Posts Tagged ‘Inflation accounting’

Today I’m publishing the first guest post in The Summa‘s history.  Written by Robert (Bob) Jensen, Trinity University Emeritus Jesse H. Jones Professor of Accounting, it was originally sent out on the AECM listserv.  Given that the AECM policy is that anything sent out is in the public domain, and given that Bob frequently captures e-mail postings and puts them on his own web site, I’m just going to publish his letter.

by Robert (Bob) Jensen
Trinity University Emeritus Jesse H. Jones Professor of Accounting

Before I begin, I would like to mention an old theory case that I taught years ago that for students concisely explains the difference between financial statements prepared under historical costs, price-level adjustments, replacement costs, and exit values —  www.cs.trinity.edu/~rjensen/temp/wtdcase2a.xls.  It was almost always considered one of the best take aways from my theory course even though students worked on it the first day of the course.

Now on to:  “Is Inflation a Problem for Accounting?” by David Albrecht, The Summa, September 25, 2011.

Firstly, I would like to thank David for making both a timely and scholarly blog posting. I agree with David’s criticisms of the FASB and IASB for not requiring price-level adjusted (PLA) statements at lower trigger points for inflation.

One article that I really like concerning inflation is “Inflation and Delusion,” by Edward Jaffe, dshort.com, May 26, 2010.  This ties directly into David’s blog post.

I don’t think David’s reference to the defunct FAS 33 has much bearing other than to point out that price level adjustments (general or current cost) are not worth much if they are poorly done to save the cost of generating more accurate numbers. So much leeway for error was allowed in FAS 33 that I’m in sympathy with analysts who purportedly ignored the supplementary FAS 133 statements in annual reports (see my discussion at http://www.trinity.edu/rjensen/Theory02.htm#FairValue).

Consideration must also be given to the fact that in nations having higher inflation contracts are generally written/indexed to make inflation no longer such a big risk in terms of the contracts themselves. Of course changes in inflation rates might indirectly affect business revenues and costs apart from the inflation adjustments in contracts. For example, inflation rates can affect export and imports even if they do not affect demand deposits in banks.

And students should definitely keep in mind that neither general PLA adjustments nor replacement cost adjustments are surrogates for “value” accounting. Both are simply adjustments to historical costs to allow for changes in either general purchasing power or relative price changes in different economic sectors.

The real economic problem becomes when longer-term contracts are not indexed to inflation as often happens when inflation is considered relatively modest (as in the U.S.) rather than extreme (as in Israel). Present FASB accounting standards are not doing a good job in isolating monetary-item gains and losses.

Don’t forget to take a look at www.cs.trinity.edu/~rjensen/temp/wtdcase2a.xls.

Thanks very much, Bob.

Debit and credit – – David Albrecht

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According to my naked eye, the U.S. is afflicted with significant inflation.  Food prices are up.  Gasoline and transportation prices are up.  Healthcare prices are up.  Clothing prices are up.  Entertainment prices are up.  Higher education tuition is up.  Everything is up, except my mortgage payments.  These are increasingly difficult to pay given that higher education wages have remained constant for the past ten years and I have less left over at the end of the month.

But is inflation large enough to impact the interpretation of financial statements?  As I discuss in this essay, the answer is YES!

To address the issue of the impact of inflation on financial statements, we need a not too biased estimator of the rate of inflation.

According to information released by the Bureau of Labor, inflation (as measured by the CPI) has been relatively low over the past ten years, usually averaging 2-3% per year.  I have always been skeptical of these reports, for three reasons.  First, the reported government figures don’t agree with my perception of the change in prices.  I think that inflation has been higher.  Second, the U.S. government has significant incentives to under report inflation.  A low reported inflation rate means that government transfer payments (such as social security) are minimized.  Also, a high reported inflation rate has adverse impacts on the ruling party’s (Republican or Democrat) to remain in power.  Third, I’m aware that the methods used to calculate the CPI have changed during the past 30 years.  For example, volatile changes in prices are minimized in the weighted average index.

So, how high has been inflation using non-government supplied computations?  Such a computation would remove the government bias, but possibly introduce new biases.

I use Shadow Government Statistics, which is owned by American Business Analytics & Research LLC, a company founded by John Williams.  It uses his methods to recompute the rate of inflation using the same government methodologies in place in 1980.  According to his data, inflation has been averaging about 10% per year for at least a decade.

credit: Shadow Government Statistics.

Inflation data provided by SGS feels about right to me, and I view it as credible.  If inflation is this high (≥ 10%), then analysis of financial statements should be based on inflation adjusted numbers.  For example, if a company has been reporting an upward trend in revenues, adjusting the numbers for constant dollars might reveal a real decreasing trend in revenues.

Moreover, we need guidance from accounting standard setters as to the principles to use in financial statement preparation so that inflation adjusted numbers can be used for comparisons.  Unfortunately, this is not about to happen anytime soon under the leadership of Hoogervorst (IASB) and Seidman (FASB), because something this useful would run counter to government policy.

Never-the-less, if you are a financial statement analyst, you should be performing some inflation adjustments.

For guidance, you might refer to a copy of the obsolete Statement of Financial Accounting Standards #33 or the outdated IAS #29 (which predates IFRS).   Be aware that the IAS standard doesn’t require inflation adjusted information until inflation hits 100% over a three year period (about 26% per year).

Debit and credit – – David Albrecht

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