Pinkert, James R.

Posey, Imogene A.

English

eGrove (Univ. of Mississippi)

Woman C.P.A. Volume 40 Issue 1 Article 6 1-1978 Changes in Price-Levels: Are accounting restatements worth the cost? James R. Pinkert Imogene A. Posey Follow this and additional works at: https://egrove.olemiss.edu/wcpa  Part of the Accounting Commons, and the Women's Studies Commons Recommended Citation Pinkert, James R. and Posey, Imogene A. (1978) "Changes in Price-Levels: Are accounting restatements worth the cost?," Woman C.P.A.: Vol. 40 : Iss. 1 , Article 6. Available at: https://egrove.olemiss.edu/wcpa/vol40/iss1/6 This Article is brought to you for free and open access by the Archival Digital Accounting Collection at eGrove. It has been accepted for inclusion in Woman C.P.A. by an authorized editor of eGrove. For more information, please contact egrove@olemiss.edu. Changes in Price-LevelsAre accounting restatements worth the cost?James R. Pinkert, Ph.D., is Associate Professor with the Department of Computer Sciences, California State University, at Chico. He holds an MBA degree in accounting from the University of Tennessee and his work with data processing has been coordinated with management information systems, accounting systems, and EDP auditing.They own a modest piece of land They didn’t pay much for.But that was many years ago And now it’s worth much more.They also hid away some cash Their old age to augment.It seemed to be more than enough Until its PuPU1 went.And so they sit and wonder About their Balance Sheet; To ascertain their status Is really quite a feat.The cash they saved so faithfully Is scarcely worth a thing.Their land that was near worthless Could ransom any king.    1PuPU is John C. Burton’s acronym for Purchasing Power Units; for example, see John C. Burton, “Financial Reporting in an Age of Infla­tion”, Journal of Accountancy, February, 1975, page 70.Imogene A. Posey, CPA, CMA, is Associate Professor of Accounting at the University of Tennessee in Knoxville. She is a member of A WSCPA, the Tennessee Society of CPAs, AAA, AICPA, and NAA. She has been published in accounting texts, professional journals, and has recently joined the staff of The Woman CPA as Reviews Editor.The little poem illustrates some basic aspects of the general price-level adjust­ment problem (hereafter referenced with the acronym PLAD). PLAD presents a cruel dilemma to individuals and is just as prevalent in financial reporting and data for decision making; in fact, it is apparent in all data for economic consideration.How practical is it to present an asset at its historical cost when this historical cost is often totally meaningless? Con­sider the friend who in the 1930’s purchased ten acres of forest (including 2,000 feet of lake frontage) for $ 100; this land is currently in a prime recreational area where lake frontage is selling for $ 110 per foot. Or, in the other direction, hypothesize an accounting firm which, repeating one of the author’s mistakes a thousand fold — a few years ago purchased calculators for $ 123.95 which are now available for $49.95.Even naive citizens are aware of changing land values, sometimes pain­fully aware, and more than few have also felt cheated when competitive marketing has driven down the purchase price for a showy new toy only a few months after the owner bought it.Many Americans further understand, all too well, what economists mean when the dollar is referred to as a rubber measuring stick that bends and stretches to show like quantities at different costs, year after year. The 1958 dollar was not the same as the dollar in the 1978 pocket. As U. S. dollars grow smaller in implication as exchange potential, so does the joy of the real-estate holder whose ten acres of forest and lake fron­tage have soared in “value”. Those un­dependable dollars can be even more perfidious than calculators, and microwave ovens, that lure the eager into costly buying mistakes.Of course, the dynamic dollar and the specific item considerations are in­terdependent. The dynamic dollar is a manifestation of the composite specific item changes, and each specific item change is in turn a composite of its own individual relative changes and the dynamic dollar.This paper is a brief consideration of some aspects related to PLAD. In Sec­tions 1 through 4 the authors consider some underlying questions: what index to use; how difficult is the application; what does one do with the problem child — monetary gains and losses; last, but very definitely not least, is it worth all the effort.Problems with replacement cost in an age or rapid technological advances are discussed in Section 5.Replacement cost has been advocated as an alternative to PLAD or as part of a combined technique in conjunction with PLAD. The Securities and Exchange Commission (SEC) adopted disclosure requirements for financial statements for fiscal years ending after December 25, 1976, The Commission requires (for the 1,000 largest nonfinancial cor­porations2) disclosure of certain specified replacement cost information on statements filed with the SEC. The footnote disclosure for assets must in­clude the current replacement cost of in­ventories and the estimated current cost of replacing the productive capacity of depreciable, depletable, and amor­tizable assets on hand at the end of each fiscal year. Additionally, there must be a statement as to the amount of deprecia­January, 1978 /17tion, depletion, amortization, and the cost of sales, assuming that they had been computed on the basis of replacement costs of the productive assets.The authors’ alternative to PLAD is presented in Section 6. Finally, a brief summary and conclusion is given in Sec­tion 7. The question to ponder is — if ac­countants don’t find a final solution soon, will the new SEC disclosure re­quirements be expanded perhaps to the entire financial statements, be covered by the auditor’s opinion, and subse­quently become part of the generally accepted accounting principles?The recognition of the problem dates to early U. S. history. In 1780, some notes were issued by the State of Massachusetts. Both the principle and the interest were adjusted by the ratio:R = cost (5 b. corn, 68# beef, 10# wool, 16# leather) £130The subject was mentioned infrequently in the accounting literature until 1935, when Henry W. Sweeney