Inflation Accounting: What Will General Price Level Adjusted Income Statements Show?

Abstract

The most significant and persistent complaint about published financial statements in recent years has been that they do not recognize the economic facts of life. Inflation is a reality throughout the world, yet its effects go unrecognized in financial statements prepared in accordance with generally accepted accounting principles in the United States and in most of the other countries of the Western World. Inflation distorts all financial statements, but primary attention in the many public discussions of this topic is usually focused on the way inflation affects reported income. This article analyzes the likely income statement effects of recording inflation adjustments. Two different approaches to adjusting for inflation have been suggested in the accounting literature. One substitutes for the recorded historical cost data of each of the items in the financial statements the current cost. The other adjusts the recorded historical cost data for changes in the value of the monetary unit since each item was acquired. The former deals with specific price changes of individual items, the latter with changes in the general price level. Since most adjustments are made by the use of price indexes, the first approach relies on indexes of specific prices, the second on an index of the general price level. The appendix of this article explains and illustrates the essentials of both approaches. The current cost approach is conceptually superior (and presents more meaningful statements) in our view, but the general price-level approach has received authoritative support because of its greater objectivity and auditability. In both the United States and the United Kingdom, the authoritative accounting bodies are currently considering the question of general price-level adjusted financial statements and may issue pronouncements requiring their publication in the near future. In both countries, the general pricelevel statements would be supplemental to the conventional unadjusted historical cost statements. 1 Since general price-level adjusted statements are likely to be the only adjustments for inflation with official sanction, the rest of the body of this article is concerned with the effect of such adjustments on reported earnings. (Some of the results of using current cost adjustments are illustrated in the appendix.) In the remaining sections we analyze the effects of general price-level adjustments on the 30 Sidney Davidson, Arthur Young Professor of Accounting, University of Chicago, is currently on leave as a Fellow of the Center for Advanced Study in the Behavioral Sciences, Stanford, California. Roman L. Weil is Mills B. Lane Professor of Industrial Management, Georgia Institute of Technology. The authors thank Christine Ciarfalia and Samy Sidky for their research assistance and the Ford Foundation Faculty Research Fund of the Graduate School of Business of the University of Chicago and the National Science Foundation for research support. They thank Richard M. Cyert, Yuji Ijiri, and Mary Peeler for various kinds of help. 1. Footnotes appear at end of article. (Pp. 83-84)