- Email: [email protected]
Accounting for inflation: The need for action
O~tEGA, The Int. Jl of M g m t Sci,, Vol. 3, No. 1. 1975
Accounting for Inflation: The Need for Action R BROUGH University College of Swansea (Received May 1974)
The article was prepared at a time when the business community still seemed very uncertain about the significance of changing price levels in relation to accounting statements. Those, including the author, who believed that the unadjusted figures being produced in company revenue accounts and balance sheets gave potentially misleading information sought in various ways, mainly in books and articles, to give greater awareness of the problem. The author's contribution was designed to demonstrate, simply and unequivocally, how business capital, in real terms, is liable to be eroded in periods of rising prices.
THERE has been evidence in recent months of a reawakening of interest in the topic of the accountancy of changing price levels. Actually, in view of the direction in which practically all prices have been moving over the last decade or more, 'accounting for inflation' may be regarded as the more appropriate name for the topic. It can be fairly argued that interest in this subject should never have been allowed to wane; it is, indeed, difficult to see how that could have happened if its real significance had been generally recog~ised in the business world. The purpose of the present article is to demonstrate as shortly but as convincingly as possible the inadequacy of accounting methods which disregard the fact of price level changes. If, after reading the article, the reaction produced is that of a feeling of inability to look an unadjusted profit calculation in the face again, then the writer's objective will have been achieved. By way of illustration, a very simple example is used. It relates to a small manufacturing business which makes one single product. Its output of this product is assumed to be sold as soon as it is completed (so that no finished goods stocks are carried). It requires the use of one machine: for the sake of simplicity, perhaps we can call it a 'fasset'. Only one kind of raw material stock is carried, say 'alpha'. 95
Brough--Accounting for Inflation." The business is started on 1 January 1961 with £100 capital in cash. A fasset is bought for £50, 40 units of alpha are bought and the commencing balance sheet is therefore as follows: BALANCESHEET, 1 JANUARY1961 £ Capital
£
100
Fasset Stock (40 units of alpha) Cash
100
50 40 10 100
It is estimated th.at the fasset will last for 10 years and have no scrap value. The straight line method of depreciation is adopted. In the event, the estimate of the working-life of the fasset proves exactly right. The proprietor has told his accountant that he does not wish to expand his business; on the other hand he does not wish it to contract. It is therefore decided that the proprietor will make his drawings each year exactly equal to the profit, which is calculated on conventional lines and without regard for price-level changes. At the end of 1970 the balance sheet is as shown below. The capital account details cover the whole ten years of the business' existence; it is assumed that total profit of the period was calculated at £300, and that this was the total amount withdrawn by the proprietor. BALANCESHEET,31 DECEMBER1970 £
£
Capital 1 Jan. 1961 100 add profit, 1961 to 1970 300 400 less drawings
£ Fasset-cost aggregate depreciation Stock Cash
300
£
50 50 nil 40 60
100 100
100
If, over the ten-year period, all prices have stayed the same, there is no difficulty. £50 is spent on a new fasset to replace the old one and the balance sheet becomes exactly the same as it was ten years before. But in the light of the United Kingdom's experience in recent years, the assumption of unchanging prices seems most unrealistic. Suppose, therefore, a modest increase in the replacement cost of the fasset--say to £60 by the end of the tenth year. It takes the whole of the £60 cash balance held on 31 December 1970 to pay for the new fasset, and we now have: 96
Omega, Vol. 3. No. l BALANCESHEET, 1 JANUARY1971 £ Capital
£
100
Fasset--at cost Stock
100
60 40 100
In real terms, the business has clearly shrunk since l January 1961, when it had not on[y a new fasset and £40 of stock, as now, but also £I0 cash. This is not the full story, however: assuming the price of alpha, the raw material stock, has also risen since 1961, it may well be that the £40 of stock now held represents o n l y , say, 32 units of alpha compared with 40 units which this value represented in 1961. I f we redrafted the 1 January 1971 balance sheet in what we may call £'s of 1961 vintage it would require the insertion of a balancing item; 'inflation loss' might be an appropriate term to use: BALANCESHEET, 1 JANUARY1971 (RE-DRAFTED) £ Capital less inflation loss
£
100 18
£ Fasset Stock
50 32
82 82
82
Finally, it should be clear that a balance sheet like the one that follows, written in January 1971 £'s, would show the business in exactly the same position as at the outset, the capital having been maintained intact in real terms. BALANCESHEET, 1 JANUARY1971 £ Capital add profit
£
100 277
£ Fasset Stock (40 alpha) Cash (see below)
60 50 13
377 less drawings 277 100 Inflation provision 23 123
123
