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Some aspects of inflation and published accounts
OMEGA, The Int. JI of Mgmt Sol., Vol. 2, No. 6, 1974
Some Aspects of Inflation and Published Accounts HC EDEY London School of Economics and Political Science (R#CCil,ed Jun¢ 1974; in revisedform July 1974)
Company accounts are at present drafted in an uneasy compromise between different objectives. It is not yet generally appreciated that no single figure or set of figures can sum up the whole financial state of an enterprise. The basic tools of financial management are short and long-run cash projections and the reports of actual flows which monitor these. The problem in drafting annual accounts so that they will help shareholders and others to make decisions is that financial reality requires a look into the future and this in turn calm for subjective judgement. But the more realistic are the accounts in this sense, the less susceptible are they to objective audit. Inflation adds a further level of distortion, but the effects of this can be brought out in a relatively simple way by making corrections based on movements in a general index of prices. Although there are considerable practicarl difficulties it seems likely that a more fundamental improvement would be the introduction of a 'current value' or modified 'replacement cost' approach to ordinary accounting in addition to (but not in place of) the general index inflation correction.
Introduction THE GENERAL case for requiring that the effects of changes in costs and prices be shown in published accounts rests on the view that if such accounts are to provide a basis for any kind of action involving the assessment of economic or financial alternatives, then the information in them shouid relate to prices and costs current at the time to which they refer.
How can this be done ? A number o f suggested changes in current practice to meet this requirement has been made, some involving more fundamental reforms than do others. In my view the best of those which are practicable in the short term, particuarly having regard to the need for a substantial and wide measure of agreement on method, is that set out in Exposure Draft 8 (ED8) of the Accounting Stand723
Edey--Some Aspects of Inflation and Published Accounts
ards Steering Committee. t Briefly, this proposes that the information given in the ordinary accounts should be supplemented by an inflation accounting statement in which the ordinary figures are corrected by the application of an index measuring the fall in the general purchasing power of the pound (the retail price index). Thus the normal accounting conventions are used but are applied to transactions which have been re-priced in pounds sterling appropriate to the closing date of the accounting period. The supplementary inflation statement can throw considerable light on financial results during inflation and can help to promote enquiry. It throws particular light on the effects of gearing and of holding monetary assets on the benefits of ownership. It also shows up the impact of corporation tax in conditions of inflation. One must accept that ED 8 has limited aims and that it does not attempt to deal with the more fundamental problem of how profit should be defined and how assets should be valued and liabilities assessed for the purpose of financial statements. It is concerned with inflation only--i.e, changes in the general price level--not with changes in relative prices and value, which can, of course, arise in the absence of inflation. If published accounts are to be more useful than at present in making judgements about management performance and the prospects of the enterprise, information on current values of assets (in the sense of the outlay that would be imposed on the business by their loss if it were to be fully compensated), and the effect of these on costs and revenues, seems likely to be useful, at least in some instances. Such information would not be a substitute to the type of correction envisaged in ED 8 but a supplement to it. This is not a matter of correction for inflation. It arises from the fact that relative changes in prices and values are constantly occurring in business. Such changes would arise in the absence of inflation, though they may become larger and more frequent during a period of inflation. There, are, however many difficulties and questions to be resolved, some of which are indicated below. It is in the nature of things that accounts of the type at present in use cannot in general, even when corrected for inflation, provide more than useful supporting information to back up other types of shareholder information. They certainly cannot sum up the state of an enterprise in a single unique and definitive figure, or set of figures. (The major instruments of planning and control for financial management should, in my mind, be the short and long term cash flow budgets controlled by follow-up reports of "actuals" and it is these, were it practicable to disclose them, that would best inform shareholders.) 1Accounting bodies in the British Isles collaborate through this Committee in formulating and issuing public statements which define standard procedures to be applied in the preparation of published accounts. Exposure Draft 8 has now become, in an amended form,
Provisional Statement of Standard Accounting Practice 7.
