Accounting for Changing Prices

The past year has seen inflation reach levels not seen since the early 1980s. Under the circumstances, it can be instructive to revisit the accounting guidance developed for companies to report in such an environment while applying the lessons learned in the intervening decades. This article integrates newer approaches with the methods established in SFAS 33 to demonstrate how to produce better information for users and managers from the same underlying data.

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The last time inflation was this high, Statement of Financial Accounting Standards 33, Financial Reporting and Changing Prices (September 1979), was issued, requiring large corporations to make supplementary disclosures about changing prices. For the preceding six years, inflation had been greater than 5%, and it reached 11.3% by the end of 1979. Many people were confused about accounting for changing prices, but much has been learned in the past four decades.

After three years of inflation running at less than 5%, SFAS 89 (December 1986) made those supplementary disclosures voluntary. SFAS 89’s example is complicated by foreign investment, but it uses the same suggested methods and the same current-cost data that are used in this article. Accounting for changing prices is now covered in Accounting Standards Codification section 255, “Changing Prices.”

This article is intended to help preparers, auditors, and management accountants to reach a better understanding of accounting for changing costs than was available in 1979. It covers four objectives of SFAS 33 and different ways of achieving those objectives. Although SFAS 33’s methods came closer to achieving those objectives than historical-cost methods, this analysis demonstrates that newer methods can produce more reliable measurements with the same underlying data.

Conceptual Overview of the Problem

Financial statements must report information about a company’s physical resources and changes in those resources in monetary terms, even though the relationship between the monetary unit and resources generally changes at different rates for different resources. That requirement causes complex measurement problems. Accounting theorists disagree about the best way to solve the problem, largely because they prefer different concepts of profit that are based on different concepts of capital. There are four concepts of beginning capital that can be measured with a current-cost accounting system: physical operating capability, specific purchasing power, general purchasing power, and nominal dollars. If all costs were stable, historical-cost net income (HCNI) could reliably represent all four concepts of profit with a single number. When asset costs are changing at different rates, however, those profit concepts could have different values, and HCNI would be unlikely to represent any of the four concepts because HCNI does not recognize increases in costs subsequent to acquisition.

Maintenance of Physical Operating Capability

A major objective of SFAS 33 (para. 3c) is estimating income that is distributable after maintaining physical operating capability:

SFAS 33 says that expenses are measured at amounts sufficient to maintain the physical operating capability of the enterprise (para. 100). It further explains that distributable income results after deducting the cost of replacing inventory units that were sold, rather than their historical costs (paras. 94b and 125). Exhibit 1 shows the current-cost disclosures from Schedule B of SFAS 33, with the proposed measurements in the final column.

Cost of Goods Sold and the Change in Inventory Costs

SFAS 33’s $205,408 cost of goods sold shown in Exhibit 1 is based on a simple-average current cost of $65.50 per unit, calculated as ($58 + $73)/2, times 3,136 units sold (para. 226). This represents one way of estimating replacement cost, but it can be improved. SFAS 33’s cost of goods sold is understated because its calculation contradicts two relevant facts. First, 3,036 units actually were replaced at a cost of $204,000 (para. 218), an average of $67.19 per unit. Second, paragraph 218 shows that inventory quantity decreased from 1,000 beginning units to 900 units at year-end, and those 100 unreplaced units cannot be replaced for $65.50 per unit. An objective estimate of their replacement cost at year end is the year-end cost of $73 per unit, which represents an additional $7,300 for those 100 unreplaced units. Based on observable facts, then, a better estimate of the cost of replacing all goods sold (RCGS) is

Understated cost of goods sold affects SFAS 33’s calculation of the increase in current costs of inventory (ICCI). From paragraph 233:

The $9,108 that SFAS 33 calculated for increase in current cost of depends upon the calculation for cost of goods sold (CGS). SFAS 33 did not show any way of calculating the $9,108 independently.

As a test of reasonableness, notice that $9,108 is only 15.7% of the cost of beginning inventory, while the cost of inventory actually increased 25.9%, from $58 to $73 per unit. A more direct and independent calculation would show the following:

Depreciation Expense and the Change in Equipment Costs

SFAS 33’s depreciation expense of $19,500 shown in Exhibit 1 is based on simple averages of beginning and ending current costs (para. 230). Paragraph 219 shows that a new unit of equipment was added early in 1980 for $15,000 and all eight units of equipment depreciated 10% during 1980. By year-end, paragraph 219 also shows the current cost of all equipment was $220,000 gross, including $16,000 for the added unit.