published an article on stabilized accounting4. (Many of the “new” current ideas are contained in that article!) Sweeney was concerned about rampant two percent inflation rates. Recent rates in some South American countries were over 100,000 percent. Rates in the United States and other developed countries are in two digits; a solution to this problem is badly needed!What Index?If one is going to adjust statements ac­cording to some price level index, then the choice of an appropriate index is an immediate problem.Suppose that one is going to consider a product mix of N items. This must then be definition of the following quan­tities for each item i:q(0,i) = quantity used in base year; q(l,i) = quantity used this year; q(a,i) = average quantity used;p(0,i) = price in base year; p(l,i) = price this year.Four formulae prevail currently, employ­ing various combinations of the q and p values, but the formulation of the Gross National Product Implicit Price Deflator has the strongest support.5 The crucial differentiation among the 18/ The Woman CPAmethods is quantity.Proponents of PLAD acknowledge a problem caused by changing technology, and related to q(?,i). They have decided that there should be a cutoff year Y (e.g., 1945), and that items purchased before Y should use the,year Y index. The reason is that technological advances have made the product mixes of N items prior to Y noncomparable to the product mixes after Y. How many computers and TV sets would have appeared in the 1920 in­dex listing?The authors do not think that this analysis has been carried far enough. Although setting a time range which gives better item-to-item comparability, the intrinsic capabilities of items are ap­parently not sufficiently considered. For example, an early medium-sized com­puter might have cost $100,000; a pre­sent machine of the same relative size scale, on the other hand, could easily cost several times that much. However, this modern machine is so much faster that the actual cost per computation is considerably lower.A more realistic index would result if the components of the index equations were stated in comparable units. After all, isn’t PLAD’s raison d’etre the stan­dardization of measuring units?2. From Theory to PracticeThere is no question that the first year of PLAD would be difficult — all of the indices would have to be determined for the balance sheet items. However, after the initial hump, little extra effort would be required. To demonstrate this, the authors have developed a set of com­puter programs for adjusting the balance sheet, computing monetary gains/losses and adjusting the income statement.The number of items has been limited in these programs. However, all the necessary basic logic is incorporated. Hence, the authors believe that reser­vations about PLAD founded on the premise that it is difficult to put into effect are not valid when compared to the application of other available alter­natives such as current market value or replacement cost.3. Monetary Gains and LossesOne of the problems of PLAD finan­cial statements is the disposition of monetary gains and losses. Should the monetary gains and losses be taken through the income statement or should they be excluded from net income even on an adjusted statement? According to research published by Weil and David­son6 in early 1975, there is a substantial difference in adjusted net income ex­pressed as a percentage of reported net income (by a factor of six or eight times) when monetary gains are included as compared to the exclusion of these gains. Note, however, that the results are not necessarily over statements. Many of these figures including monetary gains and losses were still below reported net income and the medians of thirty companies were near (99 to 100 percent) reported net income. Another sample of thirty companies showed a median adjusted net income including monetary gains and losses that was 92 percent of reported net in­come on the statements.Schwieger and Dittrich7 provided a graph to estimate the effect of price-level adjustments on reported net income with various ratios of net monetary debt to fixed assets, noth long-lived and shorter-lived assets. The larger the ratio the more the increase in adjusted net in­come, and the smaller the ratio the more the decrease in adjusted net income as compared to reported net income. The graphed results included adjustments for only net monetary position and fixed assets and some qualifying assumptions. The research indicated that the results of price-level adjustments are quite variable.4. Is a General Price Index Preferable To Some Other Method?There are many arguments for and against PLAD, but this paper will avoid debating them individually. Rather, one crucial question will be considered in detail.Certainly PLAD does result in a un­iform measuring unit. However, this measuring unit is applied to most items on the basis of historical cost. Do the results provide enough more informa­tion to justify all the effort.?As simple examples, consider the two situations mentioned in the introduc­tion: the land at $100 and $1,000 calculators at a total of $123,950. Assuming current index ratios for the times of purchase are 25 and 1.15, respectively, these items would be shown at $2,500 and $142,543. The first is still greatly understated and the se­cond is even worse than the unadjusted figure since the going price for these items is $49,950.Of course, the preceding paragraph implies that a better evaluation techni­que is in order. Is a technique available that will meet the criterion of objec­tivity?There is a compromise. Specific index adjustments are very objective, and yet they allow groups of items to be ad­justed independently within the general framework of PLAD. Many such in­dices are already available, since the GNP index is in essence computed from a vast set of subindices.The objections of “difficult and ex­pensive application” are heard again. “Think of General Motors and how many items they would have to adjust!”First, there is no suggestion of treating each item separately — only groups of items. Second, computer programs designed for PLAD ad­justments could be modified very easily to accomplish group translations. In­stead of just a purchase-year monetary index, each item would be tagged with both this index