724
Omega, VoL 2, No. 6 The objectives of company accounts Proposals for reform meet the serious difficulty that there is no general agreement on the basio objective that is aimed at in drawing up annual company accounts. At least three possible objectives suggest themselves: 1. To provide a statement of stewardship to the owners that is intended to show, in summary form, how their funds have been used, but not designed to give an indication of the management's business efficiency. (Such a statement would evidently not be sufficient to comply with the present company law.) 2. To provide, in addition to a bare stewardship report of the type described in l, a conservatively based assessment of the maximum amount ("profit") that could prudently be distributed in dividend without damage to the company's creditors, and generally in compliance with the company law. Since such an assessment is based on a legal requirement, breach of which can involve penalties, a fairly high degree of standardisation of the accounting procedures used is desirable, in order to reduce uncertainty about the correctness of the result. Such an assessment also serves the purpose of providing a basis for tax assessment, which similarly demands a reasonable degree of certainty in the calculation. 3. To provide a reasonably precise assessment of the success of the management in producing a satisfactory return for the shareholders to date without sacrifice of future prospects. It is evident that an assessment of future prospects is an essential part of judging management success to date, since it is possible to make current results appear satisfactory by action which prejudices the future, and unsatisfactory current cash flows can mask a brilliant future. An account which could serve this purpose would also therefore serve that of providing information as a guide to investment decisions and for such public purposes as investigations under anti-trust or price control legislation. Company accounts at present are widely assumed to serve all three of the above objectives. The conventions on w .hich they are based, however, reflect something of an uneasy compromise between objectives 1 and 2 on the one hand, and objective 3 on the other. There is a wide misapprehension on this question. Many people assume that accounts are designed to serve objective 3, or at least that they should be.
Limitations of present accounting conventions in the absence of inflation When considering the question of inflation and its effects on company accounts, it is helpful first to examine the uses and limitations of these documents in the context of the above objectives in the absence of inflation, i.e. in the absence of changes in the general price level, when the only changes in prices, costs and values are relative ones, and the value of money is constant. 725
Edey--Some Aspects of Inflation and Published Accounts For objective 1, simple stewardship accounts, an audited summary of cash receipts and payments, with a list of assets owned and of legal liabilities, would suffice. Such an objective would not be affected by inflation, since the accounts would presumably be intended only to indicate, when audited, the presence or absence of fraud and the cruder forms of negligence on the part of the directors. Accounts on present-day lines seem to be fairly satisfactory instruments for achieving objective 2 provided the standards of accounting procedure and presentation are reasonably well-designed. The precise conventions to be used for this objective are to some extent a matter of public policy, since what is needed is a set of conventions that are susceptible of reasonably objective application, that is, where the area of subjective judgement is limited, and is as dearly specified as possible. Whether adjustments for general inflation should be applied is a matter calling for decision on the criteria to be adopted: a. for deciding how the maximum legal distribution to shareholders by way of dividend is to be determined (if indeed any limit is in fact necessary beyond a general requirement that directors should not pay any dividend which could reasonably be expected to endanger the position of creditors); and b. for settling the appropriate basis for corporation tax assessment insofar as this is determined by the accounting policies adopted by the company. The considerations mentioned below in relation to objective 3 have some bearing also on measurements for objective 2, in relation to: a. the limitations of the figures prepared (e.g. for tax purposes) under presentday conventions; b. the problem posed by the increasing degree of subjectivity in assessment introduced by a move towards a more precise assessment of the economic results of the business operations; c. the implications of adjustments respectively for inflation alone (as in ED 8) and for other price and value changes. Objective 3 above related to the assessment of the economic achievement of management for the benefit of shareholders or other interested parties (such as the Monopolies Commission), and of the economic prospects of the company. Problems which pose themselves in this context, even when inflation is absent, and which are superimposed on those of inflation when the latter is present, are: (1) What definition of profit, if any, will provide a satisfactory indicator ? From the common-sense point of view of the man in the street, profit as a measure of management success is the increase in the value of the enterprise (or of his share in it) after allowing for dividends and for any new capital paid in. Since the value of the enterprise as a whole is in the end dependent upon the 726