The £13 shown for cash is the equivalent amount in January 1971 £'s to the £10 of January 1961 £'s, assuming a deterioration in the purchasing-power of money to that extent over the ten-year period. There is r o o m for discussion as to the basis on which 1961 and 1971 £'s should be equated, but that it will take more 1971 £'s to be equivalent to a given number of 1961 £'s can, I trust, be accepted. 97
Brough--A ccountingfor Inflation: It is evident, therefore, that a total of £23 should have been lifted out of the calculated profit so that the proprietor's drawings would be restricted to £277. On the assumptions made about price-changes, this would just have ensured that the capital of the business was maintained intact in real terms--and to be frank, any other version of maintaining capital intact makes little sense. Our proprietor, on becoming aware of what has happened to his business, will be entirely justified in feeling that he has in some way been let down by his accounting system. It is astonishing that this really serious problem has been so consistently ignored. It seems to have been brought into the open for the first time by H. W. Sweeney in his book Stabilized Accounting, written in 1936, (quoted [1]). He said: "Now the success of tile whole system of business depends upon the truthfulness of reports. The truthfulness of reports depends mainly on the truthfulness of the dollar--and the dollar is a liar ! For it says one thing and means another". Two years before the publication of Sweeney's book, Ludwig Von Mises, an economist, had observed in his Theory of Money and Credit, (quoted [1 ]): " o f the liability to variation of the value &money, the merchant, the accountant and the commercial court are alike unsuspicious. They hold money to be a measure of price and value, and they reckon as freely in monetary units as in units of length, area, capacity and weight." Nobody has ever found it necessary to construct index-numbers to show how the weight of an ounce or the length of a yard or the capacity represented by a cubic foot have varied over time, but it is generally accepted that there is need of an index-number to record changes in the internal purchasing power of the pound. As a matter of fact, there appears to be a need for more than one index : one, prepared by the Department of Employment and Productivity, in respect of retail prices and another, produced by the Board of Trade, relating to wholesale prices. And yet, in conventional accounting, we still seem insistent on calling a pound a pound, whatever its vintage. It will be contended, perhaps, that we cannot have done so very much harm: the great majority of businesses do survive and even expand. It seems irrefutable, however, that if they had followed a policy of distributing the whole of their 'profit' to their proprietors, real capital could not have been maintained intact without the periodic injection of additional funds. It seems that there are two main reasons why we have not heard more about the ill-effects of rising price-levels. One is that until the last couple of years inflation has been at a modest rate. In some South American countries, it has been so rapid that it compelled recognition of the problem. But, of course, a small 3% per annum (simple interest) rise in fixed asset replacement costs means that £130,000 is needed to replace equipment which cost £100,000 originally and is now, after ten years, due for replacement--and only £100,000 has been retained in the business in the form of depreciation provisions if conventional depreciation accounting has been employed and increasing replacement cost ignored. The 98
Omega, Vol. 3, No. 1
second reason is that it does not seem to matter if businesses do not allow for rising price levels by some formal procedure which builds up reserves--called, for example, Fixed Assets Replacement Reserve and Stock Price-Change Reserve--so long as they retain profits and put them to, say, General Reserve Account. But, when doing this, they should not suppose that the growth in these reserves represents the extent of their provision for expansion from within. This would be a delusion: a substantial part of their retentions is merely serving to cushion them against (to hide from them ?) the effect of inflation. It is possible that academics must bear some of the blame for so little having been done about the problem: they have been divided on the question of whether it should be tackled by means of specific indexes relating to specific assets, as in the simple illustration outlined above, or by the use of some general indexnumber. An excellent illustration of the simplicity of the general index method was provided as long ago as 1958 by A R Mutton [2]. It is not my intention to discuss here the respective merits of the two methods. It would seem futile, however, to go on waiting for the perfect method of adjustment which everybody could accept. If we treat seriously the problem of changing price levels ourselves, we may in time persuade the Inland Revenue that something should be done about it, not only for income tax and corporation tax, but for capital gains tax, too. It bears thinking of!
REFERENCES 1. CHAMaERSRT (1966) Accounting Evaluation and Economic Behaviour. Prentice Hall, Englewood Cliffs, New Jersey. 2. Mtrrro,'q AR (1958) Accounting for inflation. The Accountant. 8 February.
