In this article we will discuss about inflation accounting in USA, UK and India.
Inflation Accounting in United States of America (USA):
Accounting bodies in USA have been concerned with the impact of price changes on financial reporting since many years ago However, considerable attention could be given to inflation accounting only in 1969 when the Accounting Principles Board (APB) issued Statement No. 3 “Financial Statements Restated for General Price-Changes” which recommended supplementary disclosure of general price level information.
Since then this topic gained interest and in 1974, the Financial Accounting Standards Boards issued an Exposure Draft, Financial Reporting in Units of General Purchasing Power, which proposed mandatory supplementary disclosure of general price-level adjusted statement.
While this FASB’s Exposure Draft was under study, Securities and Exchange Commission, in 1976, issued Accounting Series Release No. 190 (ASR 190) which required large firms to disclose particular replacement cost data Shortly, after ASR 190 was issued, the FASB withdrew its 1974 Exposure Draft and in September 1979 issued Statements of Financial Accounting Standards No 33 (FAS 33), “Financial Reporting and Changing Prices” Shortly after the issuance of FASB Statement No. 33 the SEC announced its decision to withdraw the replacement cost disclosure rules set forth by ASR No 190.
Before discussing FAS 33, it should be understood that in United States financial reporting has a dual regulatory structure, with the FASB and the SEC being the primary authorities. The SEC has been given statutory power by the Securities Acts of 1933 and 1934 to ensure satisfactory financial reporting to serve the public interest.
In setting standards and disclosure rules, the SEC aims to assure the public availability in an efficient and reasonable manner on a timely basis of reliable, firm-oriented information, material to informed investment, and corporate strategic decision-making.
The SEC had usually relied on the accounting profession to establish generally accepted accounting principles with respect to annual reports and statements filed with it. By issuing FAS 33, which requires mandatory supplemental information pertaining to the effects of changing prices on business operations, the general objective of the FASB has been to improve the relevant informational content of financial statements.
In FAS 33’s statement of objectives, four specific uses of the FAS 33 information are stated:
(1) Assessment of future cash flows:
When prices are changing, measurements that reflect current prices are likely to provide useful information for the assessment of future cash flows.
(2) Assessment of enterprise performance:
Measurements that reflect current prices can provide a basis for assessing the extent to which past decision on the acquisition of assets have created opportunities for earning future cash flows.
The growth in value of assets held (holding gain) is to be regarded as one aspect of performance even though it may be distinguished from operating performance. This clearly points to a measurement of comprehensive income and operating performance could be measured by the ‘earnings’ concept.
(3) Assessment of the erosion of operating capability:
Information on the current prices of resources that are used to generate revenues can help users to assess the extent to which and the manner in which operating capability has been maintained. This concedes the potential usefulness of a physical capital maintenance concept.
(4) Assessment of erosion of general purchasing power:
Investors typically are concerned with assessing whether an enterprise has maintained the purchasing power of its capital. The first three of these uses point to a current cost or current value accounting system, whereas the fourth points to general price-level adjustment (CPP).
However, it does not necessarily point to general price- level adjustment of traditional historical cost accounts, if the case for a current valuation basis were accepted.
The following data are required to be disclosed in accordance with FAS 33:
(1) Income from continuing operations adjusted for the effects of general inflation.
(2) Income from continuing operations on a current cost basis.
(3) Purchasing power gains and losses on holding monetary items reported separately (i.e., not included in the income from continuing operations). 4 Holding gains on non-monetary items net of inflation and reported separately as “increases or decreases” on non-monetary items.
(5) Current costs or lower recoverable amount of inventory and property, plant and equipment at the end of the current fiscal year.
(6) A five-year summary of specific relevant financial data expressed in constant dollars.
The above disclosure requirements establish minimum disclosure levels and companies are encouraged to provide additional information. The detailed disclosures required in FAS 33 are mentioned here.