Omega, FoL 2, No. 6 future flow of surplus cash which it can generate, profit in this sense can only be ascertained by making an overall valuation of the enterprise at the be~nni~g and end of each period. (There is an analogy here with the actuarial determination of the profit on a life-fund by the calculation of net present value.) If it were possible to adopt this concept of profit, the price-level problem, so far as it related to profit measurement, would reduce to bringing opening and closing valuations to the same price level by use of a general index of consumption prices. The practical difficulties in the way of developing such a definition for published accounts do not need to be stated here. The idea does, however, seem useful because it provides a clear conceptual base from which thinking can start. The problem would be to choose a set of accounting conventions which would provide a reasonable approximation to this ideal and which could be applied consistently in practice, assuming this to be desired. As already noted, an assessment of the company's future prospects is a necessary accompaniment of the assessment of the degree of management success. (2) A definition of profit on the above fines thus requires an annual overall assessment of the enterprise's value, based necessarily on the judgment of management. It thus leads to the dit~culty that the figure on which management is to be judged is itself based on higldy subjective judgements by that management. The scope for audit would almost certainly be limited to reporting on the method used in the assessment. (3) On the other hand, the present method of profit calculation has, in the absence of inflation, the following limitations in achieving the objective under discussion: (i) Profit is obtained in effect (though accountants do not usually look at it in this way) by summing certain types of change over the year (with allowance for dividends paid out and new capital paid in) in the net assets listed in the balance sheets. (ii) The calculations for (i) are based on standardised rules that preclude additions in value being brought in unless an asset has been converted into cash or a near-cash equivalent; but reductions in expected realisable value or value in use in the ordinary course of business are brought in. Hence the net accounting change in value of an asset over a year does not necessarily approximate, in size or even in direction, to the change that management judgement would accord to it: where management recognises in a given year a rise in value, the accounts can record a fall. (iii) Value changes, even on a standardised basis, that cannot be identified with specific liabilities and provisions, or with recorded assets, do not enter into profit calculation at all. 727
B
Edey---Some Aspects of Inflation and Published Accounts (iv) It follows from (i), (ii) and (iii) that, even in the absence of inflation, accounting costs do not necessarily bear any consistent relationship to the current economic costs of operation in the sense of the sacrifice of current purchasing power, actual or in prospect, arising from business actions.
Inflation correction by general price index In conditions of inflation, a new distortion is added in that the historic costs on which the accounting values and costs are based relate to different pricelevels and hence to different amounts of purchasing power even where relative prices are constant. It is the purpose of inflation accounting of the type used in ED 8 to remove this distortion. In effect it adjusts all assets and liabilities by applying the change in the general price index since the date of acquisition, and then (a) writes monetary claims by and against the company down again to their face value in money (thus recording a net gain or loss to the equity interest due to having such claims), and (b) writes down any other assets if it is estimated that the inflation-corrected value will not be realised in the ordinary course of business in the short run (current assets) or long run (fixed assets). The inflation-corrected figures are, therefore, still subject to the limitations outlined in (i)-(iv) above. Adjustments to asset values and costs by reference to costs of replacement A general price index correction applied, year by year, to the value of the equity interest in the company will thus show the amount of current value needed to maintain intact the original invested purchasing power (calculated from a given starting point). In assessing the cost of using an asset, however (e.g. as cost of sales or depreciation), a figure related to its current replacement cost may give a better approximation of the current economic cost than if the valuation basis adopted is historic cost, or (where there is inflation) historic cost adjusted by a general price index. However, a number of problems arise: (a) A suitable special index number or other indication of replacement cost must be found. (b) A precise definition of what is meant by replacement is necessary. This, in principle, will depend upon the business context. In some situations no replacement is intended. In others the aim would be to replace the asset in question by a wholly different kind of investment, so that "replacement" can only refer to the cash flow stream produced by the replaced asset or to the service that the asset in question is providing. In some situations the replacing asset would be identical except in age to the one replaced. In others replacement cost seems to have little meaning unless it refers to the cost to the enterprise as a whole of replacing a specified increment of cash 728
Omega, VoL 2, No. 6 flow earned or of service or goods supplied, and the replacement cost of any one specified asset has little or no sign/ficance by itself.
