Constant purchasing power accounting

What Is Constant Purchasing Power Accounting?

Constant purchasing power accounting (CPPA) is an accounting model designed to restate financial statements to account for changes in the general purchasing power of money, primarily due to inflation or deflation. This approach falls under the broader category of inflation accounting within financial reporting. Unlike traditional historical cost accounting, which records transactions at their original nominal values, CPPA adjusts these values using a general price index to present financial information in units of constant purchasing power at a specific point in time, typically the end of the reporting period. The goal of constant purchasing power accounting is to provide a more accurate picture of a company's financial position and financial performance by removing the distorting effects of changing prices on financial figures.

History and Origin

The conceptual underpinnings of constant purchasing power accounting can be traced back to the early 20th century, notably through the work of economist Henry W. Sweeney, whose 1936 book "Stabilized Accounting" extensively explored the concept of adjusting financial records for changes in the value of money. Interest in inflation accounting, including CPPA, intensified during periods of high inflation, such as the 1970s.

In the United States, the Financial Accounting Standards Board (FASB) issued Statement No. 33, Financial Reporting and Changing Prices, in 1979, which required large public companies to provide supplementary information adjusted for the effects of changing prices, including a constant dollar accounting method, which is essentially CPPA. However, due to various factors, including declining inflation rates and concerns about complexity and usefulness, the FASB later made these disclosures voluntary with Statement No. 89 in 1986, and eliminated certain historical cost/constant dollar disclosures with Statement No. 82 in 1984.⁹, ¹⁰

Internationally, constant purchasing power accounting is more prominently mandated in economies experiencing hyperinflation. The International Accounting Standards Board (IASB) addressed this through International Accounting Standard (IAS) 29, Financial Reporting in Hyperinflationary Economies, issued in July 1989. This standard requires entities operating in such environments to restate their financial statements in terms of the measuring unit current at the balance sheet date.⁸

Key Takeaways

• Constant purchasing power accounting (CPPA) adjusts financial statements for changes in the general purchasing power of money.
• It aims to provide a more accurate view of financial position and performance, especially in inflationary or hyperinflationary environments.
• CPPA uses a general price index, such as the Consumer Price Index (CPI), to restate historical costs.
• It distinguishes between monetary and non-monetary assets and liabilities, as only monetary items lose or gain purchasing power.
• In the U.S., mandatory CPPA disclosures were largely discontinued, but it remains critical in hyperinflationary economies under international standards like IAS 29.

Formula and Calculation

The core principle of constant purchasing power accounting involves restating non-monetary items from their historical cost to their equivalent value in terms of current purchasing power. This is typically done using a conversion factor derived from a general price index.

The formula for restating a historical cost of a non-monetary item to its constant purchasing power equivalent is:

Where:

• Historical Cost: The original cost of the asset or liability when it was acquired.
• Current Price Index: The value of the chosen general price index (e.g., Consumer Price Index) at the end of the reporting period.
• Price Index at Acquisition Date: The value of the same general price index on the date the asset or liability was acquired.

For example, if an asset was acquired for $10,000 when the price index was 100, and at the current balance sheet date the price index is 150, the restated amount would be:

This restated amount reflects the equivalent purchasing power of the original $10,000 at the current reporting date.⁷

Interpreting Constant Purchasing Power Accounting

Interpreting financial statements prepared using constant purchasing power accounting requires understanding that all figures, including those in the income statement and balance sheet, are expressed in a common unit of purchasing power, typically the purchasing power of the currency at the end of the latest reporting period. This makes financial data across different periods more comparable, as the measuring unit is stabilized.

When a company applies constant purchasing power accounting, it will report a net monetary gain or loss. This gain or loss arises because monetary assets (like cash and receivables) lose purchasing power during inflation, while monetary liabilities (like payables and debt) allow the entity to pay back with less valuable currency, resulting in a gain. Conversely, in deflationary periods, monetary assets gain purchasing power, and monetary liabilities result in a loss. This gain or loss on the net monetary position is a crucial component of earnings in a CPPA framework.⁶

By removing the effects of inflation on historical costs, CPPA provides insights into a company's real profitability and the maintenance of its capital maintenance. It helps users of financial statements understand whether the company's reported profits genuinely represent an increase in its economic resources or merely a reflection of rising prices.

Hypothetical Example

Consider a hypothetical company, "Widgets Inc.," operating in an economy experiencing significant inflation.

• Scenario: Widgets Inc. purchased a machine on January 1, 2023, for $100,000. The general price index (GPI) on that date was 100.
• Depreciation: The machine has a useful life of 10 years, with no salvage value. Under historical cost accounting, annual depreciation would be $10,000 ($100,000 / 10 years).
• Inflation: On December 31, 2023, the GPI has risen to 110.

