSIS AND F7ALUATI0N OF THE

PROBLEMS INVOLVED WITH REPORTING FOR

PRICE-LEVEu CHANGES

by

JOHNNY CARL WALKER, B.B.A.

A THESIS

IN

ACCOUNTING

Submitted to the Graduate Faculty of Texas Tech University in Partial Fulfillment of the Requirements for

the Degree of

MASTER OF SCIENCE IN ACCOUNTING

Approved

December, 1969

Ai^H-ae^M.

A/^, .^•'•'r

ACKNOWLEDGMENTS

I wish to express my sincere appreciation

to Dr. Bill Bishop for his direction both in and

out of the classroom. His genuine interest,

patience, and guidance made the completion of

this thesis possible.

A special thank you also goes to my parents,

Mr. and Mrs. J. C. Walker, for their continued

support and encouragement through the years.

ii

TABLE OF CONTE 'TS

ACKNOWLEDGMENTS

LIST OF EXHIBITS

LIST OF FIGURES

I. INTRODUCTION

Statement of Problem

Purpose

Scope

The Need for Price-Level

Adjustments

Suggested Solutions

Development of the Following

Chapters

Definition of Terms . . .

Summary

II. BACKGROUND OF THE PRICE-LEVEL PROBLEM . . .

Development of Price-Level

Accounting in the United States . . .

The Nature of Changing Prices

Objective of Price-Level

Adjustments

Summary

III. A DISCUSSION OF TWO PROPOSALS—BY THE A.A.A. AND THE A.I.C.P.A A Statement of Basic Accounting

Theory

Accounting Research Study No. 6 . . . .

Summary i t t

11

ii

V

vi

1

1

2

2

3

4

4

6

9

10

10

22

30

32

33

33

52

69

iv

IV. AN EVALUATION OF THE TWO PROPOSALS . . . . 70

A Statement of Basic Accounting

Theory ~ 71

Accounting Research Study No. . . . . 78

Importance of Criteria 82 «

A Review of the Evaluations 83

Summary 84

V. A SUGGESTED PROPOSAL 85

General Procedures 85

Advantages of Proposal 93

Limitations of Proposal 93

Summary 94

VI. SUMMARY AND CONCLUSIONS 96

BIBLIOGRAPHY 101

LIST OF EXHIBI' S

Exhibit Page

A. Balance Sheet 48

B. Balance Sheet 49

C. Income Statement 50

D. Statement of Retained Earnings 51

E. General Price-Level Restatement 64

F. General Price-Level Restatement 65

G. General Price-Level Statement 66

H. Statement of Retained Earnings 67

T

LIST OF FIGURES

Figure Page

1. A Half Century of Price Changes 23

2. Relative Rates of Change for Consumer Price Indexes for Selected Countries (Vertical Scale Logarithmic) 1958 =100 25

vi

itj

CHAPTER I

INTRODUCTION

Accounting data are the primary source of informa­

tion under which external users act, as well as the primary

means of reporting on the stewardship of management-

Accounting data also provide a means by which management

makes decisions relating to the operations of the company.

As a result, the accounting information presented to externa

users and used by management must be as accurate as possible

Statement of problem

The basic problem with reporting during periods of

changing price levels is focused on the fact that our

monetary unit is assumed to have a stable value; however,

over the last twenty years, this assumption has been far

from accurate. During the period 1945 to 1965, the pur­

chasing pov;er of the dollar shrank from 100 percent to

58 percent. As a result, financial statements are often

composed of dollars of different "sizes." The main danger

associated with reporting data composed of an aggregation

of dollar sizes lies in the fact that such statements which

Staff of the Accounting Research Division, "Reporti the Financial Effects of Price-Level Changes," Accounting Research Study No. 6 (New York: American Institute of Certified Public Accountants, Inc., 1963), pp. 7-8.

purport to show historical cost do not clearly reflect the 2

amount of purchasing power foregone in acquiring assets.

Many readers of financial statements do not realize the

shortcomings of these "mixed dollar" statements and tend

to regard the dollar values presented in the statements in

terms of their current purchasing power rather than the

purchasing power they commanded when they were exchanged 3

for particular assets.

purpose

The first objective of this thesis is to analyze

and compare the American Institute's approach to price-

level adjustments with the most current proposal of the

American Accounting Association. The second objective is

to propose a new approach to price-level accounting which

will correct some of the major limitations of the above

two proposals.

Scope

The scope of this thesis is limited to a review

and evaluation of the two methods cited above. As a result

of the evaluation an alternative proposal is presented

2 Wilbert E. Karrenbrock and Harry Simons, Inter­

mediate Accounting (Dallas: South-Western Publishing Company, 1964), p. 881.

^Ibid.

that attempts to incorporate the strong points of each

approach. No attempt is made to discuss in depth the

nature of our changing monetary unit, the value of money,

or the index-number problem.

The Need for Price-Level Adjustments

Due to the steady increase in the price level over

the last twenty years, the limitations in measurements

that assume a stable monetary unit have become progres-4

sively evident. Fluctuations in the purchasing power of

the dollar may result in serious misrepresentations in the

balance sheet and income statement, and may make analysis

from conventional statements extremely difficult for both

internal and external users. As a result, there has been

an increased demand on the accounting profession to present

data which are adjusted to reflect the effects of price-

level changes. These adjustments would enable the readers

of financial statements to view them in the proper per­

spective; and adjusted statements would provide better

information for measuring operational efficiency, for pro­

viding a basis for the prediction of future income, and

for making managerial decisions.

^Ibid.

Eldon S. Hendriksen, Accounting Theory (Homewood, 111.: Richard D. Irwin, Inc., 1965.), pp. 166-167.

}

Suggested Solutions

Although to date there has not been a widely

accepted solution to the price-level problem, two major

proposals have been suggested. The Accounting Research

Division of the American Institute of Certified Public

Accountants issued Accounting Research Study No. 6

entitled "Reporting the Financial Effects of Price-Level

Changes." The American Accounting Association proposed

a solution in Chapter III of their publication, A Statement

of Basic Accounting Theory. Additionally, the problem

has had several partial solutions such as replacement-cost

depreciation, the last-in, first-out method of valuing

inventories, and appropriation reserves. To date, the

last-in, first-out method for valuing inventories is the

only one that has gained general acceptance among the

profession.

Development of the Following Chapters

In order to present a logical development and to

accomplish the stated objectives, it is necessary to

present certain background material. Chapter II is a

discussion of the basic causes of the price-level problem

in the United States. A discussion concerning the his­

torical aspects of price-level accounting in the United

States is included to serve a general background for the

reader. Also included in chapter II is a discussion of

the nature of changing prices which encompass the trend of

price changes in the United States, the instability of

money, the different types of price changes, and monetary

gains and losses. The chapter concludes with the objectives

of price-level adjustments in the financial statements.

Chapter III includes a discussion and illustration

of the methods proposed by the Accounting Research Division

of the American Institute of Certified Public Accountants

in-Accounting Research Study No. 6 and by the American

Accounting Association in its publication, A Statement

of Basic Accounting Theory. Included in the discussion

are the recommendations and conclusions presented in each

of the monographs and the specific procedures for adjusting

both the income statement and the balance sheet. Chapter III

also includes a set of illustrative financial statements

which have been adjusted according to the requirements of

each particular method.

Chapter IV consists of a critical evaluation of the

two monographs by the following criteria: cost, accuracy,

objectivity, adaptability, relevance, and simplicity.

Included in this analysis is a detailed discussion of the

strong points and weaknesses of each proposal.

Chapter V includes this author's proposal for dis­

closing the financial effects of changing prices on a

business enterprise. This approach attempts to combine

the strengths and eliminate the weaknesses revealed in

the evaluation of the two monographs in chapter IV.

Chapter VI consists of a summary of the preceding

five chapters of this thesis. Also included in this chap­

ter are the general conclusions of this author concerning

the price-level problem and the accounting profession.

Definition of Terms

Several terms must be defined as to their precise

meaning as they apply to this thesis. The most important

terms in the field of price-level accounting are defined

below, and those necessary in later chapters are defined

as needed.

base period or base date: the common date that serves as a basis for comparison—it may be either a point in time or a period of some duration

conimon dollar: dollars of different purchasing power restated in terms of dollars of the same purchasing power^

current cost: replacement costs or fair market value^

general price level; encompasses the overall group of goods and services exchanged in all segments of the economy in the periods being compared. The universe includes all transactions

Staff of the Accounting Research Division, Accounting Research Study No. 6, p. 65.

^Ibid., p. 25.

®Ibid., p. 27.

that place goods and services In the hands of the final consumers. An increase or decrease in the general price level is directly attribut­able to inflation or deflation^

gross national product implicit price deflators; is the resultant composite index implicit in the relationship of the figures before and after deflation, and the most comprehensive index available. It measures the relationship between (a) the total value of goods and services produced in terms of current dollars and (b) the total value of goods and services expressed in prices of a base year. It is divided into four classes of expenditures: personal consumption expenditures; net exports of goods and services; gross private domestic investment; and govern­mental purchase of goods and services. Each of these four classes is further subdivided into its component parts^^

holding gain; arises from holding monetary assets during periods of falling prices or from maintaining liabilities during a period of rising prices^^

holding loss; arises from holding monetary assets during periods of rising prices or from maintaining liabilities during a period of falling prices^^

monetary items; cash, receivables, and payables--these items are automatically restated in terms of current dollars^^

money illusion; the belief that the unit of measure (the "dollar") is stable and that "prices" (i.e., values in exchange) are in

Ibid., p. 82.

10 Ibid., p. 76.

^^Ibid., p. 126.

^^Ibid., p. 126.

^^Ibid., p. 24.

8

motion when in fact the exchange values may be reasonably stable and the unit of measure itself in flux^^

non-monetary items; inventories, plant, and equipment are stated at a conglomerate of dollars if they are not adjusted^^

price-level adjustments; express or restate each item on the financial statements in terms of a "common dollar"; that is, in terms of a dollar of the same general purchasing powar^^

price-level changes; limited to the change in the general purchasing power of the dollar that occurs during periods of inflation or deflation^^

price-level changes—general; occurs as a result of a change in the value of the monetary unit during periods of inflation or deflationl8

price-level changes—specific; represents a change in its exchange value (in the absence of general price movements)^^

price index: a series of measurements, expressed as percentages, of the relationship between the average price of a group of goals and services at a succession of dates and the average price of a similar group of goods and services at a common date^O

^^Ibid., p. 14.

l^Ibid., p. 24.

^^Ibid., p. 25.

' Ibid., p. 5.

^^Hendriksen, p. 165.

19 Ibid., p. 163.

^^Staff of the Accounting Research Division, Accounting Research Study No. 6, p. 63.

purchasing power; the ability to buy goods and services with a given quantity of money (e.g., one dollar) compared to what that same quantity of money could have purchased at an earlier date'

Summary

A general statement has been presented to indicate

the problems involved with reporting in periods of changing

prices and to support the need for price-level adjustments

clarifying financial reporting. The objectives have been

stated, certain necessary definitions have been included,

and the development of the remainder of this thesis has

been formulated.

21 Hendriksen, p. 165.

CHAPTER II

BACKGROUND OF THE PRICE-LEVEL PROBLEM

Development of Price-Level Accounting in the United States

Since 1900 prices have been steadily rising. This

steady increase has been of major concern to the accounting

profession. The following discussion will explore the

nature of the events which have led to the current state

of price-level accounting in the United States.

1900 to 1940

Prior to the stock market crash of 1929, many

undesirable practices existed in financial reporting. The

fact that independent audits were not required of newly

listed companies on the New York Stock Exchange was of

major importance. Furthermore, no specific disclosure

requirements had been prescribed by either of the two major

accounting institutions or the New York Stock Exchange.

State laws were mostly concerned with the protection of

creditors. Stockholder's interests were generally neglected,

As a result of the lack of statutory and regulatory concern.