99
Accounting for Inflation: The Need for Action R BROUGH University College of Swansea (Received May 1974)
The article was prepared at a time when the business community still seemed very uncertain about the significance of changing price levels in relation to accounting statements. Those, including the author, who believed that the unadjusted figures being produced in company revenue accounts and balance sheets gave potentially misleading information sought in various ways, mainly in books and articles, to give greater awareness of the problem. The author's contribution was designed to demonstrate, simply and unequivocally, how business capital, in real terms, is liable to be eroded in periods of rising prices.
THERE has been evidence in recent months of a reawakening of interest in the topic of the accountancy of changing price levels. Actually, in view of the direction in which practically all prices have been moving over the last decade or more, 'accounting for inflation' may be regarded as the more appropriate name for the topic. It can be fairly argued that interest in this subject should never have been allowed to wane; it is, indeed, difficult to see how that could have happened if its real significance had been generally recog~ised in the business world. The purpose of the present article is to demonstrate as shortly but as convincingly as possible the inadequacy of accounting methods which disregard the fact of price level changes. If, after reading the article, the reaction produced is that of a feeling of inability to look an unadjusted profit calculation in the face again, then the writer's objective will have been achieved. By way of illustration, a very simple example is used. It relates to a small manufacturing business which makes one single product. Its output of this product is assumed to be sold as soon as it is completed (so that no finished goods stocks are carried). It requires the use of one machine: for the sake of simplicity, perhaps we can call it a 'fasset'. Only one kind of raw material stock is carried, say 'alpha'. 95
Brough--Accounting for Inflation." The business is started on 1 January 1961 with £100 capital in cash. A fasset is bought for £50, 40 units of alpha are bought and the commencing balance sheet is therefore as follows: BALANCESHEET, 1 JANUARY1961 £ Capital
£
100
Fasset Stock (40 units of alpha) Cash
100
50 40 10 100
It is estimated th.at the fasset will last for 10 years and have no scrap value. The straight line method of depreciation is adopted. In the event, the estimate of the working-life of the fasset proves exactly right. The proprietor has told his accountant that he does not wish to expand his business; on the other hand he does not wish it to contract. It is therefore decided that the proprietor will make his drawings each year exactly equal to the profit, which is calculated on conventional lines and without regard for price-level changes. At the end of 1970 the balance sheet is as shown below. The capital account details cover the whole ten years of the business' existence; it is assumed that total profit of the period was calculated at £300, and that this was the total amount withdrawn by the proprietor. BALANCESHEET,31 DECEMBER1970 £
£
Capital 1 Jan. 1961 100 add profit, 1961 to 1970 300 400 less drawings
£ Fasset-cost aggregate depreciation Stock Cash
300
£
50 50 nil 40 60
100 100
100
If, over the ten-year period, all prices have stayed the same, there is no difficulty. £50 is spent on a new fasset to replace the old one and the balance sheet becomes exactly the same as it was ten years before. But in the light of the United Kingdom's experience in recent years, the assumption of unchanging prices seems most unrealistic. Suppose, therefore, a modest increase in the replacement cost of the fasset--say to £60 by the end of the tenth year. It takes the whole of the £60 cash balance held on 31 December 1970 to pay for the new fasset, and we now have: 96
Omega, Vol. 3. No. l BALANCESHEET, 1 JANUARY1971 £ Capital
£
100
Fasset--at cost Stock
100
60 40 100
In real terms, the business has clearly shrunk since l January 1961, when it had not on[y a new fasset and £40 of stock, as now, but also £I0 cash. This is not the full story, however: assuming the price of alpha, the raw material stock, has also risen since 1961, it may well be that the £40 of stock now held represents o n l y , say, 32 units of alpha compared with 40 units which this value represented in 1961. I f we redrafted the 1 January 1971 balance sheet in what we may call £'s of 1961 vintage it would require the insertion of a balancing item; 'inflation loss' might be an appropriate term to use: BALANCESHEET, 1 JANUARY1971 (RE-DRAFTED) £ Capital less inflation loss
£
100 18
£ Fasset Stock
50 32
82 82
82
Finally, it should be clear that a balance sheet like the one that follows, written in January 1971 £'s, would show the business in exactly the same position as at the outset, the capital having been maintained intact in real terms. BALANCESHEET, 1 JANUARY1971 £ Capital add profit
£
100 277
£ Fasset Stock (40 alpha) Cash (see below)
60 50 13
377 less drawings 277 100 Inflation provision 23 123
123
