In much of Europe during the 1970's inflation ran at a very high level. This article describes the effects and reasons of price change on the historical cost based financial statement. By using the CPP and CCA model, the adjustment should be made to account during inflation. And the current view of IASB is also clarified.
Introduction
As early as 12th century, under the control of Henry I, England faced a dramatic fall of the value of silver coins. From that, most of the Europe countries had experienced the inflation, and the inflation had spread all over the world. (Hewitt, 2007) As an economic phenomenon which has worldwide influence, inflation is defined as "an increase in the price of a basket of goods and services that is representative of the economy as a whole." (www.economics.about.com) In the 1970s, the world suffered the great inflation. From 1973 through 1983, the Consumer Price Index (CPI) rose an average of eight percent per year with the incomes increased at an average of ten percent. (Keefe,2009). This inflation was caused by many reasons: the political environment, the overheated economy as well as the embargo on Arab oil in 1973. To solve the inflation problem, governments take measures such as increasing the interest rate. Inflation made specific price changes and the unbalanced relationship between the supply and demand. Ignoring inflation can lead to a variety of accounting problems and these problems are at their worst if the currency being used of a hyperinflationary economy. This report will describe the effects that price changes can have on historical cost based financial statements, why and how the adjustments should be made to account for changing price levels, the two main systems for making these adjustments and the current view of the International Accounting Standards Board (IASB).
The price changes effects on historical cost
Historical cost accounting (HCA) refers to "the traditional method of accounting whereby each transaction is recorded at its monetary amount at the time of the transaction and no attempt is made to adjust the recorded amounts to take account of inflation." (Melville,2009) Financial statement is measured in units of currency and usually we assumed that the value of the currency being used is stable. As the price changes, the effects of it are very clear considering the valuation of assets in a balance sheet. For example, land and buildings may be recorded and added together at a variety of values which are measured by the historical cost and subsequent valuations. Similar properties may be recorded and added together at very different values because they were bought at different times. For those users of a balance sheet who are expecting to gain information about the value of a business, such balance sheet may be misleading. Furthermore, the profit of such balance sheet is calculated complicated. (Alexander & Nobes, 2004) For instance, if Jone ran his business on ï¿¡100, and he bought a bag on ï¿¡40 in Jan. 2nd as an inventory. He sold it on ï¿¡50 in Jan. 4th, and then bought the same bag on ï¿¡44 in Jan. 6th. So we build the statements on the next days. The profit maybe simply calculated by 50-40=10. In the Jan 5th, after the sales, Jone had increased his money on ï¿¡110. If we take the ï¿¡10 as the gains, the business had the same amount of capital as the origin in Jan. 8th. However, if we compared the business in Jan. 3rd and the Jan. 9th, we found that both of them had a bag and some cashes. In terms of bag, the business had one bag with one bag, and the business had the same size. In terms of money, the business had 60 pounds in Jan.3rd, and it had only 54 pounds in Jan. 9th. The business was therefore got smaller by 4 pounds. Thus, something must be wrong if we calculate this way.
Why adjustments should be made to account?
Historical cost accounting is well-established, and it is a comparatively simple accounting system that all accountants understand. In addition, the key characteristic is objective. (Melville, 2009)The transaction-based historical cost was used by the UK without challenged until the price level changed rapidly in the 1950s and reached an annual rate of increase of 20% in the mid 1970s.(Elliott&Elliott,2009) The weakness of the historical cost accounting had gradually revealed, and the inflation had exacerbated the problems. The HCA defects including:
"Profit is overstated when inflationary changes in the value of assets are ignored.
Comparability of business entities, which is so necessary in the assessment of performance and growth, becomes distorted.
The decision-making process, the formulation of plans and the setting of targets may be suboptimal if financial base data are out of date.
Financial reports become confusing at best, misleading at worst, because revenue is mismatched with differing historical cost levels as the monetary unit becomes unstable.
Unrealised profits arising in individual accounting periods are increased as a result of inflation." (Elliott& Elliott, 2009)
We continue to discuss the example we mentioned before. If the comparison is correct, then the gains of ï¿¡10 was not true. Actually, selling the firstbag and buying the second bag are two parts of a complete action. If he didn't sell the first one, he could not buy the second bag. In fact, the gain of this transaction is 50-44=6. We assumed the profit is ï¿¡6, this will reduce the maximum drawing of 10-6=4, which will fit the "smaller size" of 4 pounds. As a result, it may be more informative if the cost of sales figure related to any particular sale is calculated as equal to the cost of the resulting replacement, rather than to the cost of the item actually sold. The replacement figure must be recorded in the balance sheet. It is the double entry for an increase in the recorded figure for an item of inventory.
In order to combat the defects of HCA, some adjustments should be made to account for changing price levels such as the Current purchasing power (CPP), Current entry cost or replacement cost (RC), and Net realisable value (NRV).