10

11

management was given the complete responsibility for the

accuracy and adequacy of the financial statements.

During this period liquidity was of prime importance

to creditors who felt that asset values rather than earning

power was the major factor affecting the security values of

a firm. Consequently, the balance sheet was accorded the

status as the most important financial statement. There

was an underlying philosophy that the appearance of the

balance sheet reflected the prosperity of the corporation.

As a result, assets, both tangible and intangible, were

assigned values above actual cost. The major problem

associated with such a practice was that appraised values

were not based on the opinions of independent expert

2

appraisers.

Such undesirable reporting practices continued

through the 1920's until the stock market crash in 1929.

Accountants, as well as investors, became aware of the

dangers involved in the write-up of assets when massive

write-downs were required during the ensuing depression.

Stephen A. Zeff, "Episodes in the Progression of Price-Level Accounting in the United States," Accountants Magazine, LXVIII (April, 1964), 285.

^Ibid., p. 286.

12

The early 1930's produced widespread criticism of

accounting practices. This criticism led to the passage

of two securities acts by Congress. The first act,

passed in 1933, provided that all securities which were

sold through the mail and in interstate and foreign com­

merce were to have full disclosure of all facts which were

relevant to their sale. The major limitation of this act

was that it related only to original issues. In order to

provide more complete protection for investors, the

Securities and Exchange Act was passed in 1934. This

extended the coverage of the first act to include the

regulation of the trading of securities. The Act of 1934

also established the Securities and Exchange Commission.

This Commission was given the power to prescribe both

accounting practices and to establish disclosure require­

ments. This responsibility was delegated to the American

Institute of Accountants (which later became A.I.C.P.A.).

The two bodies have been in agreement on practically every 4

major issue for the last thirty years.

Reed K. Story, A Search for Accounting Principles--Today's Problems in Perspective (New York; The American Institute of Certified public Accountants, Inc., 1964), p. 20.

^Percival F. Bundage, "Influences of Government Regulation on Development of Today's Accounting Practices," Journal of Accountancy, XC, No. 5 (November, 1950), 385.

13

Another result of the crash was the shift in the

relative importance of the two traditional financial

statements. There was a definite de-emphasis of the

balance sheet and asset valuation, and an increased emphasis

on the going concern concept. Thus, the income statement

became the most important financial statement. Investors

began to realize that the earning power of a firm, not the

asset values, was the proper basis for their investment

, . . 5 decisions.

The memory of the massive asset write-downs lasted

throughout the 1930's. As an outgrowth of this sentiment,

the subject of price-level change became a dormant topic,

except for the major works of Henry Sweeney and Kenneth

MacNeil. Sweeney wrote several articles which were pub­

lished in The Accounting Review expressing the view that

historical costs were useless in periods of changing' prices

unless they were restated in terms of dollars of the same

general purchasing power. He illustrated the theory pro­

posed in his articles in a book. Stabilized Accounting,

which was published in 1936.

^Zeff, p. 286.

Henry W. Sweeney, Stabilized Accounting (New York; Harper Brothers, 1936).

14

MacNeil»s work. Truth in Accounting, advocated the

use of economic values rather than historical costs."^

MacNeil»s ideas were not received well by many of the

practitioners. It was not until recently that the works

of either author have been appreciated as contributions to p

price-level studies.

1940 to Present

During the war accountants became involved with

military duties, governmental activities, and with the

accounting problems caused by mobilization. However, shortly

after the end of the war, the sharp increase in prices again

brought the problem of price-level changes to the attention

of businessmen and accountants. Three of the major corpora­

tions, E.I. du Pont de Nemours and Company, United States

Steel Corporation, and Chrysler Corporation tried to adjust

for inflation by making supplementary changes on their income

statements to reflect losses in purchasing power. United

States Steel and du Pont included supplementary depreciation

charges on their income statements to account for the loss

in purchasing power. However, since their auditors had taken

exception to such a procedure, the Securities and Exchange

Commission rejected both attempts. On the other hand.

7 Kenneth MacNeil, Truth in Accounting (Philadelphia;

University of Pennsylvania Press, 1939). p Zeff, p. 288.

15

Chrysler recorded accelerated depreciation on its assets

rather than relating the additional charges to the loss in

purchasing power. Chrysler's auditors did not take excep­

tion to such a procedure, and the Securities and Exchange 9

Comn\ission accepted the additional charges.

In 1947 the American Institute of Accountants

issued Accounting Research Bulletin No. _32. The Institute

advocated the retention of historical cost for recording

transactions in the accounts. The subsequent agitation

over this pronouncement became so great that, in 1948,

the Institute reaffirmed its position in a special letter

to its members. The letter recommended for the first time

that practitioners begin to experiment with supplementary

schedules adjusted for price-level changes. Also in 1947,

the Institute received a $30,000 grant from the Rockefeller

Foundation to start a three-year study of business income

v;ith special emphasis on the effect of price-level changes.

The committee was designated "The Study Group of Business

Income," and consisted of over forty members. This group

was responsible for the following publications and articles:

1. Five Monographs on Business Income

2. "An Inquiry Into the Nature of Business

Income Under Present Price-Levels"

^Stewart Yarwood McMullen, "Depreciation and Historical Costs, The Emerging pattern," Journal of Accountancy, LXXXVIII, No. 4 (October, 1949), 302.

16

3. "Business Income and Price-Levels, An

Accounting Study"

4. "The Case Against Price-Level Adjustments

in Income Determination"

5. "Changing Concepts of Business Income"

Upon completion of the project, the Study Group made two major

recommendations; first, cost statements should be supple­

mented by additional schedules determining income measured

in units of equal purchasing power; second, there should be

an effort to develop acceptable methods for the measurement

of income in terms of current purchasing power. For the

most part, very little recognition has been given in account­

ing literature to the Study Group's recommendations.

In 1950 the American Accounting Association became •

concerned with the price-level problem. The Association

subsequently issued "Supplementary Statement No. 2"

authored by the Committee on Concepts and Standards Under­

lying Corporate Financial Statements. The major recom­

mendations and conclusions of the Committee were as follows:

1. Supplementary schedules adjusted for the

over-all effects of the general price-level

changes should be prepared and issued.

2. The supplementary statements need not be

covered by the auditor's opinion.

^^Jeff, pp. 290-291.

17

3. purchasing power gains ^n monetary items

should be eventually recognized.

The Committee also published the following books concerning

the problems of price-level changes.

1. Case Studies of Four Companies by

Ralph Coughenour Jones

2. Basic Concepts and Methods by Perry Mason

3. Effects of Price-Level Changes on Business

Income, Capital, and Taxes by Ralph

Coughenour Jones

During the remainder of the 1950's, there were

three major events in the development of price-level

accounting. In 1953 the American Institute issued

Accounting Research Bulletin No. 43 restating the forty-two

Accounting Research Bulletins previously issued. In

Chapter 9 of this Bulletin, the Institute reaffirms the

previous position which recommended the retention of

historical cost, supplemented with the use of additional

12 schedules reflecting the effects of price-level changes.

The second major event concerning price-level accounting

was the instigation of a study program conducted by the

• •"•Zeff, pp. 290-291.

^^Accounting Principles Board, Accounting Principles Original Pronouncements, II (New York; American Institute of Certified Public Accountants, May 1, 1968), 6032.

18

Research Division of the A.I.C.P.A. in 1957. " The

investigation encompassed a survey of 669 corporate

executives and educators and revealed that 74 percent

favored the use of "current dollar depreciation" for

determining net income. The survey also revealed that

51 percent would have required disclosure of "current

dollar depreciation" and 59 percent would have used

supplementary statements or footnotes. Finally, in 1957

the American Accounting Association's special committee

revised the position taken in the 1951 statement.^^

Although the committee still suggested the use of supple-

mentary schedules, no mention was made as to whether

general or specific indices were to be used.

In the early 1960's, two major works on the price-

level problem received considerable attention. The first,

by two economists. Professors Edgar O. Edwards and

Phillip W. Bell, is The Theory and Measurement of Business

15 Income. The two authors discuss a valuation of the

^^"Opinion Survey on Price-Level Adjustment of Depreciation," Journal of Accountancy, CV, No. 4 (April, 1958), 30.

Accounting and Reporting Standards for Corporate Financial Statements—1957 Revision (Madison, Wisconsin; American Accounting Association, 1957).

^^Edgar O. Edwards and Philip W. Bell, The Theory and Measurement of Business Income (Berkeley and Los Angeles: University of California Press, 1961).

19

replacement cost approach to measuring income. The second

is Accounting Research Study No. 3 entitled "A Tentative

Set of Broad Accounting Principles for Business Enterprises"

authored by Professor R. T. Sprouse and Maurice Moonitz.

In this monograph the authors advocate the use of net

realizable value for stock-in-trade and periodic revalua­

tions for long-lived assets. Both of these recommendations

were significant departures from the position taken by the

American Institute.

In 1963 the Research Division of A.I.C.P.A. issued

Accounting Research Study No. 6 entitled "Reporting the

17 Financial Effects of Price-Level Changes." In this

publication, the research staff discusses the entire scope

of the problem of changing prices and the resulting effects

on income and valuations. The major recommendations of

the study are as follows;

1. Price-level adjustments should be reflected

with the use of completely adjusted state­

ments as supplementary exhibits to the

^^Robert T. Sprouse and Maurice Moonitz, "A Tentative Set of Broad Accounting Principles for Business Enterprises," Accounting Research Study No. (New York; American Institute of Certified Public Accountants, 1962)

" Staff of the Accounting Research Division, "Reporting the Financial Effects of Price-Level Changes," Accounting Research Study No. 6 (New York; American Institute of Certified Public Accountants, 1963).

20

primary statements or the use of extra columns

in the primary statements.

2. Statements should be adjusted only for changes

in the general price level.

3. The Gross National Product Implicit Price

Deflator is the only index suitable for

adjusting the supplementary statements.

The study includes illustrations of the implementation of

the approach to the price-level problem. Also the

financial statements of both domestic and foreign corpora­

tions are included which have been adjusted by various

methods to reflect the effects of changes in the price

level.

In August of 1966 A Statement of Basic Accounting

18 Theory was released by the American Accounting Association.

Although this monograph deals with a multitude of topics,

in Chapter III along with appendices A and B, the Committee

proposes and illustrates a solution to the price-level

problem. The major recommendations made by the Statement

are;

1. Reporting should include a presentation of

both historical cost and current replacement

cost in a multi-valued report.

^^American Accounting Association, A Statement of Basic Accounting Theory (Evanston, -Illinois: American Accounting Association, 1966).

21

2. Both general and specifij indices should be

used to adjust historical cost figures.

For the most part, the Statement was not received well by

most members of the profession. One of the major objec-

19 tions raised was the lack of preciseness and clarity.*

The most current publication concerning accounting

for changes in the price-level is the statement of the

Accounting Principles Board entitled Financial Statements

Restated for General Price-Level Changes, released in

June of 1969. The major recommendation of the release is;

General price-level information may be presented in addition to the basic historical-dollar financial statements, but the adjusted statements should not be presented as the basic statements.^0

The authors of the Statement also conclude that the Gross

National Product Implicit Price Deflator is the only

reliable index currently available. Since these are the

basic conclusions reached in Accounting Research study

No. 6, it appears that this publication is basically a

restatement of the conclusions of that study. Unlike

Accounting Research Bulletin No. 6, the new Accounting

Robert R. Sterling, "A Statement of Basic Accounting Theory: A Review Article," Journal of Accounting Research, V (Spring, 1967), 111.

^^Accounting principles Board, "Financial State­ments Restated to General price-Level Changes," Statement of the Accounting Principles Board No. 3 (New York; American Institute of Certified Public Accountants), June, 1969.

22

Principles Board release provides general guidelines for

preparing general price-level statements, with illustra­

tions of specific procedures. Accounting Research Study

No. 6 emphasizes the fact that the illustrations are not

intended to provide a detailed, technical guide for the

use of an accountant in preparing a set of adjusted

financial statements in an actual case.

