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DISCUSSION PAPER
Report No,: DRD84
The Algebra of Inflation Accounting
James Tybout
July 1984
Development Research DepartmentEconomics and Research Staff
World Bank
The views presented here are those of the author, and they should not beinterpreted as reflecting those of the World Bank
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AR-01 2a/JTD /#3
THE ALEORA F INFLATION ACCOUNTING
by
James Tybout
The World Bank
July 1984
This papcr vas prepared for World 1,1atk research project "liberalization and
Stabilizatio J in the Souithen Coe" (R.10 T7h-85), Te author is grateful to
Jaitr,c de2 Mejo lor con umts on an earl:.Lr drft. The views and interpretations
pre,cated h arevi ar v th-oc of the puthor e,ri should not be< attributed to the
World Bjunk or tsc njffilin:s.
Abstract
This paper develops algebraic representations of the various possible
distortions that inflation can introduce in financial statements, and of the
associated corrections that have been develODed by accountants. Adjustments
to balance sheets and income statements are presented for two basic cases:
general inflation, and inflation cum changing relative prices. Empirical
evidence concerning the impact of these adjustments is reviewed, and it is
noted that when inflation rates are substantial, the change in accounting
figures can be quite dramatic.
AR-012a/J'TD//3 - 1 -
OVERVIEW
In developing countries, analyses of the corporate sector often must
proceed on the basis of inflation-distorted financial statements. If these
distortions are ignored, findings regarding firms' financial structures and
earnings rates may be grossly in error. What appears to be an insolvent firm
may be simply an illiquid one; what appears to be a negative net profit rate
may be positive; and what appears to be a positive gross earnings stream may
be negative. Misreadings of these conditions can lead to inappropriate policy
recommendations and major resource misallocations.
To aid researchers who must interpret inflation-distorted financial
statements, this paper develops an algebraic exposition of the biases in
statements that firms have prepared according to traditional accounting
techniques, and of the methods available for their correction. Section I
introduces a simple representation of financial statments which do not suffer
from inflation distortions. Using this representation as a reference point,
section II demonstrates how traditional accounting practices lead to biases
when general inflation is present. Also, empirical evidence regarding the
impact of corrections for such biases is reviewed. Section III extends the
framework developed in previous sections to accomodate the possibility that
relative price changes accompany general inflation, and reviews additional
empirical evidence. Finally, section IV summarizes the four basic distortions
discussed in this paper and offers some general observations on the
circumstances under which they are likely to be significant.
I. FINANCIAL STATEMENTS IN A WORLD OF STABLE PRICES
A. Balance Sheets
Corporations regularly prepare two basic financial statements. The
AR-012a/JTD///3 - 2 -
first is a balance sheet,, which reports stocks of assets and liabilities.
From this statement, inferences can be drawn regarding such things as the
quality of a corporation's assets, the ease with which these assets can be
liquidated, and the distribution of claims on these assets between creditors
and shareholders. For expository purposes. a highly simplified balance sheet
is presented in table 1. Notice that all physical magnitudes are measured in
units that have a value of one base-period currency unit, and that all price
indices are defined with reference to this period (i.e., PO= P = P = 1).
Because each item in the balance sheet is expressed in terms of its value at
time T, this statement is "undistorted" and will serve as a reference point in
sections below.
B. Income Statements
The second basic financial statement prepared by corporations is an
income statement. This item-by-item summary of revenues and costs allows one
to isolate the sources of fluctuation in a corporation's net income stream,
and to formulate opinions regarding future performance. A highly simplified
income statement is presented in table 1. 1/ Bere, too, physical magnitudes
are measured in units that sell for one base period currency unit. Output is
assumed to sell at the general price level, PT, and inputs are assumed to sell
xat the inventory price, P . So long as prices are stable over the life of the
firm, entries in this statement may be interpreted to represent real
magnitudes. Accordingly, as with the balance sheet introduced above, this
1/ Note that to economLze on notation, labor costs have not been separatedout. The reader should either view "sales revenue" as net of thesecosts, or view "other expenses" as inclusive of them. Taxes have alsobeen ignored.
AR-012a/JTD/113 3 -
Table 1: The Structure of "Undistorted" Financial Statements
Balance Sheet at time T Income Statement for the Period 0 to T
C DT Gross Sales Revenue QPT
P XT Cost of Sales PT[X +U-XT]
k KPT WT Initial. Inventories X0
Purchases UPX
Closing Inventories XT T
Depreciation yKOPk
Other Expenses EPT
Net Income [Q-E]PT - [XO+U-XT]PT - yKOPk
Ct = monetary assets at time t: cash, deposits, net receivables
D t= monetary liabilities at time t: total debt
X = inventories at time t
K = fixed capital stock at time t
W = net worth at time t
Q = physical sales volume between time 0 and time T
U = volume of inputs purchased between time 0 and time T
E = real volume of other expenses between time 0 and time T:interest, overhead, administrative and marketing costs
Y depreciation rate per fiscal period on fixed capital
P = general price level at time t
P = price of inventories at time t
Pik price of fixed capital at time tt
AR-012a/JTD/#3 - 4 -
income statement will be used as an "undistorted" reference point in sections
that follow.