Saleable values of individual assets Reporting saleable value of individual assets may convey useful information in certain contexts. It is more likely,to be significant in relation to assets of a non-specific character which enjoy a good market and have a value which is substantial in relation to the total resources of the company. In such a context a knowledge of realisable value may be a relevant factor in estimating whether the management are making economic use of the resources in their hands, and in j.udging the scope for raising further loan finance. On the other hand it is d~oubtful whether an estimation of the value of highly specialised fixed assets on a forced sale would in general be of much significance except perhaps to, say, a banker contemplating an advance of money to an enterprise on the verge of insolvency. Conclusions The foregoing considerations suggest that the major questions to be answered in the process of drawing up proposals for reform are the following: (A) What alterations, if any, are required in present accounting conventions in the absence of inflation ? (B) Does the method of ED 8 (current purchasing power correction) combined with any changes arising under (A) provide an adequate method of correction for general inflation ? A number of detailed questions that arise in considering these points are: (1) Should the capital contributed by equity shareholders, directly and through profit retentions, be measured in terms of constant consumer purchasing power, and therefore adjusted year by year by a general consumer price index, when judging whether a profit has been made, whatever the method used for valuing assets and calculating current costs ? How far is the answer affected by the assumed accounting objective ? (2) Is original cost adjusted by a general price index (and then reduced by writing down to the estimated value of the asset in the ordinary course of business where this is less) a good substitute for a more accurate attempt at assessment of asset value for (a) balance sheet valuation and (b) calculation of profit? In other words, is the method of asset valuation used in ED 8 an adequate approximation method for both purposes ? How far is the answer affected by the assumed objective 7 (3) Should the question of balance sheet valuation be separated from that of profit calculation ? 729
Edey---Some Aspects of Inflation and Published Accounts (4) Should directors be required to comment to shareholders if in their view the future prospects of the enterprise do not justify the balance sheet values taken as a whole ? In such a case, should a specific provision be written into the accounts ? Should such a provision reduce reported profit ? (5) Should a reasoned report be made in the contrary case to (4), i.e. where the directors' assessment of the value of the enterprise as a whole exceeds the balance sheet figure ? (6) How far can the sum of the estimated replacement cost of individual assets less an allowance for depreciation, where relevant, provide a good indication of the current value of the enterprise as a whole ? }
(7) Would the re-calculation of costs on the b~tsis of the estimated replacement cost of individual assets used up or otherwise depreciated give a better indication of costs facing the company than present methods, or the method of ED 8 ? (8) If a re-calculation of asset values on the basis of replacement cost were carried out annually, should the consequential excess (or deficit) of value over the value determined by applying a general consumer price index (as in ED 8) be regarded as current profit (or loss) for tax and other purposes ? (9) Would the reporting of the estimated replacement cost of individual assets be useful ancillary information, especially where the assets were of a nonspecialised character, with a good market ? (10) Should the estimated net disposable value of fixed assets be reported to shareholders, as ancillary information? (11) If replacement cost (adjusted for depreciation) is accepted as an appropriate concept in relation to asset valuation and cost estimation, should it be defined in relation to particular assets or in relation to the capacity to produce a particular mix of goods or services by the use of the complex of assets ? If the latter, should it be defined in relation to the future cost of increments of production? Or should it relate to the replacement of the total production of the enterprise ? (.12) I f replacement cost (adjusted for depreciation) is accepted as an appropriate concept for asset valuation and cost estimation, how should the convention be modified to allow for situations where replacement would not be economic? (13) Given that values and costs are related to a particular management policy (a decision by management to scrap an asset may represent a change in their view of its value to the business) should there be a requirement that management report, with some degree of precision, the main elements of their commercial strategy? 730
Omega, VoL 2, No. 6 (14) Should fiabilities be represented in the balance sheet at the current market value based on prevailing rates of interest ? If so, should gains or losses arising from such adjustments be treated as profit or loss for tax or other purposes ?