The £13 shown for cash is the equivalent amount in January 1971 £'s to the £10 of January 1961 £'s, assuming a deterioration in the purchasing-power of money to that extent over the ten-year period. There is r o o m for discussion as to the basis on which 1961 and 1971 £'s should be equated, but that it will take more 1971 £'s to be equivalent to a given number of 1961 £'s can, I trust, be accepted. 97
Brough--A ccountingfor Inflation: It is evident, therefore, that a total of £23 should have been lifted out of the calculated profit so that the proprietor's drawings would be restricted to £277. On the assumptions made about price-changes, this would just have ensured that the capital of the business was maintained intact in real terms--and to be frank, any other version of maintaining capital intact makes little sense. Our proprietor, on becoming aware of what has happened to his business, will be entirely justified in feeling that he has in some way been let down by his accounting system. It is astonishing that this really serious problem has been so consistently ignored. It seems to have been brought into the open for the first time by H. W. Sweeney in his book Stabilized Accounting, written in 1936, (quoted [1]). He said: "Now the success of tile whole system of business depends upon the truthfulness of reports. The truthfulness of reports depends mainly on the truthfulness of the dollar--and the dollar is a liar ! For it says one thing and means another". Two years before the publication of Sweeney's book, Ludwig Von Mises, an economist, had observed in his Theory of Money and Credit, (quoted [1 ]): " o f the liability to variation of the value &money, the merchant, the accountant and the commercial court are alike unsuspicious. They hold money to be a measure of price and value, and they reckon as freely in monetary units as in units of length, area, capacity and weight." Nobody has ever found it necessary to construct index-numbers to show how the weight of an ounce or the length of a yard or the capacity represented by a cubic foot have varied over time, but it is generally accepted that there is need of an index-number to record changes in the internal purchasing power of the pound. As a matter of fact, there appears to be a need for more than one index : one, prepared by the Department of Employment and Productivity, in respect of retail prices and another, produced by the Board of Trade, relating to wholesale prices. And yet, in conventional accounting, we still seem insistent on calling a pound a pound, whatever its vintage. It will be contended, perhaps, that we cannot have done so very much harm: the great majority of businesses do survive and even expand. It seems irrefutable, however, that if they had followed a policy of distributing the whole of their 'profit' to their proprietors, real capital could not have been maintained intact without the periodic injection of additional funds. It seems that there are two main reasons why we have not heard more about the ill-effects of rising price-levels. One is that until the last couple of years inflation has been at a modest rate. In some South American countries, it has been so rapid that it compelled recognition of the problem. But, of course, a small 3% per annum (simple interest) rise in fixed asset replacement costs means that £130,000 is needed to replace equipment which cost £100,000 originally and is now, after ten years, due for replacement--and only £100,000 has been retained in the business in the form of depreciation provisions if conventional depreciation accounting has been employed and increasing replacement cost ignored. The 98
Omega, Vol. 3, No. 1
second reason is that it does not seem to matter if businesses do not allow for rising price levels by some formal procedure which builds up reserves--called, for example, Fixed Assets Replacement Reserve and Stock Price-Change Reserve--so long as they retain profits and put them to, say, General Reserve Account. But, when doing this, they should not suppose that the growth in these reserves represents the extent of their provision for expansion from within. This would be a delusion: a substantial part of their retentions is merely serving to cushion them against (to hide from them ?) the effect of inflation. It is possible that academics must bear some of the blame for so little having been done about the problem: they have been divided on the question of whether it should be tackled by means of specific indexes relating to specific assets, as in the simple illustration outlined above, or by the use of some general indexnumber. An excellent illustration of the simplicity of the general index method was provided as long ago as 1958 by A R Mutton [2]. It is not my intention to discuss here the respective merits of the two methods. It would seem futile, however, to go on waiting for the perfect method of adjustment which everybody could accept. If we treat seriously the problem of changing price levels ourselves, we may in time persuade the Inland Revenue that something should be done about it, not only for income tax and corporation tax, but for capital gains tax, too. It bears thinking of!
REFERENCES 1. CHAMaERSRT (1966) Accounting Evaluation and Economic Behaviour. Prentice Hall, Englewood Cliffs, New Jersey. 2. Mtrrro,'q AR (1958) Accounting for inflation. The Accountant. 8 February.
99