There exists a close relationship between balance sheets and income
statements. Specifically, when a corporation pays no dividends and neither
retires nor issues shares, the change in its net worth from one fiscal year to
the next coincides with its net income. To see why, note that whenever
revenues accrue, these are either used to defray production costs (i.e.,
wages, materials, interest, etc.), to acquire assets, or to retire debt.
Hence asset acquisitions plus debt retirements represent revenue in excess of
production costs, or net income. But clearly, from table 1, they also -
represent the change in net worth. This link between income statements and
balance sheets will prove central to the discussion that follows.
II. FINANCIAL STATEMENTS IN THE PRESENCE OF GENERAL INFLATION
Firms must somehow.estimate the conceptual magnitudes introducee in
table 1. For expository purposes, suppose they do this using a pure "historic
cost" (HC) accounting system. (Variants of this system are quite common among
developing countries.) Then each item reported in their financial statements
is a simple cumulative reflection of previous transactions. For example,
abstracting from depreciation adjustments, a balance sheet entry of 20 pesos
for fixed capital may reflect a 5 peso capital expenditure 3 years ago, and a
15 peso expenditure last year. Similarly, in the income statement, each flow
entry is calculated as a simple aggregation over the recorded valies of all
outlays or receipts of a given variety: A gross sales figure of 24 may
reflect the receipt of 2 pesos at the end of each month In the fi3cal year.
So long as all prices are stable, the [ntertemporal aggr!gation
implied by HC accounting norms is justifiable, and the conceptual magnitudes
AR-012a/JTD///3 - 5 -
introduced in table 1 are well approximated by recorded figures. However, in
an environment where the price level is rising, this accounting method leads
to a number of potentially important distortions. These distortions, and the
accounting system that has been developed to deal with them, are now reviewed
for the case in which all prices in the economy are rising at the same
(perfectly observable) rate.
A. General Inflation and Balance Sheets
To explain the bias that inflation creates in HC balance sheets, it
is first necessary to distinguish between "monetary" and "nonmonetary"
items. The former are assets and liabilities whose value is fixed by contract
or statute in terms of the domestic currency, such as deposits, accounts
receivable, and debts. The latter are all other items except net worth, or
for present purposes, inventories and capital. (Net worth is a residual
account.) Recorded values of monetary items are not distorted by inflation
under an HC accounting system because changes in the price level do not affect
their nominal value. However, nonnmonetary items generally increase in
nominal value during inflationary periods, and therefore tend to be carried on
HC books at less than their current worth. This is the esssence of the
inflation distortion.
Understatement of nonmonetary items means that firms' financial
status is misrepresented in several respects. First, firms appear to have
smaller and more liquid asset stocks than they actually do. Second, the
fraction of total assets which is debt-financed is exaggerated. Finally,
because net worth growth is understated, nominal and real income measures
based on this statistic are too low.
AR-012,/JTD///3 - 6 -
Accountants have developed a system for rectifying these inflation-
induced misrepresentations in KC financial statements. This system -- known
variously as "historic cost/constant dollar," "general purchasing power," or
"constant purchasing power" (CPP) accounting -- is based on a straightforward
principle: historic values of nonmonetary items should be brought forward to
imputed current values using a general price inflator. More precisely, each
nonmonetary asset should be valued at its historic cost, weighted by the ratio
of the current price level to the price level on its acquisition date.
If fixed capital and inventory prices are not changing relative to
the price level, and if the general rate of inflation is accurately observed,
this adjustment will yield the conceptually correct balance sheet introduced
in table 1. Moreover, because CPP-corrected net worth figures will represent
the nominal wealth of shareholders under these assumptions, growth in net
worth over the fiscal period will be interpretable as nominal income.
To illustrate the calculation of corporate incoma from CPP-corrected
balance sheets, table 2 presents these statements for the fiscal years ending
at times t=O and t=T. Here, to isolate net worth on the right hand side of
each statement, gross monetary assetL and liabilities have been replaced by
net monetary assets (M,=C,-D t), which may be of either sign. Also, because it
is assumed that all price indices are growing at the same rate, the general
index, Pt, has been used in place of Px and Pk. Finally, notice that nominalt te
income, expressed in terms of the various balance sheet items, has been decom-
posed into two components. The first is real income, and the second, termed
"capital maintenance", is the amount by which net worth at time 0 would have
had to grow in order to be undiminished ir real terms at time T, or
w0 [(PT/Po)-1'
AR-012a/JrD/#3 - 7 -
Table 2
CPP-Corrected Balance Sheets and Associated Net Income
Balance Sheet at Time 0 Balance Sheet at Time T
0 M
Xop0 1rPT
K 0P0 KPT WT
0 T W r - yK ]PT
T WO = 'MT - MO(PT/PO) + (XT - XO )PT+ l T
+ {XO T 0) + KO T 0) + M 0(P ) -1]}
= real income + capital maintenance
Mt = net monetary assets at time t; i.e., cash, net tradecredit, and other financial assets minus all debt
X = inventory stock at time t expressed in base period prices
K = fixed capital stock at time t in base period prices
W = net worth at time t
P = general price level at time t
y annual rate of depreciation of fixed capital
I = gross fixed investment during fiscal year, in base periodprices
= KT - (1-y)KO
AR-0J2a/JTD///3 - 8 -
B. General Tnflation and Income Statements
Intertemporal compartsons are embodied in income statements as well
as balance sheets and, in the presence of inflation, these result in several
additional distortions under the HC system. First, historic input costs are
understated relative to the sales revenues they generate because they are
recorded earlier. Second, depreciation costs are understated relative to
actual replacement costs because they are based upon the historic cost of the
capital stock. Finally, no recognition is made of the fact that monetary
items held over time do not maintain their real value. If these distortions
are left uncorrected, the contribution of various revenues and costs to net
income will be misrepresented. Moreover, the resultant net income figure will
not agree with the CPP-corrected figure derived in table 2 from balance
sheets. It is now explained how CPP accounting deals with these problems.