731
Some Aspects of Inflation and Published Accounts HC EDEY London School of Economics and Political Science (R#CCil,ed Jun¢ 1974; in revisedform July 1974)
Company accounts are at present drafted in an uneasy compromise between different objectives. It is not yet generally appreciated that no single figure or set of figures can sum up the whole financial state of an enterprise. The basic tools of financial management are short and long-run cash projections and the reports of actual flows which monitor these. The problem in drafting annual accounts so that they will help shareholders and others to make decisions is that financial reality requires a look into the future and this in turn calm for subjective judgement. But the more realistic are the accounts in this sense, the less susceptible are they to objective audit. Inflation adds a further level of distortion, but the effects of this can be brought out in a relatively simple way by making corrections based on movements in a general index of prices. Although there are considerable practicarl difficulties it seems likely that a more fundamental improvement would be the introduction of a 'current value' or modified 'replacement cost' approach to ordinary accounting in addition to (but not in place of) the general index inflation correction.
Introduction THE GENERAL case for requiring that the effects of changes in costs and prices be shown in published accounts rests on the view that if such accounts are to provide a basis for any kind of action involving the assessment of economic or financial alternatives, then the information in them shouid relate to prices and costs current at the time to which they refer.
How can this be done ? A number o f suggested changes in current practice to meet this requirement has been made, some involving more fundamental reforms than do others. In my view the best of those which are practicable in the short term, particuarly having regard to the need for a substantial and wide measure of agreement on method, is that set out in Exposure Draft 8 (ED8) of the Accounting Stand723
Edey--Some Aspects of Inflation and Published Accounts
ards Steering Committee. t Briefly, this proposes that the information given in the ordinary accounts should be supplemented by an inflation accounting statement in which the ordinary figures are corrected by the application of an index measuring the fall in the general purchasing power of the pound (the retail price index). Thus the normal accounting conventions are used but are applied to transactions which have been re-priced in pounds sterling appropriate to the closing date of the accounting period. The supplementary inflation statement can throw considerable light on financial results during inflation and can help to promote enquiry. It throws particular light on the effects of gearing and of holding monetary assets on the benefits of ownership. It also shows up the impact of corporation tax in conditions of inflation. One must accept that ED 8 has limited aims and that it does not attempt to deal with the more fundamental problem of how profit should be defined and how assets should be valued and liabilities assessed for the purpose of financial statements. It is concerned with inflation only--i.e, changes in the general price level--not with changes in relative prices and value, which can, of course, arise in the absence of inflation. If published accounts are to be more useful than at present in making judgements about management performance and the prospects of the enterprise, information on current values of assets (in the sense of the outlay that would be imposed on the business by their loss if it were to be fully compensated), and the effect of these on costs and revenues, seems likely to be useful, at least in some instances. Such information would not be a substitute to the type of correction envisaged in ED 8 but a supplement to it. This is not a matter of correction for inflation. It arises from the fact that relative changes in prices and values are constantly occurring in business. Such changes would arise in the absence of inflation, though they may become larger and more frequent during a period of inflation. There, are, however many difficulties and questions to be resolved, some of which are indicated below. It is in the nature of things that accounts of the type at present in use cannot in general, even when corrected for inflation, provide more than useful supporting information to back up other types of shareholder information. They certainly cannot sum up the state of an enterprise in a single unique and definitive figure, or set of figures. (The major instruments of planning and control for financial management should, in my mind, be the short and long term cash flow budgets controlled by follow-up reports of "actuals" and it is these, were it practicable to disclose them, that would best inform shareholders.) 1Accounting bodies in the British Isles collaborate through this Committee in formulating and issuing public statements which define standard procedures to be applied in the preparation of published accounts. Exposure Draft 8 has now become, in an amended form,
Provisional Statement of Standard Accounting Practice 7.