1. Supplementary Income Statement for Current Year:
The supplementary income statement must include both constant dollar and current cost information; in particular, the following disclosures are required as a minimum (FAS 33, pares 29-30):
Constant Dollar Disclosures:
(a) Information on income from continuing operations for the current year on a historical cost/constant dollar basis.
(b) The purchasing power gain or loss on net monetary assets for the current fiscal year (which must not be included in income from continuing operations).
Current Cost Disclosures:
(a) Information on income from continuing operations for the current fiscal year on a current cost basis.
(b) The current cost amounts of inventory and property, plant and equipment at the end of the current fiscal year.
(c) Increases or decreases for the current fiscal year in the current cost amounts of inventory and property, plant and equipment, net of inflation (such increases and decreases, or realisable holding gains should not be included in income from continuing operations).
When income from continuing operations on a current cost basis is not materially different from income on a historical cost/constant dollar basis, then the current cost disclosures may be omitted, provided that the omission is noted in a footnote (FAS 33, para 31).
This materiality rule is effective in exempting many financial institutions and other enterprises holding relatively small amounts of inventory, property, plant, and equipment from the current cost disclosure requirements.
Income from continuing operations is defined as “income after applicable income taxes but excluding the results of discontinued operations, extraordinary items and cumulative effect of accounting changes.” [FAS 33, para 22 (g)]. In addition, income from continuing operations excludes purchasing power gains and losses on net monetary items and increases or decreases in the current cost of inventory and property, plant and equipment.
2. Five-Year Summary of Financial Data Adjusted for Changing Prices:
A five-year summary must disclose the following information for each of the most recent fiscal years (FAS 33, para 35):
(a) Net sales and other operating revenues.
(b) Historical cost/constant dollar information.
(i) Income from continuing operations
(ii) Income per common share from continuing operations.
(iii) Net assets at fiscal years end.
(c) Current cost information.
(i) Income from continuing operations.
(ii) Income per common share from continuing operations.
(iii) Net assets at fiscal years end.
(iv) Increases or decreases in the current cost amount of inventory and property, plant and equipment, net of inflation.
(d) Other information.
(i) Purchasing power gain or loss on net monetary items.
(ii) Cash dividends declared per common share.
(iii) Market price per common share at fiscal years end.
3. Required Footnote Disclosures:
In addition to the supplementary income statement and the five-year summary, FAS 33 requires the following disclosures in footnotes (paras 33-34):
(i) The aggregate amount of depreciation, on both historical cost/constant dollar basis and a current cost basis, in the event that depreciation expense is allocated among several expense categories (as when depreciation expense is allocated between costs of goods sold and separate expense item).
(ii) The principal types of information used to calculate the cost of (a) inventory, (b) property, plant, and equipment, (c) cost of goods sold, and (d) depreciation, depletion, and amortisation.
(iii) Any difference between (a) the depreciation methods, estimates of useful lives, and salvage values of assets used for calculations of historical cost/constant dollar depreciation and current cost depreciation, and (b) the methods and estimates used for calculation of depreciation in the primary financial statements.
(iv) The exclusion from the computations of supplementary information of any adjustments to or allocations of the amount of income-tax expense in the primary financial statements.
A closer examination of the FAS 33 disclosure provisions reveals that it requires the disclosure of income from continuing operations on a historical cost/constant dollar basis. In order to make this adjustment, a general price level index is used, which is an average measure of the individual price changes taking place in the economy.
FAS 33 requires the disclosure of general purchasing power gains from holding monetary liabilities and monetary assets, respectively, during a period of inflation. However, the purchasing power gain or loss on net monetary items is not included in measuring the income of the period.
Additionally, FAS 33 requires the disclosure of holding gains and losses from inventories, property, plant and equipment less the general inflation component that produces an illusory, fictitious gain or loss.
To the extent that a portion of these assets are financed through debt, part of the realised holding gain can be treated as income attributable to the present shareholders. FAS 33, however, does not have any provisions for a gearing or financing adjustment.