For reasons that should become apparent later, the discussion begins by
developing expressions for income statement items in midyear prices, then
these expressions are converted to year-end magnitudes.
1. Cost of Goods'hold
First consider the input cost distortion. If firms were to calculate
both input costs and the resultant sales revenues using prices prevailing when
the latter accrued, they would correctly record gross earnings between time 0
and T as total sales minus total costs, each in midyear prices. Assuming
physical sales and input acquisitions take place at the constant rates q=dQ/dt
and u=dU/dt, respectively, this gross earnings figure would be 1/
jO [q-u]Ptdt = [Q-U]PA'
1/ In this section the price level is represented as linear in time inorder to conform with the accounting literature.
AR-012a/JTD///3 - 9 -
where A = T/2. Unfortunately, it is not feasible to calculate the cost of
each input used on the basis of prices prevailing when the corresponding
output is sold. Instead, firms calculate the cost of goods sold as initial.
invenLories plus purchases, less closing inventories. This system often leads
to a systematic understatement of costs in an inflationary environment. For
example, suppose the physical inventory stock is constant at X throughout the
fiscal year, the average input remains in inventory for a period 2A before
use, and a "first-in, first-out" (FIFO) accounting rule is used. I/ Then the
calculated cost of goods sold is not UPA' but a figure smaller by the
amount X [P - P'], where P'=P and P' P_:T 0T T-A 0 -A
initial inventory XPOT
+ purchases fJOuPtdt
- closing inventory XPTT
Cost of goods sold UPA - X[PT -0
Clearly the understatement of input costs occurs because the increase
in the value of inventories due to inflation has been implicitly treated as a
capital gain and an increase in the earnings stream. An expression for income
which embodies this bias is presented in line 5 of Table 3, where the first 5
lines represent the basic items in an historic cost income statement. (It is
no longer assumed that inventory stocks are constant.)
1/ Under a FIFO valuation rule, each input taken from inventory for use isvalued at the price prevailing when the oldest good was placed ininventory.
Table 3- CUP Income Stactvent *
Item Mid-year prices Year end prices
(1) Sales QP
(2) Cost of Goods sold [(2.1)+(2.2)-(2.3)] X0 0 TPT + UP
(2.1) beginning inventories XPO
(2.2) purchases UPA
(2.3) closing inventories XTP'
(3) Other Operating Expenses EPA(overhead and interest)
(4) Depreciation yKO
(5) Historic Cosr Income [(1)-(2)-(3)-(4)] [Q-U-E]PA+XTP'-XOPO-YKO
(6) Adjustments for General Inflation [(6.1)+(6.2)] X0 A 0JT(A P'] + yKO [A-1
I
(6.1) cost of goods sold 0 0 A/PO) - 1]
K PT [(PA')- 1
(6.2) depreciation YYOPA- 1]
(7) Adjusted Income [(5)-(6)I (Q-U-E]PA T 0 A-KOPA [Q-U-E]P +[% -X 0 T-KOPT
(8) Inflation Loss on Monetary Assets ** MO(PT/PO) +[Q-E-U]P - I?
(9) Net Adjusted Income (7)-(8) [I-yK T
* Account format is from Scapens (1981); algebraic representation is the author's.
** Refer to table q.
P price level at time t Q - sales during year in base period prices
P - price level at time t-A U * intermediate good purchases during year in base period prices
T M time index at end of fiscal year E overhead and interest expenses during year in base period prices
0 M time index at start of fiscal year K 0 beginning of fiscal year capital stock in base period prices
A - T/2 Y - annual depreciation rate on capital stock
- 1/2 average time spent by a good in inventory M - net monetary assets at time t
I - grCss fixed investment during fiscal year, in base ?riod prices
AR-012a/JTD/#3 - 11 -
The undervaluation problem present in the top of Table 3 is
eliminated under CPP accounting norms by valuing inventories in terms of the
same prices as sales and purchases, i.e. by weighing the initial and closing
book values of inventories by P PO and PA /P , respectively. This
correction to historic cost of goods sold is typically entered as a separate
item in an."inflation adjustments" account (refer to line 6.1 of table 3).