724
Omega, VoL 2, No. 6 The objectives of company accounts Proposals for reform meet the serious difficulty that there is no general agreement on the basio objective that is aimed at in drawing up annual company accounts. At least three possible objectives suggest themselves: 1. To provide a statement of stewardship to the owners that is intended to show, in summary form, how their funds have been used, but not designed to give an indication of the management's business efficiency. (Such a statement would evidently not be sufficient to comply with the present company law.) 2. To provide, in addition to a bare stewardship report of the type described in l, a conservatively based assessment of the maximum amount ("profit") that could prudently be distributed in dividend without damage to the company's creditors, and generally in compliance with the company law. Since such an assessment is based on a legal requirement, breach of which can involve penalties, a fairly high degree of standardisation of the accounting procedures used is desirable, in order to reduce uncertainty about the correctness of the result. Such an assessment also serves the purpose of providing a basis for tax assessment, which similarly demands a reasonable degree of certainty in the calculation. 3. To provide a reasonably precise assessment of the success of the management in producing a satisfactory return for the shareholders to date without sacrifice of future prospects. It is evident that an assessment of future prospects is an essential part of judging management success to date, since it is possible to make current results appear satisfactory by action which prejudices the future, and unsatisfactory current cash flows can mask a brilliant future. An account which could serve this purpose would also therefore serve that of providing information as a guide to investment decisions and for such public purposes as investigations under anti-trust or price control legislation. Company accounts at present are widely assumed to serve all three of the above objectives. The conventions on w .hich they are based, however, reflect something of an uneasy compromise between objectives 1 and 2 on the one hand, and objective 3 on the other. There is a wide misapprehension on this question. Many people assume that accounts are designed to serve objective 3, or at least that they should be.
Limitations of present accounting conventions in the absence of inflation When considering the question of inflation and its effects on company accounts, it is helpful first to examine the uses and limitations of these documents in the context of the above objectives in the absence of inflation, i.e. in the absence of changes in the general price level, when the only changes in prices, costs and values are relative ones, and the value of money is constant. 725
Edey--Some Aspects of Inflation and Published Accounts For objective 1, simple stewardship accounts, an audited summary of cash receipts and payments, with a list of assets owned and of legal liabilities, would suffice. Such an objective would not be affected by inflation, since the accounts would presumably be intended only to indicate, when audited, the presence or absence of fraud and the cruder forms of negligence on the part of the directors. Accounts on present-day lines seem to be fairly satisfactory instruments for achieving objective 2 provided the standards of accounting procedure and presentation are reasonably well-designed. The precise conventions to be used for this objective are to some extent a matter of public policy, since what is needed is a set of conventions that are susceptible of reasonably objective application, that is, where the area of subjective judgement is limited, and is as dearly specified as possible. Whether adjustments for general inflation should be applied is a matter calling for decision on the criteria to be adopted: a. for deciding how the maximum legal distribution to shareholders by way of dividend is to be determined (if indeed any limit is in fact necessary beyond a general requirement that directors should not pay any dividend which could reasonably be expected to endanger the position of creditors); and b. for settling the appropriate basis for corporation tax assessment insofar as this is determined by the accounting policies adopted by the company. The considerations mentioned below in relation to objective 3 have some bearing also on measurements for objective 2, in relation to: a. the limitations of the figures prepared (e.g. for tax purposes) under presentday conventions; b. the problem posed by the increasing degree of subjectivity in assessment introduced by a move towards a more precise assessment of the economic results of the business operations; c. the implications of adjustments respectively for inflation alone (as in ED 8) and for other price and value changes. Objective 3 above related to the assessment of the economic achievement of management for the benefit of shareholders or other interested parties (such as the Monopolies Commission), and of the economic prospects of the company. Problems which pose themselves in this context, even when inflation is absent, and which are superimposed on those of inflation when the latter is present, are: (1) What definition of profit, if any, will provide a satisfactory indicator ? From the common-sense point of view of the man in the street, profit as a measure of management success is the increase in the value of the enterprise (or of his share in it) after allowing for dividends and for any new capital paid in. Since the value of the enterprise as a whole is in the end dependent upon the 726