The Nature of Changing Prices

Since 1915, prices in the United States have more

than tripled. Figure 1 shows the price-level trends in

the United States as reflected by three different indices.

Periods of rising prices followed the two world wars in

1919 and in 1941. Major periods of price declines were

during the early 1920's and during the depression of the

1930's.

Instability of Money

Conventional accounting practices were designed

to account only in terms of historical costs. The major

reason underlying such a practice is the measure of

objectivity which can be realized from using only historical

costs. However, such objectivity is based, in part, on the

assumption that our unit of measure is stable. A review

91 * Accounting Research Study No. 6, p. 121.

23

120

110

100

90

80

70 •

60

50

40

30

20

-

1

• i; / 1 1 \

f A » n

1 /.^V/ 1 / • >

1 • * if: >'

" i / : •••

i/* '1 • '1*

^•v f • '/.* . j i '

M m •

t

' * ' • ' • ' f 1

Index Numbers 1957-1959 = 100 J.

• / • ' • • / *

1/ * *"

W I/;-

• •

# • #•

""N / .'I \ / ''^

*< \ I . "

\ v / \ f V

•

l l l l " I M H l i i i t t m i l m t l . . . . l i f i i l i i . .

1915 20 25 30 35 40 45 50 55 60 65

120

110

100 ... Implicit price Index

- 90

- 80

70 _.

60

50

40 _

- Wholesale Price Index

Consumer Price Index

30

20

Source: Martin R. Gainsbrugh and Jules Backman, Inflation and the Price Index, Studies in Business Economics, No. 94 (New York; National Industrial Conference Board, Inc., 1966), p. 3.

Fig. 1.—A Half Century of Price Changes

24

of Figure 1 points out the fact tha*- since 1940 the

stability assumption has been far from realistic. Prices

have doubled in the short period of twenty years.

Although this increase is relatively mild as compared to

certain other countries (Figure 2), it has confronted the

accountant with a seemingly insoluble dilemma. He is

trying to generate accounting data which is realistic and

useful to both internal and external users while operating

under the criterion of objectivity which is an integral

part of the cost principle. In the opinion of this author,

the emphasis placed on the objectivity of using only •

historical costs can be traced to the older generation of

accountants who remember the massive write-downs during

the depression, or who had the privilege of working during

the periods when prices were relatively stable.

Types of price Change

Primarily, there are two types of price changes:

general and specific. Both are continually occurring in

our economy; and it is often difficult, if not impossible,

to separate the two. However, they are conceptually

different phenomena.^^ As a result, the accountant must be

aware of the differences between the two if he is to be

22 Eldon S. Hendriksen, Accounting Theory (Homewood,

Illinois: Richard D. Irwin, Inc., 1968), p. 163.

25

3000

2000

1000 900 800 700

600 500

400

300

200

100

Indonesia

Z. /

-7^ Brazil ~

7" y "7"

X- y Argentina ^

/ ^-i^ /^c--^

^ t •_

y' / 7^

United Kingdom -r-,v.„ * ^ Japan U.S.

i I I 1 I I 1958 1959 1960 1961 1962 1963 1964

Source: United Nations Monthly Bulletin of Statistics, XVIII (August, 1964), 148-157. May-June, 1964, represents the 1964 index level.

Fig. 2.— Relative Rates of Change for Consumer Price Indexes for Selected Countries (Vertical Scale Logarithmic) 1958 = 100

26

successful in reporting in periods of changing prices.

The following is a brief description of the two major

types of price changes.

Specific Price Changes

A specific price change is a change in the actual

exchange value of a specific commodity. These changes

result from such factors as technological improvements,

changes in consumer taste, and changes in supply. If

assets are held during periods when their related specific

price increases, a "holding gain" results. If the specific

price of assets being held declines, a "holding loss"

occurs.^ However, unless the changes in the general price

level are known, and the accounts are restated to reflect

these changes, no determination of genuine profit or loss

can be made. The computation of a holding gain or loss

which does not exclude general price-level changes includes

an element in the income statement which should have been

a restatement of capital.

The problem associated with accounting for "holding

gains and losses" is one of timing. Conventional accounting

• Ibid. , pp. 163-164.

^^Maurice Moonitz, "General v. Specific Price Changes: A Note," Journal of Accounting Research (Autumn, 1966), p. 254.

27

holds that gains and losses are not recognized until

"realized." Recognition of a holding gain or loss would

be postponed until the disposition of the specific asset.

Advocates of the recognition of holding gains and losses

feel that failure to recognize these items results in

errors in both the balance sheet and income statement

presentations. On the other hand, advocates of deferring

such gains and losses feel that the objectivity of the

cost principle is sacrificed when assets are revalued

before disposal.

General Price-Level Changes

General price-level changes result from the change

in the value of the monetary unit during periods of

inflation and deflation. These changes may be the result

of changes in the supply of money alone, or they may

represent changes in the total supply and demand of all

25 goods and services in the economy. Contrary to specific

price changes, general price changes do not result in

holding gains or losses. Instead, changes in the general

price level result in gains and losses only on monetary

items. The change of the general price level affects

25 Ibid., p. 163.

28

non-monetary assets by merely changing the value of

capital.^^

Indices are used to measure the movement of the

general price level. They express the current general

level of prices in relation to a base period. The recip­

rocal of this ratio reveals the changes in purchasing

power. Thus, general price-level indices facilitate

comparisons between periods in which the dollar commands

different purchasing powers.^

Changes in Specific and General Prices

The difficulty in determining whether price changes

are general or specific lies in the fact that the two

classifications of prices often move in different directions

as well as at different rates. Traditional accounting has

not recognized either movements; however, numerous proposals

have been made by accounting organizations and individuals

to facilitate adjustments of financial statements for

28 either or both types of price changes.

26lbid., p. 163.

^^Hendriksen, p. 165.

28ibid., p. 165.

29

Monetary Gains and Losses

During inflationary or deflationary periods, gains

or losses result from holding monetary assets. The basic

reason for this lies in the fact that monetary assets,

such as cash, receivables, or liabilities, represent no

more than the stated amount in current dollars, regardless

of the change in the general price level. For example,

X borrows $1,000 from Y at the beginning of the year when

the price level is 100. If X repays the loan in a period

when the price level has risen to 150, X will realize an

economic gain in that the repayment of the $1,000 repre­

sents only 50 percent of the purchasing power it had when

X originally borrowed the money. Thus, periods of inflation

are said to benefit debtors. Conversely, periods of

deflation benefit creditors.

The following rules can be formulated concerning

monetary gains and losses:

During a period of rising prices:

(a) a loss arises from holding monetary assets;

(b) a gain arises from maintaining liabilities

During a period of declining prices:

(a) a gain arises from holding monetary assets; (b) a loss arises from maintaining liabilities^^

2^Ibid., p. 165.

^^Harry Simons and Wilbert p. Karrenbrock, Intermediate Accounting (Cincinnati: South-Western Publishing Company, 1964), p. 800.

30

Due to the nature of monetary gains and losses,

differences of opinion exist as to the proper method for

their disclosure in the financial statements. One author

suggests that they be treated as a reduction of the cost

31 of depreciable assets. Another view is that these gains

and losses can be considered to be realized as they occur

except for long-term debt, which should not be realized

32 until payment of the debt. The approaches of the American

Institute and the American Accounting Association are

similar. Both propose to include purchasing power gains

and losses in supplementary income statements before net

income.

Objective of Price-Level Adjustments

The primary objective of providing statements

adjusted for changing prices relates to the presentation

of significant accounting information, not only to general

public, but also management, creditors, and all other

interested parties.

O-1

Auther Andersen and Co., Accounting and Reporting problems of the Accounting Profession (Second Edition; Chicago, 1962), pp. 16-17.

^^endriksen, p. 176.

31

Net Income

The adjustment of the income statement to reflect

changes in the price-level has several advantages. First,

such adjustment provides more meaningful measures of the

operating efficiency of the firm by measuring income in

terms of common dollars. Also, adjusted statements pro­

vide for a more realistic comparison of income between

different periods, and between other firms. Second, the

income statement is often used as a predictor of future

earnings; restatement of income in terms of common dollars

enables predictions to be based on more comparative and

meaningful net income figures. Furthermore, adjusted

statements reveal changes in the purchasing power of the

firm, whereas unadjusted statements only reflect the change

in money values. Finally, management utilizes the net

income figure to compare financial results with original

plans. Restatement of income in terms of the same pur-

33 chasing power makes this comparison more valuable.

Balance Sheet

Due to the steady increase in prices, the balance

sheet has lost much of its meaning and usefulness as a

financial statement, price-level adjustments are a step

- Ibid., pp. 166-169.

32

in restoring the usefulness of the balance sheet to

provide meaningful financial information. Comparisons

and ratios provide a more meaningful measure of the

firm's growth when based on common-dollar statements.

As a result, the effects of inflation or deflation on the

different clashes of equityholders are disclosed when

statements are adjusted for price-level changes.^^

Summary

In Chapter II, the general background of the

price-level problem was discussed. This background con­

sists of the development of price-level accounting, the

nature of the problem of changing prices, and the objective

of price-level adjustments in the financial statements.

Chapter III consists of a discussion of the proposal

presented by the American Accounting Association in

A Statement of Basic Accounting Theory and by the Research

Division of the American Institute of Certified Public

Accountants in Accounting Research Study No. 6.

^^Ibid., pp. 169-172.

CH;^PTER III

A DISCUSSION OF TWO PROPOSALS—BY THE

A.A.A. AND THE A.I.C.P.A.

As discussed in Chapter II, several methods for

reporting the effects of price-level changes have been

proposed. This chapter will be devoted to an explanation

of two of the most recent proposals: first, the method

suggested by the American Accounting Association in its

publication, A Statement of Basic Accounting Theory;

second, the proposal of the Research Division of American

Institute of Certified Public Accountants in Accounting

Research Study No. 6.

A Statement of Basic Accounting Theory

The major purpose of A Statement of Basic Accounting

Theory was to develop an integrated statement of accounting

theory to serve as a guide for educators, practitioners,

and others interested in accounting. The study was authored

by a committee of nine members with Charles T. Zlatkovich

as chairman. Although the monograph discusses a variety

of topics. Chapters II and III have special significance

to the area of price-level accounting.

In Chapter II of the monograph, the Committee

developed four standards to be used in evaluating accounting

33

34

information: (1) relevance; (2) verifiability;

(3) freedom from bias; (4) quantifiability. Acceptable

accounting data does not require complete adherence to

these standards. In certain instances, it will be possible

to realize them more fully than in others. Furthermore,

the degree of compliance will be determined to a certain

extent by the intended use of the accounting data. Price-

level accounting is affected by these standards in that,

to be acceptable, the adjusted statements must be in

compliance.

General Recommendations

Chapter III of the study pertains to accounting

information and the external user. The Committee discusses

the relative merits of current replacement cost information

as evaluated by the four standards mentioned above. They

concluded that current cost information could be obtained

which would adequately meet the prescribed standards.

However, it was also concluded that the use of only current

replacement cost information was not acceptable since it

"obscures the consummated market transaction." As a result,

the Committee recommended that "both types of information

be presented in a multi-valued report, in which the two

35

types of information appear in adjacent columns." Such

a presentation has the advantage of reflecting the dif­

ferences caused by environmental influences and enables

the accountant to better meet the relevance standard.

The Committee selected current cost of replacement as the

basis for expressing accounting data. This information

would be determined by current market prices when avail­

able; otherwise specific price indices would be used for

the adjustments. In situations where neither current

majrket prices or specific price indices are available, an

adjustment for the change in the general price-level should

be made.''

Adjustment of the Balance Sheet

In Appendices A and B of the monograph, the Committee

suggests and illustrates an approach for introducing price-

level data into the reporting process. The following

discussion encompasses the sources to be used in obtaining

current replacement cost information.