FA 33 requires the reporting of income from continuing operations on a current cost basis (or lower recoverable value). Although FAS 33 does not provide a monetary working capital adjustment, the current cost income from continuing operations may be viewed as “distributable” or “sustainable”, indicating the amount the firm can sustain in the future or distribute as dividends while maintaining its capital and continuing normal operations. Such data should be relevant for investment decision-making to the extent that such income measures can help investors to predict cash flows.
Applicability of FAS 33 Requirements:
FAS 33 is applicable to:
….. Public enterprises that prepare their primary financial statements in US dollars and in accordance with US generally accepted accounting principles and that have, at the beginning of the fiscal year when financial statements are being presented, either.
(а) Inventories and property, plant and equipment (before deducting accumulated depreciation, depletion and amortisation) amounting in aggregate to more than $ 125 million, or
(b) Total assets amounting to more than $1 billion (after deducting accumulated depreciation).
FAS 33 is applicable to most of the large companies and is also applicable to large financial institutions (commercial bank, thrift institutions, and insurance companies).
However, FAS 33 encourages other companies and organizations to present such supplemental disclosures. FAS 33 provides for the different treatment of certain assets in special industries, e.g., oil and gas reserves, timberlands, mining properties, and income producing real estate.
In November 1984, the FASB issued Statement of Financial Accounting Standards No. 82 (FAS 82) ‘Financial Reporting and Changing Prices- Elimination of Certain Disclosures’ which supersede some portions and amends other portions of FAS 33. The major effect of FAS 82 is to eliminate the requirement for disclosure of constant dollar information for firms that report current cost/constant purchasing power data.
That is, disclosure of income from continuing operations, income per share, and net assets on an historical cost/constant dollar basis is no longer required for firms that report current cost data adjusted for the effects of changes in the purchasing power of the monetary unit. Disclosure of purchasing power and net holding gains and losses is still required.
The FASB’s issuance of FAS 82 integrates the two different approaches to deal with the problem of changing prices. Current cost accounting is an attempt to deal with problems created by changes in specific prices, while historical cost/constant purchasing power accounting is an attempt to deal with problems created by changes in the general price level.
Current cost/constant purchasing power accounting is considered by many to be theoretically superior to either current cost of historical cost/constant purchasing power accounting.
The changes required by FAS 82 suggest that the Financial Accounting Standards Board (FASB) believes the current cost/constant purchasing power disclosures will be more useful. These disclosures, however, will still be supplementary.
While the changes brought about by FAS 82 will facilitate the evaluation of the current cost/constant purchasing power model, FAS 82 does nothing to change the advantages favouring historical cost data in future empirical tests.
After FAS 33, the FASB issued FAS 89 in 1986 entitled as “Financial Reporting and Changing Prices.” According to FAS 89, current cost income measurement, purchasing power gain or loss and holding gain information (as well as the five year summary of selected financial disclosure) are encouraged but not required.
FAS 89 was made voluntary in 1986. The FASB, thus, beat a hasty retreat from the problem of accounting for changing prices. The obvious factor leading to the retreat in accounting for changing prices was the slowing down of the inflation rate.
Inflation Accounting in United Kingdom:
The first UK attempt to account for inflation was made through a Statement of Standard Accounting Practice (No. 7) favouring general price level adjusted historical cost accounting (otherwise known as CPP accounting) issued in 1974. This statement was similar to the FASB’s 1974 Exposure Draft, which also supported general price-level accounting.
In 1975, a government-appointed committee on inflation accounting headed by FEP Sandilands proposed a current cost accounting system having no provisions for the impact of general inflation on monetary items. Sandilands Report faced lot of criticism. Therefore, a new Steering Group was formed.
In 1976, the Steering Group prepared an Exposure Draft (ED 18), which was essentially a proposal for a current cost system with supplementary disclosure of adjustments for general inflation on the monetary holdings of a firm. ED 18 was criticised particularly by financial institutions, because of its inadequate treatment of monetary items, and was subsequently abandoned as a result.