If a "last-in, first-out" (LIFO) valuation procedure is used, and
inventory stocks are stable, no adjustment will be necessary. This because
under LIFO, the book value of inventories does not grow with inflation.
Rather, the "stock-at-beginning can be thought of as remaining untouched
throughout the year.. .forming a kind of permanent nucleus. At the end of the
year, still valued at its historical cost, it becomes stock-at-end" (Baxter,
1975, p. 84). For this reason, many have advocated the use of LIFO as a
simple means to eliminate understatement in the "cost of goods sold"
account. However, because it is an ad hoc "fix-up" that introduces new biases
in balance sheet inventory values and does not perform well when inventories
are not stable, some have argued in favor of the FIFO-plus-correction approach
(e.g., Baxter, 1975, Chapter 9).
2. Depreciation Costs
Biases in EC income statements because of inaccurate "cost of goods
sold" figures are very likely to be exacerbated by historic value depreciation
figures. Here the imputed reduction in physical capital due to wear and tear
is a fraction of the initial stock, valued at historical purchase prices, Sup-
pose the initial capital stock, K0 , is expressed in terms of base year prices
(perhaps it was purchased in Lhe base year), and that the fraction y of this
stock will be depreciaLed in the current year. Then at year end, the correct
value oE the capital stock in mid year prices is [I + (1-y)KO PA, where I is
AR-012a/JTD/#3 - 12 -
current year gross investment expressed in base year prices. The associated
correct value of depreciation is KO YPA . However, under HC bookkeeping
these items are recorded as IPA + K 0 (1-Y) and K0y, respectively, meaning
K (1-Y) and yK0 both should be adjusted by the factor P A Under CPP
accounting, the difference between historical depreciation cost and adjusted
depreciation cost, i.e., KO YPA- 1], is entered in the inflation adjustment
account along with the adjustment to "cost of goods sold" (see line 6.2 of
table 3). After netting out historical depreciation and these charges, income
in midyear prices becomes
(1) Y = [Q-U-E]PA + [XT 0 A- yKO A'
where E is "other expenses" of the fiscal year, expressed in base year prices.
Notice that because dividends and new share issues or retirements
have been disallowed, this partially corrected income measure must equal net
purchases of inventories, fixed capital, and net monetary assets. Also, be-
cause the average price during the year of the former two will be given byrPA,
the first term of equation I reflects the amount of earnings allocated to
gross fixed investment and net monetary asset purchases (i.e., IPAhMT .
It follows that the income measure in equation I may be rewritten as:
(2) Y = [M - M + [X -X P + [I - yK PT 0 T 0 A 0 A
This form of equation 1 will prove useful below, when the inflation loss from*
holding net monetary assets is discussed.
3. Loss Due to Net Monetary Asset Holdings
The final correction to HC statements deals with the fact that
AR-012a/JTD/#/3 - 13 -
monetary assets and liabilities shrink in real value over time. Without this
-correction, misleading conclusions regarding firm profitability are likely to
be drawn. For example, during inflationary times, nominal interest charges
include a premium to offset the expected decline in the real value of debts.
If the gain that firms enjoy from this decline is not recorded as a revenue,
but all of the nominal interest cost is recorded as a cost, the firm will
appear less profitable than it actually is. Similarly, if firms which carry
cash and interest bearing deposits were to record all financial revenues as
income, but not deduct from this the amount of income necessary to sustain the
real value of their monetary assets, they would be overstating profitability.
The CPP correction to HC accounts which adjusts for losses and gains
on monetary items may be viewed as a counterfactual exercise. It is an
approximate answer to the question: If all monetary assets and liabilities
had actually been perfect inflation hedges, how much more (or less) would the
firm have earned? This issue is addressed with calculations along the lines of
those presented Table 4.- First, initial net monetary assets, M0 , would have
grown to a value of MO(P T /P0) by the period's end if they had been perfect
hedges. Likewise, if the sales revenue accruing at time t had all gone into
perfect hedges it would have grown to [Pt q]T Pt) by period's end, making
total revenue simply FTQ, or PT /PA times recorded gross sales revenues.
Outlays for inputs and other expenses would have to have been realized by
liquidating hedges, and hence must also be scaled by PT /PA before subtracting
them. Finally, any fixed capital investments would have been an alternative
For a fuller discussion of these calculations, see Scapens (1981).
AR-012a/JTD/#3 - 14 -
Table 4 Net Inflation Loss on Monetary Items
(1) Net initial monetary assets m (P /Pwith perfect hedging
(2) Gross sales with perfect QPThedging
(3) Input and other expenseswith perfeet hedging [U+E]P
T(4) Fixed capital purchases IP
(5) Net end of period monetaryassets assets MT
(6) Inflation loss on monetaryassets [(1)+(2)-(3)-(4)-(5)] M0 T P0 )-T + [Q-U-E]PT -PT
* General format taken from Scapens (1981, table 4.4); algebraicrepresentation is the author's. See table 3 for variable definitions.
AR-012a/JTD/#3 - 15 -
to monetary asset accumulation and must be subtracted in year end prices. 1/
The resultant (hypothetical) net end-of-period monetary asset stock would have
been
M0 T/ 0 PT[Q-U-E] - IPT
If the actual end-of-period net monetary asset stock is subtracted from
thisfrom this figure, the difference may be viewed as that amount of earnings
which was foregone because monetary assets were not held in inflation hedges
(refer to line 6, table 4).