American Accounting Association, A Statement of Basic Accounting Theory (Evanston, 111.: American Accounting Association, 1966), p. 9.

2Ibid., p. 33.

36

Current Assets

Items such as cash, accounts and notes receivable,

prepaid expenses, and supplies do not require current

adjustment on the balance sheet because they are already

expressed in current terms. However, current replacement

cost information for marketable securities and inventories

is required and determined as follows:

Marketable Securities

Current replacement cost information can be readily

Obtained for marketable securities by reference to current

market quotations.

Inventories

Supplier's catalogues provide a primary source of

obtaining current replacement cost data for inventories.

This source satisfies the requirements of verifiability,

quantifiability, and freedom from bias. In fact, the

Committee concluded that a current replacement cost valua­

tion of inventories removes the bias present in the lower

of cost-or-market rule.

^Ibid., pp. 73-84.

37

Property, plant, and Equipment

This classification denotes all types of land,

structures, and equipment of a tangible nature whose use­

ful life will cover more than one accounting period. The

following is a discussion of the acceptable sources of

current replacement cost data for the different elements.^

Machinery and Equipment

The Committee recommended the following four

sources for determining the current replacement cost of

machinery and equipment;

1. The purchase price of new equipment can be used

when determined on the current market and adjusted for

current depreciation. A supplier's catalogue price

adjusted for trade discounts provides a clear indication

of current replacement cost if the same machinery or equip­

ment or its service equivalent is available on a continuing

basis.

2. The purchase price of used equipment can be

utilized when determined in the current market. When prices

are not available on certain items, current replacement

cost of a similar item could be used.

^Ibid., pp. 75-78.

38

3. A downward adjustment •'3 required when a more

efficient machine is available which can do the same amount

of work at a reduced operating cost.

4. Specific indices are currently available for

broad classifications of equipment. These indices can be

used especially for unique assets which are not available

from a continuing source of supply.

Buildings

Buildings are unique in that no two are exactly

alike. However, they may be classified into categories of •

use such as apartments, warehouses, or office buildings.

The Committee concluded that specific indices are currently

available to provide replacement cost information for the

different classifications of buildings. Because of the

unique nature of buildings and the changing technology in

the .building industry, replacement cost indices are

determined on a service equivalent basis.

Land

The Committee recommended two alternatives for

determining the current replacement cost of land. The

first suggestion utilizes the purchase price of an equiva­

lent tract of land as a reflection of current replacement

value. This method is highly feasible because land trans­

actions are often a matter of public record. The second

39

possibility is the use of a specific price index of the

land values for a particular area. These indices, when

prepared by independent, responsible agencies, would be

used when current sales figures are not available. A

special problem arises if the cost of land includes

buildings and other improvements and there is no distinc­

tion as to the relative prices of each. In such a case,

it would be possible to either determine the current cost

of a similar unimproved track of land or to determine the

current replacement cost of the building and deduct it

from the total cost.

Minerals and Other Natural Resources

The procedures for determining replacement cost of

these assets parallels the techniques outlined for land used

as building sites. Sufficient data are currently available

to determine the current market value of the different

natural resources; however, the accountant must rely on

independent appraisers to determine the quantities involved.

Long-Term Investments

The procedures for determining the current replace­

ment cost of long-term investments are often unique to the

investment itself. The Committee recommended the following

40

sources of current replacement cost information for these

assets.

1. Large blocks of stock may have a market price

per share different from that determined through the

exchange of a smaller number of shares. In such cases,

the use of quoted market prices provides the best source

of current replacement cost data. However, when quoted

market prices are not available, book value can be used

when computed after current cost measurements have been

compiled.

2. For small blocks of stocks which are not

traded through an exchange, the Committee recommends an

adjustment for the change in the general price-level.

3. Due to the unique nature of mortgage notes,

market quotations for similar classes of securities can be

used.

intangible Assets

For intangibles such as patents, trademarks, copy­

rights, and goodwill, the only feasible method of adjust­

ment is the use of the general price-level. Franchises

should be adjusted for the general price-level change except 6

where the grantor offers them on a continuing basis.

^Ibid., pp. 74-75.

^Ibid., pp. 78-79.

41

Ecfuities

Current liabilities, like most current assets, are

not restated because they are always expressed in current

terms. The Committee recommended the following procedures

for determining the current cost of the remaining classes

of equityholders.^

Long-Term Liabilities

Interest bearing bonds are valued at their net

amount. Discounts and premiums on bonds payable are

accumulated in an amount equal to the difference between

the expected yield and the interest rate on the face of

the bond.

Estimated Taxes on the Increase to Current Cost

The difference between current valuations and

historical cost will be taxed when it is realized for

federal income tax purposes. This tax computation is made

by applying the current tax rate to all increases except

capital gains.

''ibid., pp. 82-85.

42

Stockholders' Equity

Stockholders' equity will be represented by one

figure because there is no practical way to determine the

current cost of the constituent elements. Therefore, this

figure merely balances the equity side of the accounting

equation.

Adjustment of the Income Statement

Although no specific procedures were recommended

for determining the current cost of items on the income

statement, the following general guidelines can be inferred

from the illustrations in Appendix B of the monograph.

Sales

The sales figure is composed primarily of cash and

account sales. As such, it is already expressed in current

terms and requires no adjustment.

9 Cost of Goods Sold

Inventories

The beginning inventory should be restated to

reflect the change in the general price-level throughout

Ibid., p. 85.

^Ibid., p. 85.

43

the year. The ending inventory should be restated according

to the procedures outlined in the current asset section of

this chapter.

Materials, Labor, and Other Variable Costs

Generally, these items do not require restatement

since they are already expressed in current terms. However,

items such as prepaid insurance which is allocated to

overhead should be adjusted for changes in the general

price-level when the coverage extends beyond a single year.

Fixed Costs (Excluding Depreciation)

These are items which have required an expenditure

of current dollars and as such are stated in current terms.

Depreciation

Naturally, since depreciation is computed on assets

that are restated in current terms, it must also be restated,

This calculation can be made most easily by computing

depreciation on historical cost and then increasing it by

the same percentage that the current replacement cost of

the asset exceeds its historical costs.

44

Amortization

As stated earlier, intangibles should be restated

to reflect the change in the general price level.

Naturally, the amortization of these intangibles should

be adjusted for the same effect.

Current Cost Adjustment

This adjustment pertains to the material used

during the year. It reflects the current increase in the

cost of these materials. The adjustment consists of;

1. The excess of the current cost over historical

cost for items acquired and used during the year.

2. The excess of the current cost of the beginning

inventories at the time of their use over their current

cost at the beginning of the year.

3. The excess of the current cost of the ending

inventories over their historical cost.

Operating Expenses

Selling and administrative expenses (excluding

depreciation), both fixed and variable, are not adjusted

because they are already expressed in current terms. The

depreciation expense charged to these classifications

^^Ibid., p. 90.

45

should be adjusted by the same procedures as those described

above for cost of goods sold.^^

Other Income and Expenses

Naturally the type of transaction and the nature

of the elements involved will determine whether or not an

adjustment is required. The following are examples of the

12 adjustments required for these types of accounts.

Dividends

Dividends paid in cash do not require an adjustment

because, like other cash items, they are already expressed

in current terms.

Gains or Losses on Sales of Marketable Securities

The current cost of marketable securities as

determined by market quotations should be adjusted for the

change in the general price-level before computing the

resultant gain or loss.

Interest on Long-Term Bonds

Interest on long-term bonds should be computed on

the net amount of the expected yield. The resultant

l^Ibid.

- - Ibid.

46

difference between this computation and interest computed

on the face of the bond is the premium or discount accumula­

tion mentioned earlier in this chapter.

Net Gains from Current Cost Valuations

Basically, the procedure for determining net gains

or losses from current cost valuations is to take the

difference between the beginning current value of the

assets (adjusted for the general price-level change) and

13 the ending current cost valuations of the same assets.

Purchasing Power Gains or Losses

These gains or losses reflect the change in the

value of the monetary unit during the year. The computa­

tion of the gain or loss is made by taking the difference

between the monetary items at the beginning of the year

and the same values adjusted to reflect the change in the

general price-level during the year. Naturally, periods

of inflation will recognize a gain on monetary liabilities

14 held and a loss on monetary assets held.

^^Ibid., pp. 94-95.

^^Ibid., p. 91.

47

Illustrative Statements

The basic procedures for adjusting financial

statements have been discussed above. The following

statements. Exhibits A, B, C, and D, are presented to

illustrate the reporting technique specified by the mono­

graph. In order to facilitate the reader in a general

understanding of the statements, the following assumptions

and general information are given;

1. The general price-level increased 4 percent.

2. Building and equipment replacement cost

increased $700,000 gross on januajry 1, 1966.

3. Assume that the new equipment acquired is

factory equipment.

4. Periodic lease payments are $140,000 of which

$60,000 represents interest.

5. The current replacement' cost of patents

amortized during the year was $160,000 including

a specific price increase of $4,000 which

occurred during the year.

6. Land with a historical cost of $10,000 and a

current cost of $40,000 at 12/31/65 was sold

late in 1966 for $48,000.

7. Marketable securities with a historical cost of

$50,000 were sold during 1966 for $52,000.

- Ibid., pp. 86-95.

SCHIBIT A

ABC COMPANY Balance Sheet

December 31, 1965

48

Current Assets Cash and Receivables Marketable Securities Inventories: Raw Materials Work in Process Finished Goods

Une^qpired Insurance and Supplies

Total Current Assets

Investment in Stock of Affiliated Co.

Property, Plant, & Equipnient Land Buildings and Equicr.ent Allowance for Depreciation Leasehold Interests

Total Property, etc.

Intangibles Patents, Copyrights, etc.

Total Assets

ASSETS

Historical Cost

$ 260,000 180,000 300,000

$7,000,000 3.500.000

200,000 50,000

740,000

10.000

$1,000,000

$1.000.000

$ 200,000

3.500.00D 1,000,000

$4.700,000

700,000

$7.400,000

Current Cost

280,000 190,000 330.000

$11,200,000 5,600.000

200,000 52,000

800,000

10,000

$ 1,062,000

$ 1,400,000

$ 1,000,000

5,600,000 1,000,000

$ 7,600,000

1.000.000

$11.062,000

Current Liabilities Lease Obligations Others Unspecified

Long-Term Liabilities Bonds Payable, 5Ti, Due 19XX Lease Obligations Deferred Federal Incone Taxes Payable

Estimated raxes on Increases to Current Cost

Total Liabilities

Stockholders' Equity Capital Stock—$10 par Additional Paid-in Capital Retained Earnings Total Stockholders' Equity

Total Equities

EQUITIES

$ 80,000 $ 80.000 300.000 $ 380.000 300.000 $ 330.000

$2,000,000 920.000

100.000

-0- 3,020,000

$3,400,000

$3,000,000 600,000 400.000

4,000.000

$7.400,000

$ 1,900,000 920,000

100,000

1,580,500 4,500,500

$ 4.880,500

6.181,500

$11.062,000

Source: American Accounting Association, A Stater.ent of Basic Accounting Theory (Evanston, 111.: Axerican Accounting Association, 1966), pp. 81-85. Only the historical cost stete.-.ents were used.

EX>IIBIT B

ABC COMPANY Balance Sheet

December 31, 1956

49

Current Assets Cash and Receivables Inventories: Raw Materials Work in Process Finished Goods

Unexpired Insurance and Supplies

Total Current Assets

Investment in Stock of Affiliated Co.

Property. Plant, and Equip-?nt Land Buildings and Equip-ent Allowance for Depreciation Leasehold Interests

Total Property, etc.

Intangibles patents. Copyrights, etc.