Omega, FoL 2, No. 6 future flow of surplus cash which it can generate, profit in this sense can only be ascertained by making an overall valuation of the enterprise at the be~nni~g and end of each period. (There is an analogy here with the actuarial determination of the profit on a life-fund by the calculation of net present value.) If it were possible to adopt this concept of profit, the price-level problem, so far as it related to profit measurement, would reduce to bringing opening and closing valuations to the same price level by use of a general index of consumption prices. The practical difficulties in the way of developing such a definition for published accounts do not need to be stated here. The idea does, however, seem useful because it provides a clear conceptual base from which thinking can start. The problem would be to choose a set of accounting conventions which would provide a reasonable approximation to this ideal and which could be applied consistently in practice, assuming this to be desired. As already noted, an assessment of the company's future prospects is a necessary accompaniment of the assessment of the degree of management success. (2) A definition of profit on the above fines thus requires an annual overall assessment of the enterprise's value, based necessarily on the judgment of management. It thus leads to the dit~culty that the figure on which management is to be judged is itself based on higldy subjective judgements by that management. The scope for audit would almost certainly be limited to reporting on the method used in the assessment. (3) On the other hand, the present method of profit calculation has, in the absence of inflation, the following limitations in achieving the objective under discussion: (i) Profit is obtained in effect (though accountants do not usually look at it in this way) by summing certain types of change over the year (with allowance for dividends paid out and new capital paid in) in the net assets listed in the balance sheets. (ii) The calculations for (i) are based on standardised rules that preclude additions in value being brought in unless an asset has been converted into cash or a near-cash equivalent; but reductions in expected realisable value or value in use in the ordinary course of business are brought in. Hence the net accounting change in value of an asset over a year does not necessarily approximate, in size or even in direction, to the change that management judgement would accord to it: where management recognises in a given year a rise in value, the accounts can record a fall. (iii) Value changes, even on a standardised basis, that cannot be identified with specific liabilities and provisions, or with recorded assets, do not enter into profit calculation at all. 727
B
Edey---Some Aspects of Inflation and Published Accounts (iv) It follows from (i), (ii) and (iii) that, even in the absence of inflation, accounting costs do not necessarily bear any consistent relationship to the current economic costs of operation in the sense of the sacrifice of current purchasing power, actual or in prospect, arising from business actions.
Inflation correction by general price index In conditions of inflation, a new distortion is added in that the historic costs on which the accounting values and costs are based relate to different pricelevels and hence to different amounts of purchasing power even where relative prices are constant. It is the purpose of inflation accounting of the type used in ED 8 to remove this distortion. In effect it adjusts all assets and liabilities by applying the change in the general price index since the date of acquisition, and then (a) writes monetary claims by and against the company down again to their face value in money (thus recording a net gain or loss to the equity interest due to having such claims), and (b) writes down any other assets if it is estimated that the inflation-corrected value will not be realised in the ordinary course of business in the short run (current assets) or long run (fixed assets). The inflation-corrected figures are, therefore, still subject to the limitations outlined in (i)-(iv) above. Adjustments to asset values and costs by reference to costs of replacement A general price index correction applied, year by year, to the value of the equity interest in the company will thus show the amount of current value needed to maintain intact the original invested purchasing power (calculated from a given starting point). In assessing the cost of using an asset, however (e.g. as cost of sales or depreciation), a figure related to its current replacement cost may give a better approximation of the current economic cost than if the valuation basis adopted is historic cost, or (where there is inflation) historic cost adjusted by a general price index. However, a number of problems arise: (a) A suitable special index number or other indication of replacement cost must be found. (b) A precise definition of what is meant by replacement is necessary. This, in principle, will depend upon the business context. In some situations no replacement is intended. In others the aim would be to replace the asset in question by a wholly different kind of investment, so that "replacement" can only refer to the cash flow stream produced by the replaced asset or to the service that the asset in question is providing. In some situations the replacing asset would be identical except in age to the one replaced. In others replacement cost seems to have little meaning unless it refers to the cost to the enterprise as a whole of replacing a specified increment of cash 728
Omega, VoL 2, No. 6 flow earned or of service or goods supplied, and the replacement cost of any one specified asset has little or no sign/ficance by itself.