To arrive at a CPP-corrected income figure in year-end prices, one
first scales the income expression in equation 1 (or 2) up by the factor
PT /P . Then the monetary correction from Table 4, which is already in year-
end prices, is subtracted (refer to the right hand column of Table 3). To see
the logic of this, note that for nonmonetary items (inventories and
depreciation), this scaling roughly means reporting actual values at a later
point in time. But for cash flow items, it involves the assumption that all
flows accrue to, or are drawn from, inflation hedges. Hence scaling all items
in the income statement by PT /PA means assuming no monetary loss. Note that
after the monetary asset correction, we arrive at a net adjusted income (line
9) that corresponds exactly to the.CPP measure derived from balance sheet
items in Table 2.
Monetary loss accounts can, of course, also be used to arrive at an
adjusted income figure in mid-year prices. For this exercise the year-end
1/ Inventory investments are already included in total input purchases, andneed not be subtracted again.
AR-012a/JTD/#3 - 16 -
correction in line (6) of table 4 is weighted by (P /PA T
(3) 0 (PA/PO)M (PT' /PT)+PA[QUE]-IPA(3) M A 0 T PA T AQUE]IA)
then it is subtracted from the mid-year income figure (given in the left hand
column of Line 7, Table 3).
Some additional insight into the monetary correction item can be
gained by examining this mid-year variant. Recall from the discussion of
equation 2 above that the last two terms of (3) represent the actual change in
net monetary assets, or (y-MO). Hence (3) may be calculated as
(4) M - T PA /PT )M0 (PA /PO
or the nominal change in net monetary assets, less the real change in net
monetary assets, expressed in mid-year prices (e.g., Scapens, Note 10 to Table
6.18). This form of the monetary correction is easier to calculate than the
relatively cumbersome expression presented in Table 3, particularly when
sources and uses of funds are numerous. Accordingly, it is what is likely to
be used in practice.
One final observation on monetary corrections may be illuminating.
Converting (4) back to a year-end figure, line 6 of Table 4 may be expressed
as
(5) [M [M T A MT4O (P T O0
[14 T-M P T /PA )-t] + M [(P T ) - 11
AR-012a/JTD///3 - 17 -
'Here the first term represents losses on those net monetary assets which were
accumulated over the year (assuming dM/dt is constant), and the second term
represents losses on initial monetary assets.
C. Evidence on the Effects of Corrections for General Inflation
In the United States, the Financial Accounting Standards Board (FASB)
has required since 1979 that large firms prepare CPP accounts to augment HC
figures. 1/ The impact on reported profit rates has quite probably been
considerable. As reviewed by Scapens (1981), studies by Jones (1949),
Rosenfield (1969) and Pearcy (1970) compared CPP to conventional accounting
using various data bases and found (1) differences in profits during periods
of moderate inflation can be substantial, (2) the impact of CPP adjustments
varies considerably from company to company, and (3) CPP profit measures are
generally lower than unadjusted figures. More recently, Parker (1977)
obtained very similar results in his sample of 1050 U.S. firms for the period
1972 through 1974. Finally, using aggregate U.S. flow of funds accounts,
Cagan and Lipsey (1979) generated results qualitatively similar to those
obtained at the firm leval, but they found that during some recent periods
inflation-adjusted profits exceeded unadjusted figures considerably 2/
1/ These firms have also also been required to prepare supplemental figureson a "current value" basis, which will be discussed in section IIIbelow.
2/ In the Cagan and Lipsey (1979) study, inventory valuation adjustmentsranged from having virtually no impact on profits (1961 and 1962) tocutting profits by 60% (1974). Depreciation adjustments actuallyincreased profits by as muchas 7% in the mid-1960s, but decreasedprofits by up to 19% in the mid-1970s. Finally, adjustments for lossesor gains on net monetary assets had the largest impact of all during theinflationary period of the 1970s, increasing profits by nearly 69% in1974. (Clearly, firms were typically net debtors.)
AR-012a/JTD//#3 - 18 -
There is some empirical evidence suggesting that CPP adjustments
improve the correspondence between firms' financial statements and their
market performance. For example, Baron, Lakonishok and Ofer (1980) find that
the correlation between firms' "market beta" and "accounting beta" values is
stronger when the latter are estimated using CPP-adjusted financial
statements. 1/ Moreover, the distinction is sharpened when data are used that
span both low and high inflation periods. However, there is also evidence
that CPP statements do not contain much information beyond what financial
market participants were already capable of deducing. For example, Beaver and
Landsman (1982) fail to uncover a significant impact on security prices whem
firms begin reporting CPP-adjusted statements. Also, using discriminant and
logit models of bankrupcy prediction, Norton and Smith (1979) find no
additional predictive power in CPP relative to TIC statements. 2/
All of the above results must be viewed with caution inasmuch as
they are based on U.S. data, where financial markets are highly developed, and
inflation has been quite pedestrian by developing country standards. Although
"research on systems such as those in Argentina and Brazil seems absent from
American libraries and literature indexes" (Frishkoff, 1982), some preliminary
evidence on the importance of inflation adjustments is becoming available.