Total Assets

ASSETTS

H i s t o r i c a l Cost

$ 280.000 200.000 310,000

$8,000,000 3.900.000

$ 300.000

790.000

20,000

$1.110.000

$1.000.000

$ 190,000

4.100,000 900,000

$5,190.000

$ 600,000

57,900,000

Current Cost

300,000 215,000 325,000

$12,900,000 6.595.000

300,000

840,000

20,000

$ 1,160,000

$ 1,600,000

$ 1,100.000

6.303,000 94 5,000

$ 8,350,000

I 903,000

512,010,000

Current Lia':;ilities Lease Obligations Others Unspacified

Long-Terr?. Liabilities Bon3s payable, 5!'., DJe 19XX Lease Obligations Deferred Federal Incore Taxes Payable

Estimated Taxes on Increases to Current Cost

Total Liabilities

Stockholders' Eq'Jity Capital Stock—$10 par Additional Paid-in Capital Retained Earnings Total Stockholders' Equity

Total Eq'Jities

EQUITIES

$ 85,000 $ 85,000 530.000 $ 615.000 530,000 $ 615,000

$2,000,000 835,000

120,000

-0- 2.955,OOP

$3,570,000

53,000,000 600,000 730,000

4,330,000

$7,900,000

$ 1,904,500 835.000

120.000

1,^25,250 4,584,750

$ 5,199.750

6,810.250

512,010,000

Source: American Accounting Association, A Stete-.er.t o^ Basic Acco-jntinq Theory (Evanston, 111.: ; _T.erican Accounting Association, 1966), pp. 81-85. Only the historical cost state-T.ents vere used.

50

EXHIBIT C

ABC COMPANY IncoT.o Statemsnt

Year Ended Deccyiar 31, 1966

Sales (Net) $20,000,000 Cost of Goods Sold

Historical Cost Current Cost

$20,000,000

Inventories, Dsc. 31, 1965 $ 740,000 $ 832,000 Material, Labor, and Other Variable Costs 7.910,000 7,910,400

Fixed Costs (excl. deprec. & anort.) 3,000,000 3,000.000

Depreciation--Blcg. & Equip. 300,000 475,000 Amortization—Leases 100,000 101,000 X-nortization—Patents 100,000 160,000 Current Cost Adjustment -O- 200,000

$12,150,000 $127681740^ Inventories. Dsc. 31, 1956 7_90.000 _ll,^6p.000 840,000 11,841,400

Gross Margin $ 8,64 6.000 $ 8,158.600

Operating E-xpenses (datail omitted) Selling--Variable $ 2.000.000 $ 2.000.000 Selling-Fixed (including depreciation) 2.000.000 2.042,000

$ 4.000.000 §_ _£, 0 4_2 ^00 Administrative—Variable $ 500.000 $ "500.000 Administrative--Fixed

(including Depreciation) 3,000,000 3,028,000 $ 3,503,000 7,500,000 5 3,523,000 7,573,000

Net Operating Inccr^ § 1,140.000 $ 553.600 Other Revenije

Dividends $ 20.000 $ 20,000 Gain (Loss) on Sale of Marketable Securities

G a m on Sale of Land

Other Expenses Interest--Eonds Interest--Leases

Net Inco-e Before Fe-eral Inccr.e Taxes--On Transaction Basis

Federal Incoma Tax^s Applicable Net Income after rcderal Incor.a Taxes en Transaction Basis

Net Gains fron Current Cost Valuations

Fedaral Income Taxes Applicable Purchasing Power Gams on Met Net Inccr.e

SO'Jrce: American Accounting Association. A Statet'.ent of Bssic Accounting Theory (E-zanston, 111.: /•j-trican Accounting Association, 1965), pp. 81-35. Only the historical cost statements v.-ere used.

$

2,000 38,000

100.000 60.000

60,000 $ 1,200.003

160,000

$ 1.040,000 510.000

$ 530,000

$

$

(2,030) 6,400

104,500 50,000

600,600 393,300

$

$

$

?

24,320 612,920

164,500

448.420 256.450

191.970

202,300 187,220 581,490

51

EXHIBIT D

ABC COMPANY Statement of Retained Earnings Year Ended DecertODer 31, 1966

Retained Earnings, December 31, 1965

Net Income

Dividends

Retained Earnings, December 31, 1966

In terms of Historical Cost

$ 400,000

530,000

$ 930,000

200,000

$ 730,000

ABC COMPANY Statement of Stockholders' Equity Year Ended December 31, 1966

Stockholders' Equity, December 31, 1965

Add: Adjustment to restate beginning stockholders' equity in purchasing power equivalents ($6,181,500 X .04)

Net income for year

Less: Dividends

Stockholders' Equity, December 31, 1966

In terms of Current Cost

$6,181,500

247,260

581,490

$7,010,250

200,000

$6,810,250

Source: American Accounting Association, A Statement of Basic Accounting Theory (Evanston, 111.: American Accounting Association, 1966), pp. 81-85.

52

8. Bonds payable are assumed to require for annual

interest payments. The bonds were valued to

yield five and one-half percent on 12/31/65

at which time they had a remaining life of

fifteen years.

Accounting Research Study No. 6

The main purposes of Accounting Research Study

No. 6 are to research the entire problem of changing prices

and to prepare a report which makes recommendations for the

disclosure of the effect of price-level changes upon the

financial statements. The general conclusion by the members

of the study was that the effects of price-level changes

on all elements of the financial statements should be

disclosed. As a result, a piecemeal solution was not con­

sidered during the course of the study. Furthermore, the

director of the Study felt the following areas should receive

special attention:

1. A clarification of the meaning of ' price-level adjustments" of accounting data by the use of an index of the general price-level .

2. A study of the indices currently available.

3. An exploration of the forms that disclosure ^^ of price-level changes have taken or could take.

^^Staff of the Accounting Research Division, "Reporting the Financial Effects of Price-Level Changes, Accounting Research Study No._6 (New York: American institute of Certified Public Accountants, 1963).

53

General Conclusions and Recommendations

As stated above, the authors of the Study con­

centrated on three major areas. The following is a

summary of their recommendations and conclusions as

reflected in the highlights of the study: "

1. There are enough cases where actual price-

level adjustments have been carried out together with the

volumn of literature to illustrate the widespread concern

of businessmen and accountants with the need to reflect

the effects of inflation and deflation in financial

reporting.

2- Financial statements around the world indicate

price-level changes reflected in the financial statements

are practical and not misleading or dangerous to investors.

3. The study indicated that at least one index

(the Gross National Product Implicit Price Deflator) is

currently available which reflects the change in the general

price-level and is sufficiently reliable to use in adjusting

the financial statements.

4. Price-level adjustments should be disclosed as

supplemental data to the conventional statements. Such

disclosure could take place in the form of physically

separate statements, parallel statements in a combined

^'Ibid., pp. xi-xii.

54

statement, detailed supi>orting schefules (including charts

and graphs), or some combination of these.

5. All elements of the financial statements should

be restated by means of a single index of the general price

level, as of balance sheet date, so that all the financial

data will be expressed in terms of dollars of the same

purchasing power.

6. For the sake of simplicity and precision, the

study assumes that replacement cost is not to be introduced

into the financial statements.

7. Gains and losses do not arise from the restate-, —^— ——.—

ment of the nonmonetary items for the effects of changes

by the general price-level. These items merely represent

a restatement of stockholders' equity as of balance sheet

date.

8. Gains or losses do arise from recognizing the

effect of a changing price-level on monetary items.

9. This study neither expresses nor implies any

recom.mendations on social policy such as who is injured by

Inflation or deflation,

10. The best year to be used as a cut-off date is

1945 since the precision of comparison of current prices

with those prevailing in periods prior to World War II

are unreliable.

55

Procedures for Adjusting the Financial Statements

As stated above, the Gross National Product

Implicit Price Deflator is the only index currently avail-

able which is reliable enough to be used in adjusting the

financial statements. The Gross National Product deflators

are prepared by the United States Department of Commerce,

Office of Business Economics, and are published in the

Survey of Current Business and its supplement. United

States Income and Output. These publications include the

annual deflators and quarterly deflators adjusted season­

ally. While final revisions of the deflators are not

available until July of the following year, interim defla­

tors can be computed by "dividing the current dollar

estimates of the Gross National Product by the constant

dollar estimates published in the Survey of Current Business

18

in the second month following the end of each quarter.

Gross National Product Deflators in their usual

published form express only fluctuations in the general

price-level in relation to a base year. Before being used

for accounting purposes, it is necessary to restate them

in a form which translates dollars of one point in time to

dollars of another point in time. The procedure used is

to "multiply the amount involved by the index number of the

^^Ibid., pp. 176-177

56

point in time to which the conversion is to be made, and

divide by the index number of the point in time from which

the conversion is made." For a simplification of this

process, the two index numbers can be restated as a

"conversion factor" by dividing the current index number

by the index number of the point in time from which the

conversion is to be made (Exhibit E, page 64). The

resultant percentage or "conversion factor" is multiplied

by the item to be restated. For example, to convert an

asset with a cost of $50,000 from a point in time when the

index is 75, to a point in time when the index was 150,

the following computations are made:

i|^ = 2.000 (conversion factor)

$50,000 X 2.000 = $100,000

The $100,000 represents the cost of the asset restated

19 in dollars of a different purchasing power.

Adjustment of the Balance Sheet

Providing prices are relatively stable, non­

monetary items on the balance sheet are adjusted by a

conversion factor based on the average deflator of the

year in which the items were acquired. However, if prices

^^Ibid., pp. 67-68.

57

fluctuated significantly diuring the year of acquisition,

the applicable quarterly deflators should be used in

determining the conversion factor.

Monetary Items

Monetary items such as cash, receivables, current

and long-term liabilities do not require an adjustment at

the end of the current year since they are already expressed

in current dollars. However, monetary balances represented

in prior year balance sheets must be restated for general

price-level changes if meaningful comparisons are to be •

made. The restatement can be accomplished using a con­

version factor based upon the year end index of the balance 20

sheet under adjustment.

Inventory

The adjustment of the ending inventory primarily

depends upon the inventory pricing method used. When the

first-in-first-out or the weighted average methods are

used, the conversion factor should be computed using the

average index for the current year. However, if the last-

in-first-out method is used, the conversion factor should

^^Ibid., p. 129.

58

be computed using the beginning index of the current

year.^^

property. Plant, and Equipment

Actually, each asset should be restated by the

deflator of the point in time in which it was acquired.

However, since the time and effort required to apply such

a procedure would become prohibitive in many cases,

various simplifications can be used. For example, items

purchased at approximately the same time can be treated

as a single item for restatement purposes. Or, an arbitrary

cut-off point can be used for older items which are often

a relatively small portion of the total, and all items

acquired before the cut-off date can be treated as if they

were all acquired at that date.

The accumulated depreciation accounts on these

assets are the result of the accumulated charges of the

adjusted annual depreciation computed on the restated

22 amounts.

Other Assets

Although assets such as intangibles or research

and development costs were not specifically discussed in

2^Ibid., pp. 129-130

^^Ibid., pp. 124-125

59

the Study, the following procedures can be inferred from

the procedures for restating the assets previously dis­

cussed. Therefore, these assets can be restated using a

conversion factor computed with the average-yearly

deflator for the year in which they were acquired.

Capital Stock

The capital stock account is restated using the

deflators for the point in time at which each issue was

sold. The original issue should be adjusted by the deflator

prevalent at the opening of business. Subsequent issues

are restated using the average deflator for the period in

23 time in which they were issued.

Retained Earnings

The adjusted retained earnings balance is the

result of the accumulation of all the adjusted income

statements. However, where the price-level adjustment

technique is put into effect for a company which has been

in existence for a great many years, the accumulated

retained earnings becomes a balancing figure in the first

financial statements which are adjusted. In order to

isolate the total accumulated gain or loss on monetary

items, it is necessary to compute the purchasing power gain

23 Ibid., p. 130.

60

or loss on these items since the be ,inning of the company.

Because such a procedure is not feasible, either the

accumulated gain or loss on monetary items must be left

as an unidentified portion of retained earnings, or a

cut-off date selected and the gains or losses accumulated

from that point forward.^^

Adjustment of the Income Statement

Except for depreciation, amortization, and that

portion of cost of goods sold represented by the beginning

or ending inventory, items on the income statement are

already expressed in relatively current terms. Therefore,

such items need to be restated only for the changes in the

general price-level that occurred during the year.