Constant Purchasing Power Accounting Adjustment:

1. Restate Asset Cost:
   The historical cost of the machine is restated to its current purchasing power equivalent:
   Restated Cost = Historical Cost × (Current GPI / GPI at Acquisition)
   Restated Cost = $100,000 × (110 / 100) = $110,000

2. Calculate Restated Depreciation:
   Annual depreciation is now calculated based on the restated cost:
   Restated Depreciation = Restated Cost / Useful Life
   Restated Depreciation = $110,000 / 10 years = $11,000

Impact:
Under historical cost, Widgets Inc. would report $10,000 in depreciation. However, under constant purchasing power accounting, the depreciation expense for 2023 would be $11,000. This higher depreciation expense provides a more realistic view of the consumption of the asset's purchasing power value in an inflationary environment, leading to a more conservative and arguably more accurate calculation of net income and, consequently, earnings per share.

Practical Applications

Constant purchasing power accounting is primarily applied in economies suffering from chronic or hyperinflationary conditions where historical cost financial statements lose their relevance due to the rapid erosion of the monetary unit's value.

• Hyperinflationary Economies: The most prominent application is under IAS 29, Financial Reporting in Hyperinflationary Economies. This International Financial Reporting Standard (IFRS) mandates that entities whose functional currency is that of a hyperinflationary economy must restate their financial statements in terms of the measuring unit current at the balance sheet date. Indicators of a hyperinflationary economy often include a cumulative inflation rate over three years approaching or exceeding 100%. T⁴, ⁵his ensures that reported financial figures, including assets, liabilities, revenues, and expenses, are expressed in comparable units of purchasing power.
• Investment Analysis: For investors analyzing companies in high-inflation environments, CPPA can provide clearer insights into a company's underlying profitability and financial health, unclouded by nominal price increases. It helps differentiate real growth from inflationary distortions.
• Decision-Making: Management can use CPPA-adjusted figures for more informed internal decision-making, such as capital expenditure evaluations, pricing strategies, and performance assessments, as these figures reflect the real economic value.
• Lending Decisions: Lenders use CPPA-adjusted financial statements to assess the true financial capacity of borrowers in inflationary economies, mitigating the risk of lending based on inflated nominal profits.

Limitations and Criticisms

Despite its theoretical advantages in inflationary environments, constant purchasing power accounting faces several limitations and criticisms:

• Complexity: The process of continually restating financial statements using a price index can be complex and burdensome for companies, requiring significant data collection and recalculation. This complexity was a factor in the U.S. FASB discontinuing mandatory inflation accounting disclosures.
  *³ Choice of Price Index: A major point of contention is the appropriate choice of a general price index. While the Consumer Price Index (CPI) is commonly used, critics argue that a general index may not accurately reflect the specific price changes of the assets and liabilities held by a particular entity, especially for specialized industries.
  *² Lack of Universal Acceptance: Outside of hyperinflationary economies, constant purchasing power accounting is not widely adopted or mandated by major accounting standards boards like the FASB for routine financial reporting. Many countries continue to rely on the historical cost principle, often supplemented by fair value accounting for certain assets and liabilities. This lack of broad adoption can hinder comparability across different jurisdictions.
• Interpretation Challenges: While aiming for clarity, the restated figures can sometimes be counterintuitive to users accustomed to historical cost reporting. Explaining net monetary gains and losses and their impact on profitability can also be challenging.
• Relevance in Low Inflation: In periods of low or stable inflation, the benefits of constant purchasing power accounting may not outweigh its costs and complexities, as the distortions caused by inflation are less significant.

Constant Purchasing Power Accounting vs. Historical Cost Accounting

The fundamental difference between constant purchasing power accounting (CPPA) and historical cost accounting lies in how they treat the measuring unit of money over time.

While historical cost accounting is simpler and more objective due to its reliance on verifiable transaction prices, constant purchasing power accounting provides a more economically meaningful view of a company's financial standing and performance, particularly when the value of money is unstable.

FAQs

Why is constant purchasing power accounting necessary?

Constant purchasing power accounting becomes necessary in economies experiencing significant inflation because the traditional historical cost accounting method fails to reflect the true economic value of assets and liabilities. Money loses its purchasing power rapidly, making historical financial figures incomparable across different periods. CPPA helps to present a more realistic picture of a company's financial position and profitability.

Which price index is typically used for constant purchasing power accounting?

The most common price index used for constant purchasing power accounting is the Consumer Price Index (CPI), or a similar general price level index. This index measures the average change over time in the prices paid by urban consumers for a market basket of consumer goods and services. W¹hile a broader Gross National Product (GNP) deflator is sometimes considered ideal, the CPI is often chosen for its availability and frequent publication.

Is constant purchasing power accounting required in all countries?

No, constant purchasing power accounting is not required in all countries. It is primarily mandated for entities operating in hyperinflationary economies under international accounting standards such as IAS 29. In many developed economies with relatively stable inflation rates, historical cost accounting remains the predominant method, although it may be supplemented by fair value measurements for certain assets.

How does constant purchasing power accounting affect a company's financial statements?

Constant purchasing power accounting affects a company's financial statements by restating non-monetary assets, liabilities, and equity items to reflect their current purchasing power. This leads to adjusted depreciation expenses, cost of goods sold, and other operating expenses, impacting reported revenues and net income. It also results in the recognition of a net monetary gain or loss, providing a more accurate representation of the company's real financial performance and balance sheet values in an inflationary environment.