Saleable values of individual assets Reporting saleable value of individual assets may convey useful information in certain contexts. It is more likely,to be significant in relation to assets of a non-specific character which enjoy a good market and have a value which is substantial in relation to the total resources of the company. In such a context a knowledge of realisable value may be a relevant factor in estimating whether the management are making economic use of the resources in their hands, and in j.udging the scope for raising further loan finance. On the other hand it is d~oubtful whether an estimation of the value of highly specialised fixed assets on a forced sale would in general be of much significance except perhaps to, say, a banker contemplating an advance of money to an enterprise on the verge of insolvency. Conclusions The foregoing considerations suggest that the major questions to be answered in the process of drawing up proposals for reform are the following: (A) What alterations, if any, are required in present accounting conventions in the absence of inflation ? (B) Does the method of ED 8 (current purchasing power correction) combined with any changes arising under (A) provide an adequate method of correction for general inflation ? A number of detailed questions that arise in considering these points are: (1) Should the capital contributed by equity shareholders, directly and through profit retentions, be measured in terms of constant consumer purchasing power, and therefore adjusted year by year by a general consumer price index, when judging whether a profit has been made, whatever the method used for valuing assets and calculating current costs ? How far is the answer affected by the assumed accounting objective ? (2) Is original cost adjusted by a general price index (and then reduced by writing down to the estimated value of the asset in the ordinary course of business where this is less) a good substitute for a more accurate attempt at assessment of asset value for (a) balance sheet valuation and (b) calculation of profit? In other words, is the method of asset valuation used in ED 8 an adequate approximation method for both purposes ? How far is the answer affected by the assumed objective 7 (3) Should the question of balance sheet valuation be separated from that of profit calculation ? 729
Edey---Some Aspects of Inflation and Published Accounts (4) Should directors be required to comment to shareholders if in their view the future prospects of the enterprise do not justify the balance sheet values taken as a whole ? In such a case, should a specific provision be written into the accounts ? Should such a provision reduce reported profit ? (5) Should a reasoned report be made in the contrary case to (4), i.e. where the directors' assessment of the value of the enterprise as a whole exceeds the balance sheet figure ? (6) How far can the sum of the estimated replacement cost of individual assets less an allowance for depreciation, where relevant, provide a good indication of the current value of the enterprise as a whole ? }
(7) Would the re-calculation of costs on the b~tsis of the estimated replacement cost of individual assets used up or otherwise depreciated give a better indication of costs facing the company than present methods, or the method of ED 8 ? (8) If a re-calculation of asset values on the basis of replacement cost were carried out annually, should the consequential excess (or deficit) of value over the value determined by applying a general consumer price index (as in ED 8) be regarded as current profit (or loss) for tax and other purposes ? (9) Would the reporting of the estimated replacement cost of individual assets be useful ancillary information, especially where the assets were of a nonspecialised character, with a good market ? (10) Should the estimated net disposable value of fixed assets be reported to shareholders, as ancillary information? (11) If replacement cost (adjusted for depreciation) is accepted as an appropriate concept in relation to asset valuation and cost estimation, should it be defined in relation to particular assets or in relation to the capacity to produce a particular mix of goods or services by the use of the complex of assets ? If the latter, should it be defined in relation to the future cost of increments of production? Or should it relate to the replacement of the total production of the enterprise ? (.12) I f replacement cost (adjusted for depreciation) is accepted as an appropriate concept for asset valuation and cost estimation, how should the convention be modified to allow for situations where replacement would not be economic? (13) Given that values and costs are related to a particular management policy (a decision by management to scrap an asset may represent a change in their view of its value to the business) should there be a requirement that management report, with some degree of precision, the main elements of their commercial strategy? 730
Omega, VoL 2, No. 6 (14) Should fiabilities be represented in the balance sheet at the current market value based on prevailing rates of interest ? If so, should gains or losses arising from such adjustments be treated as profit or loss for tax or other purposes ?
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