A more refined approach to the treatment of monetary items was proposed in 1977 by the Hyde Committee, known as the Hyde Guidelines. Finally ED 24 became the basis for the present U.K. Standard on inflation accounting, popularly known as SSAP 16.
Objectives of SSAP 16:
The basic objective of the UK’s Statement of Standard Accounting Practice No. 16, ‘Current Cost Accounting’ (SAAP 16) is to provide more useful information than that available from historical cost accounts alone for the guidance of the management, shareholders, and others on such matters as;
(a) The financial viability of the business;
(b) Return on investment;
(c) Pricing policy, cost control, and distribution decisions; and
Disclosures required in SSAP 16:
SSAP 16 requires the following disclosures:
(1) Current cost profit and loss and balance sheet accounts both in addition to historical cost accounts.
(2) Current cost profit and loss account should show operating profit derived after making depreciation, cost of sales, and monetary working capital adjustment and the current cost profit attributable to shareholders derived after making a gearing adjustment for debt financing.
(3) In the current cost balance sheet, property, plant, and equipment and inventory should generally be included at their value to the business (normally, depreciated current replacement cost). The ‘value to the business’ concept is equivalent to the lower of the current (replacement) cost or the recoverable amount of the asset, as in USA’s FAS 33.
SSAP 16 requires current cost income statement and current cost balance sheet. CCA income statement, as given in 12.2, shows the current cost operating profit by deducting current cost adjustments for the cost of sales, depreciation, and monetary working capital.
The current cost operating profit is based on the concept of physical capital maintenance, which emphasises the operating capacity of the firm. By adding the ‘gearing adjustment’ to the current cost operating profit, the current cost profit attributable to shareholders is measured. The gearing adjustment is a measure of the benefit (or cost) accruing to the shareholders for having financed part of the operating assets through debt.
SSAP16 requires the presentation of a current cost balance sheet, the assets of which are shown “at their value to the business based on current price levels.”
Evaluating SSAP 16:
SSAP 16 has been criticised on the following grounds:
(1) The valuation base has been subject to much discussion. Some variant of value to the firm has always been adopted, with subjective assessment of value in use being the main practical problem. The precise definition of the operating capacity which has to be maintained, in defining replacement cost, has also proved elusive, especially under conditions of technical change.
(2) The most difficult area has been the treatment of monetary assets and liabilities.
(3) There has been a problem of selection of suitable indices for valuing specialist plant. Also, sometimes the valuation of such plant becomes more difficult when no obvious market exists and for which no suitable index is prepared.
(4) The calculation of a cost of consumption where an asset is not to be replaced is difficult.
(5) This accounting model is difficult to apply in case of specialised industries such as commodity trading and shipping, where the concept of operating capital maintenance is not obviously relevant.
(6) The most controversial aspect of SSAP 16 is the gearing adjustment which is heavily attacked from both theoretical and practical viewpoints. In addition, there are major international comparability problems as this adjustment frequently produces very different results from the purchasing power adjustment recommended in the US standard. This is a very important difference in the case of multinational companies with strong UK and US interests.
Developments after SSAP 16:
There was considerable criticism of SSAP 16 by companies and accountancy bodies in UK. Accordingly, the ASC issued a new exposure draft, ED 35, ‘Accounting for the Effects of Changing Prices’, in July 1984. Its recommendations were similar to those of SSAP 16, although there were some changes of emphasis.
For example, the following was suggested:
(1) All public limited companies should be subject to the new standard, except for wholly owned subsidiaries and financial companies. There would be no size test as in SSAP 16, the private companies would not be affected by the standard.
(2) Where current cost accounts are not shown as the main accounts, the information disclosed should be given in a note to the main accounts and not in supplementary current cost statements (as in SSAP 16).
(3) Adjustment calculations should be very similar to those required in SSAP 16, although it is suggested that two additional methods of calculating the gearing adjustment should be accepted.