For example, de Melo and Veneroso (1984) found that public sector enterprises
in Portugal appeared to be doing quite poorly according to their uncorrected
1/ A firm's beta value is estimated by regressing its earnings rate on theearnings rate of a "market basket" (e.g., Fama, 1976), and is an indexof the riskiness of holding its shares. A perfect correlation between *market- and book value-based betas would indicate that books capture allinformation available to market participants. For a review of earlierstudies of the association between CPP-adjusted earnings and marketearnings, see Frishkoff (1982).
2/ See, however, the criticism of this work in Solomon and Beck (19R0).
AR-012a/JTD/#3 - 19 -
financial statements.!/ The average equity to debt ratio in their sample
during 1982 was .21 and combined net income was -35 billion es.cudos. However,
when adjustments were made to account for the effects of inflation (which was
22%), the equity-to-debt ratio increased to .28 and net income increased to -7
billion escudos. In another study, Petrei and Tybout (1984) found that high
inflation and nominal interest rates in Argentina during 1981 caused HC income
statements to register net income losses on the order of -30% to -60% as a
ratio to net worth. Yet because real financial cost were quite negative,
average earnings rates after correcting for net monetary losses ranged between
40% and 50% in some quarters21/
III. FINANCIAL STATEMENTS IN THE PRESENCE OF CHANGING RELATIVE PRICES
When the relative values of different balance sheet items are
changing -- for example, when inventory prices are rising relative to the
general rate of inflation -- the CPP approach to accounting will not yield an
accurate picture of either corporate income or its determinants. One simply
cannot arrive at the conceptually correct balance sheet in table I by applying
a general inflator to historical cost data. To deal with such an environment,
accountants have developed various systems of current value (CVA) accounting.
Because these systems differ in terms of the method by which items are
assigned values, it is worthwhile to review the alternatives before describing
the common characteristics of all CVA approaches.
The Portugese do adjust fixed capital stocks for inflation, but only witha lag.
2 The Argentine inflation rate was above 200% per annum during somequarters of 1981. "Corrected" net earnings rates should not be taken atface value because it was not possible to correct "cost of goods sold"for inflation biases. Still, the magnitude of the change in these ratessuggests the importance of correcting for gains on net monetaryliabilities.
AR-01.2a/JTD/#3 - 20 -
Current value accounting, like CPP accounting, requires that all
items in financial statements be expressed in terms of their current value at
some common point in time. However, rather than relying on a general price
index to calculate these values, CVA accounting dictates that items be valued
individually with reference to various types of auxillary data that reflect
the current economic environment, This means, inter alia, that each entry can
grow in value at its own rate, and in principle, the conceptual magnitudes in
Table 1 can be estimated. But once it has been acknowedged that relative
prices are changing, some difficult conceptual problems regarding the correct
valuation system must be faced.
There are three alternative approaches to assigning values under the
CVA system: (a) replacement costs, (b) resale or "realizable" value, and (c)
value of the discounted earnings stream they are expected to generate. 1/ A
detailed treatment of the merits of each system is beyond the scope of this
paper. It may be noted, however, that a case can be made for any of these
approaches, depending upon who is going to use the data, and the relative
magnitudes implied by each (e.g., Scapens, 1981, chaps 5 and 7). For example,
if an investor who views the firm as a going concern wishes to make decisions
based on accounting data, he may favor replacement costs as the best indicator
of claims on the firm's future gross earning stream (see Revsine, 1973). On
the other hand, creditors may view.assets as collateral, and prefer to know
the resale value. To further confound matters, sometimes a case can be made
for mixing valuation methods on a given balance sheet. For example, suppose
one adopts the rule that assets should be valued at the loss the owner would
1/ Of course in perfectly competitive markets with no transactions coststhe three concepts should coinctde.
AR-012a/JTD//3 - 21
suffer if deprived of them. Then if an asset is held for use, but has a
future earnings stream valued at less than its replacement cost, the former
magnitude might be viewed as the relevant one. Other assets held by the same
firm which have at earnings stream value greater than their replacement cost
might reasonably be valued accordhig to the latter concept, because this is an
upper bound on the loss owners would suffer if the assets were lost. Whatever
the method chosen, significant practical problems of gathering and processing
data are likely to be encountered. 1/
A. Relative Price Changes and Balance Sheets
Suppose agreement has been reached on an observable set of prices
with which to value inventories, fixed capital, and items that require a
general deflator. As in section I, call these prices at time t Px, Pk, and P
respectively. Then by reconstructing the balance sheet so that all items
reflect their current value on the closing date, one arrives at a year end CVA
adjusted statement which, in principle, coincides with table 1. Recognising
that the various price indices are no longer interchangeable, the net worth
growth decomposition between real income and capital maintenance is now more
complicated then the CPP version in Table 2:
(6) W -0 = {M - M (P/P) + T - X0 P(P /P A) + [I - yK k TP AT T 0 T 0OT0O T AKOPA(PT ~A
+ (P'x [(PX /Px ) P /P~'~ + P kK [(P k /P~ k (PT'/O)+ {PX T 0T 0 0KO 0 T 0
+ [XT - x JPX[(PX/Px) - (P /P )3 + [I -yK ]Pk[Pkk/P k (P /P)MT 0 A T A T A) 0 A T A T A
1/ See Fabricant (1978) for a sobering list of difficulties.