Revenues and expenses that are earned or incurred evenly

throughout the year can be restated by either the average

or the quarterly deflator, whichever results in the most

accurate restatement. The following discussion encompasses

the major items on the income statement and assumes revenues

and expenses were earned or incurred evenly throughout the

year.

24 Ibid./ p. 133

61

Sales

Sales are restated for changes in the general

price-level using the average deflator for the current 25 year.^^

Cost of Goods Sold

Inventories

Since the ending inventory for one year is the

beginning inventory of the next, the beginning figure is

adjusted by the same deflator used in adjusting the ending

Inventory of the preceding year. Materials, when pur­

chased evenly throughout the year, are restated using

average deflator for the current period. The procedures

for restating ending inventories are based on the pricing

method in use and were discussed in the balance sheet

section of this chapter.

Labor and Overhead (Excluding Depreciation)

The study did not discuss manufacturing concerns

specifically. However, it can be inferred that the direct

labor and manufacturing overhead, if used evenly throughout

25ibid., p. 123.

2^Ibid., pp. 123-124.

62

the year, should be adjusted by the average index for the

current year.

Depreciation

Since depreciation is computed on the cost of the

asset, the simplest method for determining the restated

depreciation charge is to apply the normal rates to the

restated cost of the asset.^^

Other Expenses

Other expenses incurred during the year are re-28 Stated using the average deflator for the current year.

Dividends

Dividends which are declared and paid at the end

of the year are adjusted by the year-end deflator for the O Q

period in which they were paid.^^

Gain or Loss on Monetary Items

This gain or loss appears only on the adjusted

financial statements. This item is disclosed on the income

Statement after net profit. The simplest way to calculate

^^ibid., pp. 124-125

^^Ibid., p. 125.

2^Ibid., p. 125.

63

the gain or loss is to determine thr amount needed to

balance the financial statements after making all adjust­

ments of the non-monetary accounts. A more detailed

analysis is often desired to determine the source of the

gain or loss. As a result, the following procedures are 30 necessary:

1. Determine the gain or loss on the net

current monetary items.

2. Determine the gain or loss on the long-

term liabilities.

Illustrative Statements

The basic procedures for adjusting financial state­

ments as proposed by the authors of Accounting Research

Study No. 6 have been discussed above. The following

statements. Exhibits E, F, G, and H, are the same unadjusted

statements presented earlier in the chapter. They are

presented to aid in future comparisons and to illustrate

the rejxjrting method discussed in the Study. In order to

facilitate the reader in a general understanding of the

statements, the following assumptions and general information

are given:

1. Business was formed on January 1, 1956.

^^Ibid., p. 126.

64

EXHIBIT E

A3C COffANY General Price-Level Restatement--1966

Gross National Product Implicit price Deflators and Conversion Factors

Year

Annual Averaoe

1956

1957

1953

1959

1960

1961

1962

1963

1964

1965

1966

Q'Jflfter GNP

deflators

94.0

97.5

100.0

101.6

103.3

104.6

105.7

107.1

103.9

110.9

113.9

Conversion factors 1966 {4th o.) = 1.000

1.238

1.183

1.153

1.135

1.116

1.102

1.091

1.077

1.059

1.040

1.012

Quarter ly

1956

1963

1965

1966

1st

1st

1st

2nd

3rd

4 th

1st

2nd

3rd

4 th

92.6

106.6

110.1

110.7

111.0

111.6

112.6

113.5

114.4

115.3

1.245

1.092

1.047

1.042

1.039

1.033

1.024

1.016

1.008

1.000

Source: Accounting Principles Board, "Financial Statements Restated to General price-Level Changes," 5tetc-n;'nt of the Accounting Principles Board :;D. 3 (I.'ev; York: P-jr.erican Institute of Certified Public Accountants, June, 1969), pp. 22-25.

65

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EXHIBIT G

ABC COMPANY General Price-Level Statement

of Income for Year Ended December 31, 1966

66

Sales Cost of Goods Sold

Inventories 12/31/56 Materials, Labor, and Other Fixed Costs (Exc. depri

and anort .) Depreciat ion--aidg. & Equip. Aitortization—Leases Antortization—Patents

Inventories 12/31/66

Operating Expenses Selling Exp.--Variable Selling Ixp.—Fixed

(Depr. Included) Administrative—Variable

• Administrative—Fixed (Depr. Included)

Historical Costs

$ 740,000 7,910,000

3,000,000 300,000 100,000

, 100,000 fT27l50,000

790,000

$ 2,000,000 2,000.000

$ 4,000.000 $ 500,000

3,000,000 $ 3,500.000

$20,000,000

11,360,000 $ 3,640,000

7,500,000 $ 1,140,000

General Price-Level Basis (Restated to 12/31/66S)

$ 769,600 8,004,920

3,036,000 373,313 104,700 104,700

$12,393,233 799,480

$ 2,024,000 2,014.662

$ 4,038.662 $ 506,000

3,045.295 S 3,551,295

$20,240,000

11,593,753 $ 8,646,247

7,559,957 $ 1,056,290

Other Revenue Dividends Gain (Loss) on Sale of Marketable Serurities

Gain on Sale of Lend

Other Expanses Interest—Bonds Interest—Leases

Ket IncoT.e on Historical Basis Before Feceral Taxes

Federal Inco~e Taxes

Net Inco-e After Taxes

Purchasing Power Gain

20,000 20,240

$

2,000 38,000

100.000 60,000

60,000 $ 1,200,000

S 160.000 $

(350) 37.530

101,200 60,720

57,420 $ 1,113,710

$ 161,920

$ 1,040,000 510.000

$ 530,000

$

v>

?

951,790 516,200

435,590

503,397

743.987

Source: A.r.erican Accounting Association, A Staterar.t Basic Aceountine Theory (Evanston, 111.: Averican Accounting Association, 1965), pp. 31-85. Only tha historical cost statements vere used.

67

EXHIBIT H

AB3 COMPANY Statement of Retained Earnings Year Ended December 31, 1966

In terms of Historical Cost

Retained Earnings, December 31, 1965 $ 400,000

Net Income 530,000

$ 930,000

Dividends 200,000

Retained Earnings, December 31, 1956 $ 730,000

ABC COMPANY General Price-Level Statement of Retained Earnings for

Year Ended December 31, 1966

General Price-Level Basis (Restated to 12/31/66$)

Retained Earnings, December 31, 1965 $ 479,830

Net Income 743,987

$1,223,867

Dividends 200,000

Retained Earnings, December 31, 1966 $1,023,867

Source: American Accounting Association, A Statement of Basic Accounting Theory (Evanston, 111.: American Accounting Association, 1966), pp. 81-85. Only the historical cost statements were used.

68

2. Plants equipment, and land was acquired at

the beginning of the business.

3. All other assets and liabilities were acquired

as follows:

a. Additional factory ec[uipment costing

$1,000,000 was purchased in January of

1966.

b. Additional insurance and supplies were

purchased during December of 1966 for

next two years.

c. Marketable securities costing $50,000

were purchased January 1, 1965.

d. Stock in affiliate company was acquired

in July of 1965.

e. Intangibles were acquired in January of

1963.

f. Leaseholds were acquired in January of

1965.

4. Land costing $10,000 was sold late in 1966

for $48,000.

5. Marketable securities costing $50,000 were

sold in December of 1966 for $52,000.

6. Unexpired insurance and supplies of $10,000

as of 12/31/65 were used entirely during 1966.

7. First-in-first-out method of inventory

pricing is used.

69

8. Bonds payable call for ^nnual interest

payment.

9. Dividends were received evenly throughout

the year.

Summary

Two methods of reporting the effects of price-

level changes have been discussed in detail. Financial

statements were provided to clarify the discussion and to

illustrate the different methods of financial reporting

for price-level changes. In the following chapter, this •

author will compare and evaluate the two methods in order

to highlight their respective strengths and weaknesses.

CHAPTER IV

AN EVALUATION OF THE TWO PROPOSALS

In the preceding chapter this author discussed

and illustrated two of the most current proposals for

reporting the effects of price-level changes on the finan­

cial statements. The current chapter presents a critique

of the two proposals.

Before one can make any meaningful evaluation, he

must establish a set of criteria to use in evaluating the

relative merits of the two methods. The criteria which

this author has chosen are as follows:

1. cost: the cost of obtaining and reporting data

which reflect the effects of price changes on

the financial statement.

2. accuracy: the reliability of data to be used

in comparisons, predictions, or other forms

of financial analysis.

3. objectivity: the uniformity of financial data

which is determined by two independent sources.

4. adaptability: the quality of a proposal which

enables it to conform readily to all types of

business enterprises.

5. relevance: the requirement that data have a

logical connection to the problem to which they

pertain. 70

71

6. simplicityt the ease with which a price-level

proposal can be applied to all financial

statements.

The reaminder of this chapter will be devoted to an

evaluation of the price-level proposals suggested in A

Statement of Basic Accounting Theory and Accounting Research

Study No. 6.

A Statement of Basic Accounting Theory

Cost

As discussed in Chapter III of this thesis, the

authors of the American Accounting Association monograph

designated the current cost of replacement as the basis

for reporting the effects of price-level changes. This

information is to be determined by current market prices

when available; otherwise, the adjustment is to be made by

specific price indices. In situations where neither cur­

rent market prices nor specific price indices are available,

an adjustment for the change in the general price-level

should be used as an alternative. Such an approach for

reporting the effects of changing prices is applicable to

most forms of business enterprise; however, the cost of

obtaining the price-level information of this type may

become prohibitive. Price-level data from catalogues,

indices, or market quotations are available at a nominal

72

cost. However, in certain instance.-, costly independent

appraisals may be necessary to determine the current

replacement cost of items such as oil, gas, minerals, and

other natural resources. Furthermore, the expense of

obtaining current cost data every year for these assets

can become prohibitive, especially for companies having

operations in various parts of the world.

Accuracy

If an approach to the price-level problem is to

produce the most accurate data possible, it should disclose

the following: (1) the actual value of assets and liabili­

ties of a business enterprise; (2) gains and losses re­

sulting from holding non-monetary assets during the current

period; (3) gains and losses resulting from the acquisition

or disposal of monetary assets and liabilities during the

period; and (4) the effect of general price-level changes

on the financial statements. In order to reflect all of

the above elements, the financial effects of both specific

and general price changes must be disclosed in the supple­

mentary statements. The approach recommended in A State­

ment of Basic Accounting Theory most nearly satisfies the

above requirements.

The authors of American Accounting Association

monograph recommend the use of current replacement cost

as the basis for reporting price changes. Such an approach

73

reflects the most accurate representation of assets and

liabilities since it takes into account price fluctuations

that are unique to specific industries, specific locales,

and technological advancements. As a result, items on

the balance sheet are reported at their actual values and,

thus, present the most realistic picture of a business

enterprise. Furthermore, the accuracy of financial analysis

is increased when the financial ratios are determined from

statements reflecting the true value of the business.

The second requirement of an accurate price-level

proposal necessitates the recognition of gains and losses

resulting from holding non-monetary assets during the

current period. The American Accounting Association pro­

posal, utilizing current replacement cost as the basis for

reporting the effects of changing prices, also satisfies

this requirement. Through the recognition of holding gains

and losses, the accuracy and reliability of both the income

statement and balance sheet is increased. Non-monetary

assets are restated to reflect their true values, and net

income becomes a more accurate measure of management's

stewardship as well as a more reliable predictor of future

earnings.

Although the Committee did not specifically mention

monetary gains and losses in Chapter III of A Statement of

Basic Accounting Theory, an analysis of the illustrative

income statement in Appendix B (or page 50 of this thesis)

74

reveals the recognition of these gains and losses. The

inclusion of these items in income determination reflects

changes in the purchasing power of the dollar and results

in a more accurate net income figure for use in financial

analysis.

