Accounting for Economic Earnings: Inflation-Adjusted Replacement Cost

I am going to cap off the topic of loan accounting, which occupied my last three posts (here, here and here), with a 'proof' and further explanation of my solution to the simple problem I introduced in the first post of the series. I am doing this because some of you have asked me to explain my numbers further. Questions may also still remain regarding how the effects of inflation can be incorporated into a double-entry system of accounts. The answer is, of course, that they can, but there are a few new tricks that some might have not seen before. How exciting… new debits and credits!!

Kidding aside, even this simple example contains some mind-expanding elements for both professionals and advanced students.

For your convenience, this is a repetition of the problem statement:

• On December 31, 20x0, Lender Company invested $10,000 in a bond issued on that date with the same face amount $10,000. To keep things really simple for now (and to defer discussing differences between replacement cost and fair value), there are no transaction costs.
• The terms of the bond provide for two payments: $1,000 on December 31, 20x1, and $11,000 on December 31, 20x2. Both payments were made in full.
• Lender Company had only one other asset on December 31, 20x0: cash in the amount of $1,000. It had incurred no liabilities, and engaged in no transactions, except those related to the bond, through December 31, 20x2.
• As a rudimentary, yet sufficient, substitute for real-world measurements of inflation, we will blissfully imagine that there is only one consumption good in the world: beer. As of December 31, 20x0, a keg of beer cost $100. Immediately after the two payments on the bond, the price per keg rose to $110 and $121, respectively. (It would be perfectly legitimate to remove the dollar signs on the keg prices, and imagine that they are values of the Consumer Price Index.)

No matter, which basis of accounting you choose, the December 31, 20x0 balance sheet for Lender Company, stated in units of purchasing power as of that date will be as follows: 

I will now provide you with the T-account entries to derive the balances that are used to prepare the December 31, 20x1 financial statements, stated in units of purchasing power on that date:

 

Here are the explanations (I abbreviate "units of purchasing power" as "UP"):

And, here are the financial statements at the end of the first year:

Notice that the beginning balance sheet has been restated to reflect units of purchasing power as of 12/31/x1 (i.e., multiplied by 110/100)  even though the date of the balance sheet is one year earlier.

Finally, here are the T-accounts, explanations and financial statements as of the end of the second year:

Notice once again the treatment of the comparative periods:  20x0 has been inflated for two years (i.e., multipled by 121/100), and 20x1 for one year (i.e., multiplied by 121/110). 

To close, I'd like to remind you that reliable reporting of the effects of inflation on an entity can materially affect the financial statements, even when the inflation rate is pretty low. But, unfortunately, comprehensive inflation-adjusted replacement cost got an undeservedly bad rap when it was required by FAS 33 on a disclosure basis only. Among other things, very few accountants and analysts took the time to understand the numbers, because the patchwork implementation of some admittedly sticky issues were overly accomodating to issuers; and as a result, did not result in high-quality information.

I am hoping that inflation-adjusted replacement cost can at least begin a comeback as the FASB seeks to improve loan accounting. One thing they should know: substantial progress is possible even if inflation accounting and replacement cost measurements are not applied to all assets and liabilities. But, loan accounting, especially because interest rates are inextricably linked to expected inflation, would be a very good place to start. The implementation issues are much less problematic than, for example, hedge accounting.

Comments

[Raza]

Hi Tom, Excellent presentation, and carry over from your first post on loan accounting. Another magnum opus post from you: )My hunch is that as long we don't follow (of course in the future) that other standard setting body's lead - we will continue to make some (if not all) progress in this direction. Changes in price level and specific prices are real world realities and thus needs to be incorporated in the F/S to present (or at least closely approximate in complex situations) the true economic picture. Inflation (even the minute one) can significantly affect the numbers. The $1,000 loan with 5% interest, when get paid in full ($1050)can command only 1029 gallons of gas with a 2.0% inflation if the gas were (say 1 g = $1). So, I am right there with you on it : ) Thank you for expanding our mind horizon : )