AR-012a/JTD/#3 - 22 -
+ (POXIOT(PT ) - 1] + Pk K[(PT/PO) - 1] + M (P/p) - 1}
The first bracketed term of this net worth change looks very much like CPP
income. The only difference is that now, net purchases of fixed capital and
inventories are expressed in specific prices, and brought to year-end values
using the general price inflator. Similarly, thb last bracketed term above
resembles the capital. maintenance term in Table 3; it is the amount that
initial net worth would have had to grow in order to maintain its real
value. The middle terms are peculiar to CVA accounting, and are the topic of
some controversy. They represent holding gains on non-monetary assets in
excess of those which would have occurred if all prices had risen at the rate
of general inflation. If income is defined to be net worth growth in excess
of that necessary to maintain real net worth value, these middle terms should
be combined with the first to comprise total adjusted income. (This "real
purchasing power" notion of income is used in the United States.) Alterna-
tively, if income is defined as net worth growth in excess of that necessary
to maintain the firm's productive capacity, it should be combined with the
third bracketed term to comprise total capital maintenance. (This "capacity
maintenance" notion of income is used in Great Britain.)
B. Relative Price Changes and Income Statement
A CVA-corrected income statement is presented in Table 5. Notice
that the first 9 items are analogous to those presented in Table 3, except Ln
that specific price indices are used. (This changes historic cost entries for
inventories and depreciation, as well as inflation adjustments for these
items.) The monetary correction account is constroeted, as before, under the
assumption that the opportunity cost of holding net monetary assets is
whatever capital gain they could have generated if they had been placed in a
TIable' 5: CVA Income3 Staemnt
Uidvear nrices Year-end Prices
(1) Gross Sales QP
(2) Cost of Gooda Sold xX P x
(3) Dapreciation TX
(4) Other Expenses EP
(5) H'storic Cost Income 1(1)-()()() [--Xp + XKT +U0 Kp 74 +upý
(6) Inflution Adjustments 1(6.1)+(6.2)] x0 !-P-P ]+ x' 0to Operating Profits ..
(6.1) Cost of Goods Sold XO Ppo - x T
(6.2) Depreciation yK[ A
............--------------------------------------------------------------------------(7) Adjusted Income [(5)-(6)1 [Q-E]PA+[XT-X]P -UP -KO A T A T A A7TA
k-TK0 iA iT
1iA>-YK>
k x(8) Loss from Rolding Net Monetary asets m AP lp T [AT -P -IP Hm TP lp T- T[_Fp-UP (PT
P (PT A
(9) Adjusted Income After Monetary Correction ML(P p )-H A/ F l 0 A+0 T 14 -M (iP )+[ x p(p lp A
+[I-TK /p(P )
(10) Cain oan Nonmanetary Assets [(10.1)+(10.2)] PA /?T) {XP -P(P /P -X -X (P p -P p H X
(101)Inenores(P/P T 0 T 0 + K T T 0 + K T 0 X(10.1) Inventories (P( 7/ (XTPT-X'PO(PT/P)) +K 1P lp )-(p /P ) ) K IpTK/P (P T /P)
_+KOpkiPk /Pk )-Ptpl + fI-K lp k UP klp k (P lp UL[TXO',xPTd'?,åJ LY A T i''A>~ 0A OA T A - Ak
(10.2) Fixed Capital (PA T) {KO T o
+[,-YKO'PA[(PT/PA)-(P'P)l)
(11)------- .ar.e.... ----ca---- ....u... af....../Qi 7/'I- - - -- - -(11) Cr Income Inclusive of Real Holding Cains MT(PA/PT)-MO A(P /P 01 [APT x A x T TT1(9)+(10)1 T 0 .0+TT(,F)Xp'PA', 0 XNX0PT/P 0 )+[Xi-X 0 Ipý+X0(PT-P0(TI 0
+ KP(P /p)-Ko p(P A )+[I-yK lP (PlpT + [-YK + KO '7TiPO<iT'O)l
p- inventory price level at time t
t
AR-012a/JTI)///3 - 24 -
general inflation hedge. Line 9, expressed in end-of-year prices, corresponds
to the first bracketed term in equation 6. Hence it corresponds to corporate
income measured on a capacity maintenance basis.
The major qualitative distinction between the CPP and the CVA income
statement is that the latter includes accounts for real gains on nonmonetary
assets. These accounts (i.e., items 10, 10.1 and 10.2) represent real holding
gains on initial nonmonetary assets, plus real holding gains on the net
accumulation of nonmonetary assets over the course of the year. As usual, it
is assumed that all physical asset stocks and prices are linear in time.
Notice that line 10, expressed in end-of-year prices, corresponds to the
second bracketed term In equation 6, which implies that line 11 is real
corporate income measured on a purchasing power maintenance basis.