The final requirement of an accurate price-level

proposal necessitates adjustment of the financial statements

for changes in the general price-level. The approach pre­

sented in the American Accounting Association monograph

only partially satisfies this requirement. Items on the

balance sheet are adjusted for changes in the general price-

level. The importance of this procedure is twofold. First,

monetary gains and losses are recognized; and, thus, the

accuracy of the income statement is increased. Second,

these adjustments must be made before holding gains and

losses can be accurately determined. On the other hand,

the proposal does not require an overall adjustment of the

income statement for general price-level changes. Expenses

such as depreciation or amortization are restated on the

basis of adjusted asset values in the balance sheet.

However, revenues and the other expenses are reported at

historical cost. Since these items are expressed in rela­

tively current terms, this author acknowledges the argument

that, in most instances, the accuracy of the income state­

ment will not be materially affected due to the failure

to adjust for changes in the general price-level. However,

75

it should be pointed out that such 'adjustments are desirable

for several reasons. First, sharp fluctuations in the

general price-level may materially affect the accuracy of

the income statement. This fluctuation could be noticeable

especially in companies operating on a seasonal basis.

Second, general price-level adjustments enhance the com­

parability of income statements of different periods,

companies, and industries. Third, the cost, if any, of

applying these adjustments is nominal since additional time

or data is not required. Fourth, such adjustments do

increase the accuracy of the income statement regardless

of the materlability of the benefit received. Finally, if

only for the sake of consistency, it is best to apply these

adjustments each year rather than to wait until the general

price-level fluctuates sharply enough to require them. In

light of these facts, this author feels that the benefits

of applying general price-level adjustments to the income

statement by far outweigh the arguments against such

adjustments.

Objectivity

The objectivity of current replacement cost data

is a major area of concern in the acceptability of the

American Accounting Association proposal. Although this

author favors the use of current replacement cost data as

the basis for reporting the effects of price changes.

76

information obtained from sources such as buyers' cata­

logues or appraisals is subject to possible manipulation

or personal bias. Also, the objectivity of this approach

is further hampered since the Committee failed to recom­

mend some form of authoritative support for the replace­

ment cost data. Apparently, the authors of the monograph

intend to give management full discretion as to the dis­

closure of such information.

Adaptability

The method proposed by the American Accounting

Association for reporting the effects of changing prices

is readily adaptable to most forms of business enterprises.

For example, the price-level data required by this approach

are as readily available for a merchandising concern as

for a manufacturing concern. However, several minor

difficulties may be encountered in its implementation.

Current replacement cost data may, in certain instances,

be difficult to obtain accurately for the following items:

unlisted, untraded securities; assets located in foreign

countries; and assets located in isolated areas. For

instance, large conglomerates with foreign holdings may

have difficulty in obtaining current cost data for specific

assets. These problems are of a very minor nature and,

as such, do not limit the overall adaptability of the

approach.

77

Relevance

The primary purpose of financial reporting is to

provide data upon which external users can rely. There­

fore, it is essential that data reported be as relevant

as possible to the needs of the users. Under current

economic conditions, financial reports must include supple­

mentary price-level information to satisfy this require­

ment. The degree to which supplementary data are neces­

sary to satisfy the needs of external users depends, in

part, on the extent of price fluctuations during the year.

Furthermore, the actual value of a business enterprise

and, thus, the accuracy of the financial statements can

be materially affected by two factors: (1) the changes

in the value of non-monetary assets due to an increase in

specific market prices; and (2) the changes in the general

price-level during the year. Therefore, if financial

reports are to supply external users with data most rele­

vant to their needs, the effect of both types of price

changes on the assets, liabilities, and income of a company

roust be disclosed, in the opinion of this author, the

approach recommended by the American Accounting Association,

taken as a whole, provides for disclosure of the most

relevant information concerning the effect of changing

prices.

78 t

Simplicity

Since the American Accounting Association's

proposal reflects not only changes in the general price-

level, but also specific price changes, it is more difficult

to implement than those approaches which deal with only one

aspect of price variations. Also, the additional time and

sources of price-level data required for the proposal

increase its complexity. This may be illustrated in its

application to consolidated or diversified companies.

Accounting Research Study No. 6

Cost

The Research Division of the A.I.C.P.A. suggested

the Gross National Product Implicit Price Deflators as

the index to be used in adjusting financial statements for

changes in the general price level. These deflators are

easily obtainable since they are published in the Survey

of Current Business. Furthermore, the adjustment of the

financial statements by these deflators can be performed

by the company's own accounting personnel in a minimum

amount of time. Consequently, the cost of implementing

such a proposal is nominal.

79

Accuracy

The authors of Accounting Research Study No. 6

recommended reporting only the effects of general price-

level changes on the financial statements. Such an approach

is accurate only during periods in which specific price

movements are relatively stable. In periods when price

movements fluctuate, serious reporting errors on both

financial statements may occur.

It is possible for the specific prices of non-

mo'netary assets and the general price-level to move at

different rates and even in different directions. When

this movement occurs, state.ments adjusted only for changes

in the general price-level do not present a true picture

of the actual value of a business enterprise. For example,

if the specific price of a depreciable asset decreases

while the general price-level increases, the true value

of the asset is overstated in the balance sheet, and net

income is understated on the income statement. The primary

reason for such a misstatement stems from the fact that

specific price changes are not reflected in the balance

sheet, and holding gains and losses are not included in

income determination. As a result, the accuracy of finan­

cial statements for use in financial analysis is question­

able when the statements are adjusted only for general

price-level changes.

80

Objectivity

The criterion of objectivity is adequately met by

the proposal in Accounting Research study No. 6. The

Gross National Product Implicit Price Deflators used to

adjust the financial statements are verifiable since they

are published quarterly in the Survey of Current Business.

Also, the adjusted financial statements are verifiable

since they are the result of historical cost of items on

both financial statements multiplied by the applicable

general price-level index. Finally, the use of completely

verifiable indices reduce the possibility of manipulation

or personal bias into the financial statements.

Adaptability

The proposal in Accounting Research Study No. 6

for reporting the effects of price-level changes is adapt­

able to all forms of business enterprise. Financial state­

ments are adjusted with a conversion factor based on changes

in the general price-level as measured by the Gross

National Product Implicit Price Deflators. Since specific

data concerning market values of non-monetary assets are

not required, the method can be easily applied to all

business organizations.

81

Relevance

The relevance of a price-level proposal is determined

by the degree to which it solves the problem of fulfilling

the data needs of external users. The proposal presented

in Accounting Research Study No. 6 recommends an adjustment

only for changes in the general price-level. This factor

is important in adequately disclosing the effects of price

changes to external users. However, changes in the specific

value of non-monetary assets are also extremely important

since the failure to disclose these changes may result in

serious misrepresentations on both financial statements.

As a result, the reported data do not present a true picture

of the business enterprise. Therefore, a price-level pro­

posal must reflect both types of price changes if it is to

satisfy completely the data needs of external users. In

conclusion, since the proposal presented in Accounting

Research Study No. 6 reflects only the financial effects

of general price-level changes, it is not as relevant to

the reporting problem as one which considers both general

and specific price changes.

Simplicity

Adjustment of financial statements for general

price-level changes is one of the most simple of all price-

level approaches. The entire adjustment process requires

82

the use of only one outside source of information, the

Gross National Product Implicit Price Deflators. There­

fore, these adjustments can be as easily applied to a

small corporation as to a large conglomerate.

Importance of Criteria

At the beginning of this chapter, six criteria

for the purpose of evaluating the two price-level pro­

posals were presented. Thus far, each of the criterion

ha^ been assumed to have equal importance. However,

before this author can propose an alternate solution to

the price-level problem, he must establish the relative

importance of each criterion.

This author feels that relevance is the most

important of the criteria in reporting price changes.

Although such data may not always be completely verifiable,

in most instances it is sufficiently verifiable to be used

in reporting the effects of price changes.

The criterion of accuracy is second in importance.

This criterion depends, to a great extent, on the relevance

of the data reported. As a rule, the more relevant the

data used in financial reporting, the more accurate the

reports will be for purposes of financial analysis.

The criterion next in importance is that of

objectivity. It is an essential characteristic of all

types of reported data. However, a strict interpretation

83

of this criterion eliminates much d-ta relevant to the

price-level problem. Consequently, this criteria must be

sacrificed to a certain extent to obtain the highest degree

of relevance and, thus, accuracy.

The remaining criteria—cost, simplicity, and

adaptability—are of approximately equal importance. The

degree to which they apply will depend on the particular

circumstances of individual cases.

A Review of the Evaluations

A Statement of Basic Accounting Theory

A review of the evaluation of the American Accounting

Association's monograph reveals its relative strengths

and weaknesses. Its major strongpoints are increased

relevance and accuracy. However, the areas of cost, adapt­

ability, and simplicity have several minor limitations.

Finally, the criterion of objectivity is the only major

limitation to the proposal.

Accounting Research Study No. 6

The major strongpoints of this proposal revealed

in the evaluation were cost, objectivity, adaptability,

and simplicity. However, the proposal has major limita­

tions in the areas of accuracy and relevancy.

84

Summary

Chapter IV has presented an evaluation of the two

monographs according to the following criteria: cost,

accuracy, objectivity, adaptability, relevance, and

simplicity. This evaluation has highlighted the strengths

and weaknesses of each method. In the following chapter

this author proposes an approach to the price-level

problem which combines the strengths and eliminates the

weaknesses of each method.

CHAPTER V

A SUGGESTED PROPOSAL

In the preceding chapter, this author evaluated

the price-level proposals presented in A Statement of

Basic Accounting Theory and Accounting Research Study

No. 6. A review of the evaluation presented in chapter IV

of this thesis reveals the American Accounting Association

monograph is strongest in the areas of relevance and

accuracy whereas the Research Study is strongest in the

areas of objectivity, adaptability, cost, and simplicity. •

The purpose of this thesis, as stated in the first chapter,

is to present a price-level approach which incorporates

the strong points of each method. The remainder of this

chapter presents a proposal which, in the opinion of this

author, accomplishes the stated objective.

General procedures

A combination of the strong points of the two

proposals will recognize both specific and general price-

level changes. This author recommends the following pro­

cedures to accomplish this task:

1. Annual adjustment of both financial statements

for changes in the general price-level.

85

86

2. Revaluation of non-monetary assets periodically

to reflect their current value.

3. Disclosure of price-level data as supplemental

Information to the conventional statements.

General Price-Level Adjustments

changes in the general price-level are reflected

each year on both financial statements. This author con­

siders the Gross National Product Implicit Price Deflator

acceptable as a measure of changes in the general price-

level .

Monetary Items

Since these items are already expressed in current

terms, they will not require an adjustment at the end of

the current year. It will be necessary to adjust the prior

year end balances of monetary items for general price-

level changes to facilitate comparisons. Also, monetary

gains and losses which arise from the maintenance or dis­

position of monetary assets and liabilities must be deter­

mined each year. The procedures described in Chapter III

of this thesis are acceptable for determining these gains

and losses.

87

Non-Monetary Assets

Since non-monetary assets are periodically re­

stated, the base period index upon which a conversion

factor is computed becomes either: (1) the general price-

level at the end of the year of the most current revaluation;

or (2) the general price-level index at the close of the

preceding year. For example, assume the historical cost

of a non-monetary asset is $100,000. On December 31, 1967,

the current market value has increased to $200,000. The

$200,000 is used for purposes of disclosing price-level

changes in the financial reports for 1967. However, if the

current market value of this asset (as well as the other

non-monetary assets) does not fluctuate sufficiently to

warrant further revaluation, the $200,000 valuation is

adjusted for changes in the general price-level during the

next year. Therefore, if the year end price-level index

for 1967 was 104.0 and the year end index for 1968 was

106.0, the conversion factor would be computed as follows:

Current Year End Index—1968 106 = 1.0192 Base Year Index—1967 104 conversion factor

The $200,000 value would be adjusted by multiplying it by

the conversion factor. Thus, the value disclosed in the

1968 financial reports would be $203,840. To carry the

illustration one step further, assume that in 1969 the

general price-level rises to 108 and the specific prices

88

do not change enough to warrant a ••otal revaluation. The

conversion factor could then be determined in either of

the two ways mentioned above. First, it may be based on

the index prevalent at the close of the year in which the

most current revaluation occurred. Under this approach,

the conversion factor would be determined as follows:

Current Year End Index--1969 108 - ^ o384 Base Year Index—1967 104 conversion factor

The revalued $200,000 asset value would then be multiplied

by the 1.0394, and the reported value would be $207,680.