The problem here is that equipment services were consumed without replacement and cannot be replaced at average current cost. Using a calculation similar to cost of goods sold, a better estimate of depreciation at replacement cost (RCDE) would be as follows:

The proposed amount for replacement cost depreciation can be verified by comparing its implied increase in current cost of equipment (ICCE) with an independent measurement of ICCE. First, consider the following amounts from SFAS 33’s paragraph 235:

The implied ICCE of $17,000 can be verified with an independent measurement based on supporting data from paragraph 219:

SFAS 33’s $15,500 increase in cost of equipment is an amount that reconciles with SFAS 33’s depreciation expense, but $15,500 cannot be calculated independently. Both ICCE and depreciation expense seem to be understated by $1,500.

Thus, it appears to this author that SFAS 33’s suggested current-cost methods can be improved. The two understatements of expenses ($5,892 and $1,500) cause current-cost income from continuing operations to be overstated by $7,392. Substituting the author’s proposed expense measurements in Exhibit 1 produces a physical loss of $16,300, meaning that the company’s physical assets were eroded by approximately $16,300 before paying dividends. The under-statements of expenses also cause SFAS 33’s disclosures of increases in current costs to be understated by $7,392. The following discussion confirms those understatements.

Separation into Cost Changes and Quantity Changes

Exhibit 2 shows one way to verify physical changes. An important feature of the recommended accounting system is the separation of nominal-dollar changes into quantity changes and cost changes, similar to what cost accountants do to understand total variances in manufacturing costs. Amounts for current costs of inventory and equipment come from SFAS 33 paragraphs 218 and 219, respectively. Amounts for net monetary liabilities are from paragraph 231.

The cost changes are calculated above for the increases in current costs, and the quantity changes for inventory and equipment are calculated in the proposed expense measurements. The quantity change for equipment represents service reductions from depreciation that were partly offset by the acquisition of a new unit early in 1980. The total quantity reduction of $19,300 is the erosion of physical assets, which is the combined result of the physical loss of $16,300 and a $3,000 dividend (para. 217).

Achieving Another Objective

Even though the change in physical assets is important, users of financial statements may want to know about other changes that affect a company. SFAS 33 acknowledges another need:

The adjustments to cost of goods sold and depreciation expense … do not provide for the increase in monetary working capital (for example, cash plus receivables less payables) that is commonly required as a result of increasing prices. It is also possible that the borrowing capacity of an enterprise may be related to the current costs of its assets so that part of the increase in assets required to maintain operating capability may be provided by increasing the amount of debt rather than by retention of earnings. Some people have argued that it would be desirable to include approximate adjustments for these factors in a supplementary measure of income. (SFAS 33, para. 128)

In the United Kingdom, SSAP 16 (1980) required two adjustments for this second objective. SFAS 33 did not require such adjustments, but this argument makes sense, and it is accepted as justification for disclosing a second concept of profit. Specific profit shown in Exhibit 1 is the amount distributable while maintaining the specific purchasing power of net assets, which include monetary items as well as physical assets.

With better estimates of the cost changes, it is possible to estimate two other ways that cost changes affect the reporting company. The average rate of cost changes is calculated as (15,000 + 17,000)/(58,000 + 74,100) = 24.224%. One important effect is that the dollar amount of beginning shareholders’ equity must increase by 24.224% to represent the current purchasing power that the beginning balance of shareholders’ equity represented a year earlier. A “capital maintenance adjustment” is needed to re-scale beginning capital to year-end purchasing power:

The second effect is that any remaining cost changes could be distributed without reducing specific purchasing power, and thus is an increment to specific profit:

This distributable effect allows for proportional increases in monetary working capital and long-term borrowing, if desired by management. Using data about monetary items from paragraph 231, this also can be calculated as follows:

Adding this amount to the physical profit (loss) in Exhibit 1 produces a specific profit (loss) of ($2,977), meaning that specific purchasing power of net assets has eroded by approximately $2,977, before dividends.

Completing the Disclosures

Another weakness of SFAS 33 is that it omits potentially useful information about assets and net assets. Enough data was available in the example to report current-cost balances for inventory, equipment, and shareholders’ equity, yet SFAS 33’s suggested schedules did not disclose those amounts. One way to help users understand the new data is to include it in a statement of changes in shareholders’ equity. Exhibit 3 shows how the measurements relate to each other. The beginning and ending balances of shareholders’ equity are calculated in Exhibit 2. The $18,677 capital maintenance adjustment is the necessary link for articulating successive balance sheets that are measured in different monetary scales (dollars per quantity of asset at different year-ends). The re-stated shareholders’ equity represents the same proportions of the same assets that were represented one year earlier; now, every item in the balance sheet is expressed in dollars of year-end purchasing power. Of all amounts presented in Exhibit 3, the only item disclosed by SFAS 33 is dividends.

Summary of Proposed Measurements

The measurements proposed so far can be summarized with three adjusting entries. The first adjustment recognizes four phenomena related to changes in current costs:

This adjustment establishes meaningful benchmarks (zero-points) for measuring relevant changes in dollars of year-end purchasing power. The benchmark for measuring each non-monetary expense is the beginning quantity of its associated assets re-stated to year-end costs. The benchmark for measuring specific profit is beginning shareholders’ equity expressed in year-end purchasing power. The other function of this entry is to record the distributable portion of cost changes that is an increment to specific profit.