(4) A balance sheet should not be regarded as essential, although information should be provided regarding CCA figures for fixed assets and inventories.
These recommendations were attacked from many quarters in the latter part of 1984, and there were expected to be some significant changes before a new standard proved to be acceptable. At the end of 1984, the target date for the new standard was the second quarter of 1985, in order to replace SSAP 16 before its expiry.
However, because of the opposition which the new exposure draft produced, ED was abandoned. Shortly afterwards, the ASC announced that compliance with SSAP 16 which, technically, remained in force, was to become voluntary for all listed companies. Thus, SSAP 16 was withdrawn in 1985 without immediate replacement and the search for an acceptable solution to the problem of inflation amounting started again.
SSAP 16 is no longer mandatory. However, it is being retained as an authoritative reference on accounting under the current cost invention. The Accounting Standards Committee reaffirms its view that where historical cost accounts are materially affected by changing prices, information about the effects of changing prices is necessary for an appreciation of a company’s results and financial positions.
ASC also remains of the view that current cost accounting is the most appropriate way of measuring the effect of changing price levels on the great majority of economic entities. It, therefore, urges listed companies anti large enterprises generally to keep in mind the long term persistence of inflationary effects on their capital and, where these are judged material, to disclose information about them by reference to current cost.
The non- mandatory position of SSAP 16, the ASC feels, will free the way for innovation and development of appropriate disclosures. The ASC has announced that it intends to develop a new accounting standard on accounting for the effects of changing prices to take the place of SSAP 16 in due course.
It is intended that the proposed new standard will allow more choice of method than SSAP 16 and that the SSAP 16 methodology will be one of those that would comply with the new standard. The ASC issued an “official handbook” entitled as Accounting for the Effects of Changing Prices: A Handbook in 1986.
The major proposals of the Handbook are:
(1) It is considered ‘most appropriate’ for companies to disclose information about current results and financial position on the basis of current cost valuation.
(2) The information in 1 may be incorporated into a company’s main accounts, or in notes thereto.
(3) Companies which publish five or ten year historical summaries should restate certain items in units of CPP.
The ASC Handbook specifies the constraints of the HCA method and then proceeds to formulate remedial steps. In so doing it departs from the CCA Vs. CPP theme.
An alternative to HCA does not necessarily lie in a straight choice between these two models, argues the Handbook. Instead of opting for a particular reporting technique it included consideration of the following three variables when selecting an accounting system:
1. Basis to be adopted for valuing assets.
2. Capital maintenance concepts to be used.
3. Unit of measurement to be used.
The Handbook regards current cost asset valuation basis as more relevant than the historical cost basis.
Two different approaches may be taken in measuring the capital of a company. These are the operating capital maintenance concept which views capital in physical terms and the financial capital maintenance concepts which views capital in financial terms.
The operating capital maintenance concept is in principle the CCA approach. The Handbook expresses the opinion that both the operating capital and financial capital maintenance concepts are useful, the operating capital maintenance concept being appropriate for manufacturing companies and the financial capital maintenance concept being appropriate for value based companies whose operations are not dependent on the replacement of fixed assets.
With regard to unit of measurement, the Handbook suggests monetary measurement and units of constant purchasing power as the alternatives, i.e., it supports either Real Term Accounting (RTA) or CCA systems.
Inflation Accounting in India:
Recognising the importance of the effect of changing prices on the financial statements of business enterprises, the Research Committee of the Institute of Chartered Accountants of India (ICAI) has brought out a Guidance Note on Accounting for Changing Prices in 1982.
In preparing the Guidance Note, the Research Committee of ICAI has drawn heavily on the various publications on the subject by various international professional bodies and more particularly those by the Accounting Standards Committee in the U.K. The main objective of the Guidance Note is to encourage the adoption of accounting for changing prices, and to suggest a methodology relevant in the prevailing economic environment in India.