Under this approach, when the asset is subsequently re­

valued to reflect its current replacement cost, the year

of revaluation becomes the new base year. If the second

alternative is used to determine the conversion factor,

the computation is made as follows:

Current Year Index—1969 108 - 1.0189 Base Year Index—1968 106 conversion factor

In this situation, the revalued cost of the asset, which

subsequently has been adjusted for changes in the general

price-level, is further adjusted by the new conversion

factor. In the illustration above, the $200,000 market

value of the asset was adjusted for the 1968 general price-

level change to reflect a value of $203,840. For 1969

reports, the $203,840 would be adjusted again by the

1.0189 conversion factor which was computed using 1968 as

89

the base year. Thus, the adjusted value to be reported

would be $207,692. The $12 difference in the two approaches

Is caused by rounding and is immaterial.

It should be pointed out that these adjustments

should be made every year regardless of whether the non­

monetary assets are revalued to reflect their current

cost. There are three reasons for these annual adjustments.

First, only after these adjustments are applied can the

actual "holding gain or loss" due to specific price changes

be computed. Second, these adjustments reflect the gain or

loss from holding or disposing of monetary items during the

year. Recognition of both types of gains and losses men­

tioned above are necessary to provide the desired accuracy

of the income statement. Third, annual general price-level

adjustments update asset values between periods of

revaluation.

Finally, this author advocates adjustment of the

income statement for changes in the general price-level.

Sales and current expenses should be adjusted by the average

index of the general price-level index for the current year

if they are earned or incurred evenly during the year. When

they are earned or incurred seasonally, the general price-

level index applicable to the particular season should be

used. Naturally, items such as depreciation or amortization

are computed from the adjusted asset values on the balance

sheet and would not require this adjustment.

90

Specific Price Changes

As stated at the conclusion of Chapter IV, this

author considers relevance and accuracy the two most

important criteria in an acceptable price-level proposal.

In order for a price-level approach to provide data which

satisfy these criteria, it is necessary that the effects

of specific as well as general price changes are reflected

in the adjusted financial statements. However, financial

reporting which discloses the effects of specific price

changes is often more costly, more difficult to apply, and

more complex than general price-level adjustments. Specific

price data lacks the objectivity which can be afforded

general price-level data. This author offers the following

suggestions to minimize these limitations.

Periodic Revaluation

The complexity of the process used to obtain and

introduce current replacement cost information in the

financial reports may cause the expense of implementing

this type of information annually to be prohibitive. This

author feels that a periodic current cost revaluation should

be applied to all non-monetary items on the balance sheet

in the year such action is deemed necessary to insure the

accuracy of the financial statements. Individual assets

will not be revalued during the interim betv een the major

91

current cost revaluations. Since it is highly possible

that the value of non-monetary assets will not fluctuate

enough to warrant revaluation each year, this procedure

reduces both the cost and complexity of uitlizing specific

price data in financial reporting.

Basis for Current Cost Data

Current cost of replacement is used in the American

Accounting Association monograph as the basis for reflecting

the current value of non-monetary assets. This author

considers this basis as well as the sources provided in

the monograph acceptable for obtaining current cost data.

However, due to the nature of current cost data, serious

objections can be raised from the standpoint of objectivity.

This type of data is easily manipulated and subject to

personal.bias. To compensate for these limitations, this

author recommends certification as to the validity of such

data by independent Certified Public Accountants. Such a

requirement provides the authoritative support necessary

to insure reliability, and at the same time, remove the

danger of manipulation or personal bias entering into the

financial reports. Also, it should be noted that conven­

tional accounting recognizes arbitrary allocations which

are subject to personal bias. As a result, both financial

statements are composed of estimates which are often

inaccurate and unreliable for use in financial analysis.

92

This author realizes that ouch iterr..- are based on estimates

for the sake of simplicity, practicality, and necessity.

However, in view of these facts, it is very unrealistic

to prohibit price-level information on the grounds that

it lacks objectivity, especially when these data provide

the most accurate picture of a business enterprise.

Holding Gains and Losses

In A Statement of Basic Accounting Theory, gains

and losses from current cost valuations were recognized.

This author considers the recognition of such "holding

gains and losses" necessary to the accuracy of the income

statement, since the proposal recommended in this chapter

provides for only periodic revaluations, it is imperative

to accrue these gains and losses between periods of revalua­

tions. The accrual will be based on past fluctuation in

the prices of specific assets as well as estimates of

future changes based on current economic conditions. For

those who criticize such a procedure, this author reminds

them of the conventional accounting procedure of estimating

future income tax liability which is determined in the

same manner.

Method of Disclosure

This author agrees with both .monographs which

recommend disclosure of price-level information as

93

supplemental information. Either of the methods proposed

in the two monographs is acceptable for disclosing such

data.

Advantages of Proposal

The primary advantage of this proposal is its

recognition of both general and specific price changes.

This procedure results in the disclosure of more relevant

and, thus, more accurate information for use in financial

analysis by external users. Also, unique to this proposal,

is the reduced cost and complexity of its implementation.

This is mainly a result of periodic revaluations of non­

monetary assets rather than determining their current

value annually.

Limitations of proposal

The recognition of current replacement cost may

cause minor difficulties for consolidated or diversified

companies. This problem is unique to the nature of specific

price fluctuations and exists in any proposal reflecting

specific price movement. This is a minor limitation in

that it is probably not applicable to most situations.

The other limitation to this proposal concerns the objec­

tivity of current cost data. This author considers objec­

tivity an important factor in determining the reliability

of accounting data for external use. However, where

94

objectivity is required to the extent of eliminating

accurate accounting data, the criterion must be re­

evaluated. Objective data which does not present an

accurate picture of a company are of little value in

financial analysis and may also be highly misleading.

As a result, the criterion of objectivity must be sacri­

ficed, to a certain extent, if price-level data are to

produce the most accurate results. Also, the sources of

current cost data provided by the American Accounting

Association monograph are sufficiently verifiable for use

in disclosing the effects of price fluctuations on a

business enterprise. This fact, coupled with the recom­

mendation to include price-level information in the

auditor's opinion removes in part the danger of personal

bias or manipulation entering into the price-level

disclosures.

Summary

Chapter V presented a compromise approach to the

price-level problem. The proposal utilizes the recognition

of general price-level changes annually and specific price

changes periodically. This author feels this proposal

provides accurate and relevant information to external users

at a reduced cost because of its simplicity.

95

The concluding chapter of tiiis thesis summarizes

the preceding five chapters and presents this author's

conclusions jpertaining to the price-level problem.

CHAPTER VI

SUMMARY AND CONCLUSIONS

A general statement of the accounting problems

created by changing prices as well as a discussion of the

need for disclosure of the effects of these price fluctua­

tions in the financial reports was presented in chapter I.

As previously stated, the objectives of this thesis are

to evaluate the two monographs—A Statement of Basic

Accounting Theory and Accounting Research Study No. 6—

and to provide a new approach which incorporates the strong

points of each of these proposals. Certain definitions

unique to price-level accounting are presented and the

chapter concludes with an outline of the development of

the remaining chapters of the thesis.

The second chapter traces the historical develop­

ment of price-level accounting in the United States. The

discussion is divided into two periods—1900 to 1940, and

1940 to the present. The most important events in the

first period are the stock market crash, establishment

of the Securities and Exchange Commission due to the lack

of statutory regulation, and a shift in the importance

from the balance sheet to the income statement. The study

of the second period includes a discussion of the litera­

ture which reflected the growing concern of the accounting

96

97

profession over price fluctuations. The two major bodies

concerned with these fluctuations were the American

Accounting Association and the American Institute of

Certified Public Accountants. During this period, both

organizations issued several publications dealing with

these problems. The most current publication of the

American Accounting Association is A Statement of Basic

Accounting Theory in which the authors recommend current

replacement cost as a basis for reporting the effects of

price changes. The American Institute's most current

publication is a statement of the Accounting Principles

Board entitled Financial Statements Restated for General

Price-Level Changes. This publication reaches the same

conclusions as those in an earlier publication of the

Research Division of the Institute entitled Accounting

Research Study No. 6. However, Financial Statements

Restated for General Price-Level Changes provides guidelines

for preparing general price level statements; whereas, the

earlier publication did not. A brief^ discussion pertaining

to the instability of money, specific and general price

changes, and the objectives of price-level adjustments in

financial reportings is included in this chapter.

A discussion and illustration of two price-level

proposals are presented in Chapter III: first, that of

the American Accounting Association presented in A

statement of Basic Accounting Theory; second, that of the

98

Research Division of the American Institute of Certified

Public Accountants presented in Accounting Research Study

No. 6. The American Accounting Association recommends the

use of current replacement cost as a basis for accounting

for the effects of price-level changes. Although the mono­

graph does not specifically refer to general price-level

fluctuations, the approach does recognize their effect on

the balance sheet through consideration of monetary gains

and losses. The approach presented in Accounting Research

Study No. 6 recommends the disclosure of only general

price-level changes with the Gross National Product Implicit

Price Deflators as the only index reliable enough to measure

these fluctuations. Both monographs suggest disclosure of

price-level data in supplemental form.

In Chapter IV of this thesis, six criteria were

suggested to be used in evaluating the proposals presented

by the American Accounting Association and the Research

Division of the American Institute. The criteria used in

this evaluation are cost, accuracy, objectivity, adapt­

ability, relevance, and simplicity. A review of the

evaluation indicates that the American Accounting Associa­

tion's proposal is strongest in the areas of accuracy and

relevance with a major limitation in the area of objectivity,

The Research Division's proposal is strongest in the areas

of cost, simplicity, adaptability/ and objectivity with

major limitations in the areas of relevance and accuracy.

99

The chapter also discusses the relative importance of each

criteria in an acceptable price-level proposal. It was

established that relevance is the most important criterion

with accuracy second and objectivity third. The remaining

criteria—cost, simplicity, and adaptability—are of equal

importance. The degree to which they apply depends on the

particular circumstances.

In Chapter V, a proposal for disclosing the effects

of price-level changes on a business enterprise was pre­

sented. The proposal suggests disclosure of the effects

of both general and specific price changes on both

financial statements. The unique aspect of this proposal

is the periodic revaluation of the non-monetary items on

the balance sheet as opposed to annual revaluations. Such

a procedure reduces the cost and complexity of such an

approach while, at the same time, provides accurate and

relevant information. The major limitation of this pro­

posal is the lack of objectivity which surrounds current

replacement cost data. In order to compensate for this

limitation this author recommends that such data be in­

cluded in the auditor's opinion.

Conclusions

Upon a careful analysis of the effects of changing

prices on financial statements, this author concludes the

100

following. First/ fluctuating pri «?s pose a serious

problem In the area of satisfying the information needs

of external users. Second, it is a necessity that the

accounting profession deal with this problem if it is to

retain the confidence of the business community as a whole.

Third, there is no one acceptable solution to the problems

of accounting for price-level changes. A pragmatic solu­

tion to the problem was developed in the proposal which

Incorporates the strong points of the price-level pro­

posals presented in A Statement of Basic Accounting Theory

and Accounting Research Study No. . Finally, the

accounting problems created by fluctuating price levels

should be dealt with through continuing research.

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. •>^':'"V