and its classification code. At the end of the period, both the current general index and the list of specific indices for each classification would be read into the computer and the appropriate adjustments accomplished.As with PLAD, there would be an in­itial hump coincident with the first application. Also, such a technique would not necessarily adjust each specific item to the absolutely “best” figure (the land probably would remain understated). However, the figures would be much better than single-index- adjusted historical cost, and would maintain the objectivity of historical cost.5. Determining Replacement ValueReplacement value is a value based on replacement cost after adjustment for the already expired service potential. Replacement cost is the lowest amount that would have to be paid in the normal course of business to obtain an asset of equivalent operating capacity. How does one determine such a cost in an age of rapidly changing technology? There seem to be four basic approaches in use:2 *4682Wall Street Journal, “Replacement-Cost Ac­counting Plan Adopted by SEC”, (New York, New York), March 25, 1976, p 43Securities and Exchange Commission, “Ac­counting Series Release No. 190”, March23, 19764Henry W. Sweeney, “The Technique of Stabilized Accounting”, Accounting Review (June, 1935), pp 185-2055Financial Accounting Standards Board, “Financial Reporting in Units of General Purchasing Power”, (December, 1974)6Roman L. Weil and Sidney Davidson, “Infla­tion Accounting”, Financial Analysts Journal (January-February, 1975), pp 27-31, 70-847Bradley J. Schwieger and Norman E. Dittrich, “Variability in the Effect of Price-Level Changes on Reported Income”, Cost and Management (July-August, 1975) pp 6-118R. J. Flew and B. F. Trump, “Establishment of Replacement Values with Particular Emphasis on Technological Change,” Australian Accountant (December, 1975) pp 652-6569Edgar O. Edwards, “Depreciation Policy Un­der Changing Price Levels”, Accounting Review (April, 1954) pp 267-28010 Wall Street Journal, op. cit.1. specific prices;2. estimates based on product reproduction;3. expert valuation;4. a combination of the above with specific price index adjustments.Suppose the market offers no replacement with the same capacity. A pro-rata cost based on ratios of capacities has been suggested in that event. Complete knowledge is required, however, of the implicit cost structure of each alternative. Complications mount when the only comparable output is the product of a system with an entirely different mode of operation. Replace­ment cost in such a case might represent an adjustment of new system costs to equate that output to present processes, but that might imply a decision to switch to the new system — a decision which has not been made, and may never be made.When problems like the above arise, some proponents of replacement value recommend reversion to reproduction cost, valuation, or indexed historical cost. The author’s comments are two­fold. In the first place, reproduction cost is usually worthless because it involves an estimate on a custom-make device to replace one that was probably mass (in some sense of the word) produced. The cost of the two processes of produc­tion are scarcely comparable. More in­portant, the vast repertoire of alter­native replacement cost determination methods would result in a conglomera­tion of unreliable figures on the statements!The SEC recognizes a wide variety of “valuation” alternatives, not necessarily in the same order as those listed above. Determination of maintenance costs for current production capacity also presents problems of judgement.6. A Different IdeaIn this section the authors present their view of how statements can be made more meaningful. Most aspects of the approach have been supported in earlier sections; hence this presentation is mainly a summary.Non-monetary assets should be ad­justed using specific indices. These changes should be split between the PLAD change (taken directly to retain­ed earnings) and the individual change (taken directly to retained earnings) and the individual change (taken through the income statement). Depreciation ex­pense should be based on current cost determined by the application of specific price indices, and the balancing entries then split between historic ac­cumulated depreciation and the asset valuation adjustment account, as dis­cussed by Edwards.9Monetary gains and losses should be computed using PLAD. Any losses should be taken to a special account in owners’ equity. Gains should be recognized only to the extent that they cancel previous losses. In neither case should the values be taken through the income statement. This procedure is mandatory to recognize managements’ decisions (good or bad) without allow­ing the potential misunderstandings created by reporting monetary gains and losses as income, as discussed in Section 3.ConclusionIt is difficult to try to summarize the points presented in the previous sec­tions. Instead, a little bit of philosophiz­ing will be substituted.There are several workable ap­proaches to making statements more meaningful; obviously, the authors think that theirs is best. The SEC has moved to establish its version, which the authors do not think is best. The accounting profession is apparently sitting on its hands, which the authors also deplore.The accounting profession needs to look at the FASB exposure draft, and comments received about it, and work out some new plan, and do it soon. In the United Kingdom, the government stepped in and came up with a reasonable plan. It appears that the same thing may be happening in this country. John C. Burton, when he was Chief Accountant of the SEC, stated that the exemption for small companies may be eliminated in two or three years.10 The SEC plan should be con­sidered very carefully to determine if it is the most reasonable plan. It seems to lack careful consideration of several problem areas.Footnotes1John C. Burton, “Financial Reporting in an Age of Inflation”, Journal of Accountancy (February, 1975), pp 68-71January, 1978 /19

Changes in Price-Levels: Are accounting restatements worth the cost?

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Changes in Price-Levels: Are accounting restatements worth the cost?

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