Two main systems for making adjustment: CPP and CCA
Proposed alternatives to historical cost accounting are fall into these two categories: Current purchasing power (CPP) accounting and Current cost accounting (CCA).
Current purchasing power (CPP)
CPP system measures income and value by adopting a price index system. The basic principle is that each transaction shown in the historical cost financial statements is adjusted to reflect the change in the general purchasing power of money since the transaction took place. (Melville, 2009) HCA and CPP are both transaction-based models that apply the financial maintenance concept, which means that the profit is the difference between the opening and closing net assets or the opening and closing net assets adjusted for any capital introduced or withdrawn during the month. (Elliott&Elliott, 2009)
CPP adjustments:
All historical cost values are adjusted to a common index level for the month.
The application of a general price index as an adjusting factor results in the creation of an alien currency of purchasing power, which is used in place of sterling.
Note the application of the concept of gain or loss on holding monetary items.
CPP accounting is fairly straightforward, and it has both virtues and shortages.
CPP virtues:
It is an objective measure.
It is a measure of shareholder's capital and that capital's maintenance in terms of purchasing power units.
It introduces the concept of monetary items as distinct from non-monetary items and the attendant concepts of gains and losses in holding net monetary liabilities compared with holding net monetary assets.
CPP shortages:
It is HCA based but adjusted to reflect general price movements.
It may be wrongly assumed that the CPP statement of financial position is a current value statement.
It creates an alien unit of measurement still labeled by the ï¿¡sign.
Its concept of profit is dangerous. (Elliott& Elliott, 2009)
Current cost accounting (CCA)
CCA adopts the approach as physical capital maintenance. The basic principle of CCA is that assets consumed during an accounting period are shown in the statement of comprehensive income at their current values at the time of consumption and assets remaining at the end of the period are shown in the statement of financial position at their current values at the end of the period. (Melville, 2009)
In order to prepare current cost financial statements, a number of adjustments to the historical cost figures must be made. Adjustments are needed relating to: fixed assets, depreciation, stock, cost of sales, monetary working capital and gearing. Other than the gearing adjustment, no adjustment is made to monetary assets such as debtors or to monetary liabilities such as creditors. (Wood& Sangster, 2005)
CCA takes account of specific price inflation and introduces an undesirable element of subjectivity into financial statements, CCA has the following uses:
The operating capital maintenance statement reveals CCA profit.
Significant increases in a company's buying and selling prices will give the HCA profit holding gains content.
By using the operating capital maintenance approach, only CCA can operate profits as the authentic result for the period.
CC profit is very important. (Elliott &Elliott, 2009)
Current view of the International Accounting Standard Board (IASB)
The IASB in the UK is deciding how to respond to inflation rates that have varied widely over time. Whatever the rate of inflation is, the standard setters need to carry prepares and users of accounts with them.
When the inflation rate around the world was in double figures, there was pressure for a mandatory standard. The issue of IAS15 Information Reflecting the Effects of Changing Prices in 1983 required companies to restate the HCA accounts using either GPI or replacement costs. As the rates of inflation fell, the IAS15 became optional. In 2003, IAS15 was withdrawn as part of the ASB Improvement Project.
Accounting for inflation seems less important in most developed countries, but there is still a pressing in those "hyperinflation" countries. This led to the development of international standard IAS29 Financial Reporting in Hyperinflationary Economies. Hyperinflation occurs "when money loses purchasing power at such a rate that comparison of amounts from transactions that have occurred at different times, even within the same accounting period, is misleading." (Elliott& Elliott, 2009) IAS 29 indicates that hyperinflation exists in those countries which people prefer to keep their wealth in non-monetary assets, etc. To adjust the financial statements, whether using HCA or CCA, it should restate using the domestic measuring unit current at the statement of financial position date.
IAS29 disclose the requirements of an entity which has restated its financial statements:
The fact that the financial statements and the comparative figures for previous periods have been restated to adjust for the changes of purchasing power.
Whether the original financial statements are based on the historical cost approach or the current cost approach
The identity and level of the price index at the end of the reporting period and the movement in this index.(Melville, 2009)
Conclusion
Historical cost accounting was challenged by price change. It will be invalid assumption during the inflation. It will damage the benefits of the shareholders and the entities themselves. Adjustments are required to solve these problems. Two main methods, CPP and CCA, are adopted to adjust the price changes. Therefore, in terms of current views of IASB, the accounting standard has been developed to react to inflations in different rates.
Recommendation
Inflation has huge impact on the financial statements. Ignoring the inflation is unwise. CPP and CCA are two useful systems when considering about a company. As young shareholders, use those methods effectively will increase the probability of getting higher returns. Otherwise, IASB approach can be used to financial reporting by small and medium-size entities.