C. Empirical Evidence on Relative Price Change Adjustments
When done on a replacements cost basis, CVA adjustments may be viewed
as a refinement on CPP adjustments. Accordingly, the impact of CVA
adjustments on net income is presumably comparable to that of CPP adjustments,
and the present discussion will be confined to the (relatively limited)
empirical literature concerning the information content of firm-specific CVA
figures.
With regard to tests of association between accounting and market
earnings rates, the evidence is so,ewhat weak and mixed. On the one hand,
Easman, Falkenstein and Weil (1979) find in their panel data study of U.S.
firms that CVA earnings rates are more closely associated with market rates
than are HC figures over the period 1972-1977. (Nonetheless, only 4% of total
market variation is explained.) On the other hand. Beaver, Griffia and
Landsman (1981) find that in cross section, IC earnings rates are actually
better predictors of stock returns than CVA-adjusted earnings. To further
AR-01.2a/JTD/#3 - 25 -
confound matters, each study based on a distinct set of adjustments, and
neither should be viewed as a complete CVA system./
With regard to the prediction of bankruptcy, only one major study
appears to deal with CVA data. This is Mensah's (1983), who finds that books
adjusted according to CVA norms contain only marginally better information
than HC figures. However, when a loss function is specified that attaches
relatively large costs to classify-ng bankrupt firms as non-bankrupt (as
opposed to classifying noubankrupt firms as bankrupt), the superiority of the
CVA books increases. Here too, no strong conclusions are warranted.
Because none of the above studies deals with fully adjusted CVA books
that were prepared by firms themselves, many open issues remain regarding the
value of such inflation corrections. Perhaps more importantly, as noted in
connection with CPP studies, almost all of the research deals with industrial-
ized countries where the inflation rate has been miniscule relative to that of
Latin Amerfea. I- short, personal biases still appear to play an inordinately
large role in the debate on the merits of CVA adjustments.
IV. SUMMARY:, APPLYING THE ALGEBRA
In sections II and III, 4 basic types of inflation bias were
identified in HC income statements: input cost understatement, depreciation
cost understatement, neglect of net monetary losses, and neglect of those
capital losses due to changing relative prices. These biases are represented
in their most general form by the various adjustments in Table 5 and, to
summarize and interpret the discussion of previous sections, they are now
1/ For example, unrealized holding gains and losses are not recognized.
For a review of other (also inconclusive) studies, see Frishkoff (1982).
AR-012a/JD/#3 - 26 -
reviewed.
The first bias, inxit cost understatement, is represented by line 6.1
of table 5. Its magnitude derends upon the inventory valuation system used,
the volume of inventories carried by the firm, and the rate of inflation. If
inventory stocks are stable and a LIFO valuation system is used, the
distortion disappears: Po' and P are replaced by some common price level
that reflects the average (historic) cost of the initial stock. On the other
hand, if inventory stocks are stable but a FIFO system is used, the bias will
be roughly the annual change in prices times the inventory stock.
The second bias, which is represented by equation 6.2, is due to the
basing of depreciation expenses on historic acquisition costs. Clearly, the
more fixed capital-intensive a firm, and the more the price of capital goods
has risen since the firm acquired its stocks, the more important this bias
becomes. It is worth noting that in countries without comprehens:ive inflation
accounting systems, the capital stock is sometimes adjusted for general
inflation. In such cases depreciation figures may be relatively free of
distortions.
The third bias results from ignoring the shrinkage in real value of
monetary items, which roughly amounts to treating nominal financial costs as
if they were real costs. It is represented by line 8 of table 5 or,
equivalently, by equation 4 in section II of the text. This distortion is
directly proportional to the inflation rate, and at a given inflation rate, to
the net monetary asset stock. In hyperinflated countries it can be the single
most important source of income misstatement. If no adjustment for this
distortion is made, "net income" figures represent not real income, but rather
AR-012a/JTD///3 - 27 -
the residual earnings flow that would be available to firms after retiring
real net monetary liabilities at the rate of inflation.
The final bias is really not due to general inflation; it is present
if and only if relative prices are changing (refer to lines 10, 10.1 and 10.2
of table 5). Accordingly, unlike other biases, this relative price distortion
need not be directly related to the inflation rate. Its magnitude is deter-
mined by the discrepancy between growth in the general price level and growth
in the prices of inventories and fixed capital. Given that there is no con-
sensus on the proper valuation system for nonmonetary assets, the importance
of this relative price distortion is to some degree a matter of personal
judgement: replacement costs may follow one trajectory relative to the
general price level, while net realizable values or discounted expected
earnings stream values may follow another.
AR-012a/JTD/#3 - 28 -
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Baxter, W.T. 1975. Accounting Values and Inflation. London: McGraw-Hill.
Beaver, William 1. and Wayne Landsman, 1982, "The Incremental InformationContent of FAS 33 Disclosures" (July). Unpublished manuscript.
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Petrei, A. Humberto and James R. Tybout 1984. "How the Financial Statementsof Argentine Firms Reflected Liberalization and Reform Attempts:1976-81." Unpublished document, The World Bank.
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