The expense entries are similar to the periodic inventory method, with beginning and ending balances both measured with year-end costs. For inventory—

Beginning inventory is restated to ending cost by the first adjustment, from $58,000 to $73,000. Ending inventory is measured as ending quantity times ending cost per unit. As a result of updating the beginning balance, RCGS = purchases – quantity change at ending cost. For equipment—

Beginning equipment is restated to ending cost by the first adjustment, from $74,100 to $91,100. Ending equipment is measured as ending quantity times ending cost per unit, where quantity means the percentage of original service potential that remains at year-end. As a result of updating the beginning balance, RCDE = additions – quantity change at ending cost.

With equipment recorded net, it is easy to see that entries for both expenses are conceptually the same, but the company may prefer to use two accounts for gross cost and accumulated depreciation. The new cost-change entry and the improved expense entry are the only recording differences in the proposed system. Other entries remain the same as conventional accounting.

Practical Implications

Notice that historical-cost net income (HCNI) in Exhibit 1 is materially different from both concepts of profit. HCNI says the company is healthy, with a 21% return on average equity of $43,000 (para. 217) and a conservative dividend payout of only 33% of HCNI. Whether one defines beginning capital as physical assets or as specific purchasing power of net assets (allowing a proportional increase in net monetary items), the company had a material loss and the dividend could have been an unwise decision. Thus, while achieving two objectives of SFAS 33, disclosures of physical profit and specific profit would provide better information for managers and external users who are interested in this company’s profitability.

If the managers had this information, they might not have distributed that dividend, and they might have been motivated to operate the business more efficiently. Management accountants have the option of producing such information for internal use now, without a FASB requirement. They already know the current costs of inventory, and current-cost measurements are less complicated than conventional inventory methods, especially LIFO. Some management accountants and managers already are monitoring current costs of likely replacements for aging equipment. To help with difficult estimates, their external auditors probably have useful guidelines in their archives (which could help companies that were not operating in the early 1980s).

Achieving Two More Objectives of SFAS 33

Physical profit and specific profit give better information about how a company has performed, but some external users also would like to have information that is tailored to how they want to use it. The supplementary schedule in Exhibit 4 is suggested for that purpose.

Beginning with specific profit and adding back the specific capital maintenance adjustment yields nominal profit, which may be useful for comparison with nominal profits of other companies or with other investments whose profits are not adjusted for changes in purchasing power. Nominal profit achieves SFAS 33’s objective of assessing “enterprise performance” (paras. 3b, 131), which includes all increases in current costs.

Deducting consumer inflation from nominal profit produces consumer profit, which an average consumer may use to estimate how much the company has earned in excess of the increased costs of personal consumption. Consumer profit satisfies a final objective of SFAS 33: helping investors assess whether an enterprise has maintained the general purchasing power of its capital (paras. 3d, 139-140). Users can refine the latter estimation to compare the company’s performance with consumer inflation in any of 23 metropolitan areas or 13 broader areas in the United States.

The suggested disclosures are not competing ways of estimating one “ideal” kind of profit. They are reliable estimates of four different perspectives of profit, each with a different meaning and each providing useful information for different kinds of decisions. The proposed accounting system can accommodate four perspectives with little additional effort.

It should be noted that a shrewd user could have estimated these additional amounts from scattered numbers required by SFAS 33. Nominal profit can be estimated by adding current cost income from continuing operations (CCICO) and the increase in current costs (before inflation). Consumer profit can be estimated by adding CCICO, the monetary purchasing power gain, and the excess of increase in specific prices over the increase in general price level. In both estimates, the errors that overstate CCICO are offset by the errors that understate cost changes. On the other hand, the separate schedule in Exhibit 4 does the calculating for the user and also shows how these additional concepts relate to specific profit and shareholders’ equity.

Finding a Better Way

This analysis emphasizes processing rules rather than measuring current costs as inputs, because perfect inputs will not produce reliable outputs if the calculations are not empirically valid. For the purpose of this analysis, it is assumed that most current costs are directly observable and others can be estimated carefully by preparers and auditors. Large corporations that operated in the 1980s and large accounting firms may still have detailed records about how to estimate current costs of assets under difficult circumstances (e.g., when a possible replacement asset has major differences in service potential).

This article is intended to help accountants understand the complex problems presented by changing costs and suggest better ways of solving those problems. The above analysis shows how the current-cost calculations and the disclosures in SFAS 33 can be modified to be potentially more useful than those originally required in 1979. Until that happens, internal accountants can choose to apply all or part of this system to give managers better information about how changing costs affect their business.