The Guidance Note discusses the three proposals for accounting for changing prices, viz:
(i) Periodical revaluation of fixed assets along with the adoption of LIFO formula for inventory valuation
(ii) Current purchasing power accounting method (CPPA); and,
(iii) Current Cost Accounting (UK’s SSAP 16) method.
After discussing the above three methods of inflation accounting, the guidance Note gives some recommendations which are listed as follows:
(1) The adoption of a system of accounting for changing prices would require a considerable amount of time, money and specialised skills. Also the various techniques are still in the process of development. However, in view of the importance of the subject, it is recommended that enterprises particularly the large enterprises, may develop the necessary system to prepare and present this information.
(2) Of the various methods of accounting for changing prices, the Current Cost Accounting (based on SSAP 16) method seems to be most appropriate in the context of the economic environment in India. The periodic revaluations of fixed assets and the adoption of LIFO formula for inventory valuations are partial responses to the problem of accounting for changing prices.
Current Purchasing Power Accounting, though simple to apply, does not ensure the maintenance of the operating capability of an enterprise. Current Cost Accounting, on the other hand, is a rational and comprehensive system of accounting for changing prices, as it considers the specific effects of changing prices on individual enterprises and, thus, ensures that profits are reported only after maintaining the operating capability.
However, the introduction of a full-fledged system of Current Cost Accounting on a wide scale in India will inevitably take some time. During this transitional phase, periodic revaluations of fixed assets along with the adoption of LIFO formula for inventory valuation would reflect the impact of changing prices substantially in the case of manufacturing and trading enterprises.
(3) Adequate database has presently not been developed in India for accounting for changing prices. Therefore, every enterprise may has to select the price indices depending on its own circumstances. The detailed price indices published in its monthly bulletin by the Government of India can be adopted in a number of cases. There is no doubt that further steps will have to be taken for the timely publication of statistical information required by various industries for the implementation of accounting for changing prices.
(4) Considering the importance of the information regarding the impact of changing prices it is recommended that while the primary financial statements should continue to be prepared and presented on the historical cost basis, supplementary information reflecting the effects of changing prices may also be provided in the financial statements on a voluntary basis, at least by large enterprises.
(5) Since the presentation of statements adjusted for the impact of changing prices is voluntary, the enterprises may or may not get this information audited. However, the audit of such statements would enhance their credibility.
(6) Apart from its utility in external reporting, accounting for changing prices may also provide useful information for internal management purposes. Accounting information system is designed, primarily, to provide relevant information to various levels of management with a view to assist in managerial decision-making, control and evaluation.
However, in periods of rapid and violent fluctuations in prices, the information provided by historical cost-based accounting system may need to be supplemented by information regarding the impact of changing prices. The areas in which such information may be of prime importance to management include investment decisions and allocation of resources, divisional and overall corporate performance evaluation, pricing policy, dividend policy, etc.
(7) In countries like the United Kingdom, there have been some reforms in the tax structure in the wake of introduction of accounting for changing prices. Though the tax legislation in India, at present, does not give recognition to such an accounting system, even then accounting for changing prices would be useful for generating relevant information for internal and external decision-making.
Thus, the Institute of Chartered Accountants of India has not given its own clear opinion as to which method of accounting for price changes should be adopted by business enterprises in India. However, the Research Committee of ICAI is in favour of Current Cost Accounting (CCA) of UK.
It is significant to note that Current Cost Accounting is itself not acceptable finally in UK, and is in the process of being modified by a new standard. Recently, SSAP 16 has been withdrawn and made voluntary for UK companies.
As stated earlier, no definite standard on accounting for price-level changes has been issued in India. The Institute of Chartered Accountants of India has issued only a Guidance Note on Accounting for Changing Prices in 1982.
In absence of a definite standard, Indian Companies have not felt inspired to provide inflation disclosures in their annual reports. However, some Indian companies have given some sort of inflation accounting disclosure in their published annual reports. Some annual reports contain detailed inflation adjusted information which, undoubtedly, would prove useful to the users of annual reports.