ENFLATlON ON

THE \MPACT OF
NG RATES

CORPORAYE EARNI

Thesis *or “19 D
MECHEGAN STATE. UNE‘JERSITY

Howard L. Wright
1956

 

 

TfiB IMPACT OF INFLATLUN ON

CORPORATE EARN I NG RAT L5

BY
Howard L. firight

AN ABSTRACT

Submitted to theCSchool for Advanced Graduate Studies)of
Michigan State University of Agriculture and

Applied Science in partial fulfillment of
the requirements for the degree of

MASTER OF ARTS

Department of Accnunting

Year 1956

APPrOVEd Céiieitflfifla4yzw (:2;;J€22;e_,_

Howard L. wright

‘Ihis study consists of hath a theoretical and practical
anal’sis of earning rates during inflation. The hypothesis
is that during periods of inflation the conventional
accounting prOCedures will cause an overstatemrnt of earning
rates.

A factor in the calculation of earning rates is the net
income of th. enterprise. It is measured as a percentage of
either the average total assets or the average stockholders
equity. When there is a rise in the price level, the net
income of corporations will be dyerstated because accounting
matches current revunucs with costs whzch are, in part,
stated in dollars of a higher purchasing power. The Balance
Sheet relatilnships arr also distorted by inflation. Since
accounting assumes that the dollar is a Constant unit of
value, items such as plant and ecuipment are carried for-
ward in the balance sheets at their historical cost. This
results in an understatement of the total assets and the
stockholders equity in terms of the price level.

Nine hypothetical cases were developed in an attempt
to prove the hypothesis. The difference between the cases
was in the make-up of thc balance sheets. The assets were
assumed to have varying proportions of monetary or money
value items such as cash and accounts receivab e. The
cases had complempntary proportions of non-monetary items
such as plant, property, and eeuipment. The relationships

between the stockholders eeuity and the liabilities were also

howard L. Wright

assumed to be in varying proportions.

‘Ihe net income in each case was assumed to be the same.
The statements were then converted for an assumed increase
in the price level. it was found that the earning rates
based on the conVerted statements were materially different
from those based on the conventional statements; The
conventional earning rates were OVerstated except in the
cases which assumed a large preportion of liabilities, which
are money value items. The cases which assumed a high
preportion of monetary assets proved to have the largest
overstatement of the conventional earning rates. This is
essentially due to the fact that losses are suffered in terms
of purchasing power on the monetary assets during times of
inflation. However, there is an offsetting gain on the
monetary liabilities. From the cases developed, it appears
that the only way that a business can benefit by inflation
is to go into debt and purchase non-monetary assets with the
money borrowed. I

A manufacturing company was studied as additional
evidence. Upon adjusting the conventional statements by the
Consumers' Price Index, it was found that the earning rates
had been overstated for the ten year period studied, which
was from 1946 to 1955.

In view of the cases develOped, it certainly seems that

huward L. wright
accountants should measure the impact of inflation upon
accountinw data. This is essential if the accounting
information is to be valid and significant to all interested

parties.

TILE IMPACT OF INI‘JLATI'JI‘I ON

conyguyre-thdNG RATES

BY

howard L. wright

A my, 1 ”final/Magi
Submitted to the(5choolafor Advanced Graduate Studies)of
Michigan State University of Agriculture and

Applied science in partial fulfillment of
the requirements for the degree of

MAST LR OF ARTS

Department of Accounting

1956

LTHEszs

 

AUhNOwLEJoMnJTS

The author wishes to express his sincere thanks to
Professor L. A. Gee for his invaluable suggestions and
unfailing interest in this study.

Grateful acknowledgment is also due to or. W. A.

Paton Jr., under whose constant supervision, this inves-
tigation was undertaken. The writer is also indebted to
Dr. J. U. rdwards for open.ing the eoor to the broad area
of accounting theory in his theory seminars.

Sincere appreciation is extended to all of the readers
of this manuscript for their helpful suggestions and their
invaluable assistance in one way or another.

This work is dedicated to my wife, Audrey, without
whose encouragement, Constant suggestions, and perseverance,

it would never have been completed.

TABLE OF CONTENTS

CHAPTER

I.

II.

III. THE MEASUREMENT OF

IV.

V.

INTRODUCTION - STAT EMENT OF HYPOTIUESIS

THE NATURE OF EARNING RATES. . . .

AND
OBJmTIVBS. . . . C C C C . O O O O C O O . O

The Problem of Inflation. .
Earning Rates and Inflation
The Hypothesis. . . . . . .
The Objectives. . . . . . .

The Reasons for Earning Rates . .
The Equity Concept. . . . . . . .
The Preprietary Concept . . . . .
Miscellaneous Earning Rates . . .
Evaluation of the Proposed Earning R
Economic Concepts of Earning Rates.
Earning Rates and the Investor. . .
Summary..............

t S

o o o p o o o o

O O O (D. O O O
O

O O O O O O O O

o o o o o o o o

ACCOUNTING DATA TO REFLECT
THE IMPACT OF INFLATION ... . . . . . . . . .

The Reasons for Adjustment. . . . . . . . . .
Problems of Adjusting the Accounting Records

To REfleCt Inflation. o o o o o o o o o o 0
Conversion of the Balance Sheet . . . . . . .
Conversion of the Income Statement. . . . . .

THE APPLICATION OF PRICE LEVEL CHANGES IN THE

CALCULATION OF CORPORATE EARNING RATES --
HYPOTHETICAL CASES. . . . . . . . . . . . . .

The Methods Using the Assumptions Made. . . .
NineCaSeSoococo-0.00.00...o
Summary and General Conclusions Reached from

The Analysis of the Hypothetical Companies.

THE IMPACT OF INFLATION ON Th}: EARNING RATES

OFANACTUALUUSINESS............

Case Study of a Manufacturing Company . . .

Earning Rates and Other Case Studies. . . . .

Reported and Converted Financial Statements
of the X Manufacturing Company. . . . . . .

1-11

43-79

43
51

77

80-94

80
84

87-94

VI. SUMMARY AND CONCLUSIONS. . . . . . . . . . . . 95-100

Validity of the Original Hypothesis . . . . . 95
Significance of the Results . . . . . . . . . 97

Bibliography . . . g . . . . . . . . . . . . . . . . 101-105

CHAPTER I

Introduction - Statement Of Hypothesis And Objectives

The Problem of Inflation

During the past fifteen years, the United States has
been faced with the problem of inflation. This inflation
has had a broad impact unon economic relationships through-
out the country. The effect upon the people has been varied
in its breadth as well as its depth.

When attempting to define inflation, it is necessary to
understand some basic economic relationships such as the
determinants of price. The economists have explained the
determination of cries in the formula P=¥¥.1 In this
formula, P is the price level, M is the average amount of
money in circulation, and V is the velocity at which the
money is spent or the number of times the money is spent
within a certain period of time. Q in the equation repre-
sents the physical volume of goods and services produced
during the period. Thus, the formula eXplains the price
level as being determined by the total money suonly times
the velocity at which it is spent divided by the goods and

services which are produced during the period.

 

1. Paul A. Samuelson, Economics An Introductory Analysis,
McGraw-Hill Book Company, Inc., New York, lOFI, p.3FO.

 

 

2
Inflation exists when the supply of money in circulation
increases while the velocity of spendinr and the volume of
goods and services remain constant. Inflation may likewise
result when the velocity of ssendinn increases or the volume
of woods and services decreases. Any of these circumstances
will cause more dollars to seek the sane or fewer goods and

I)
serv1ces.“

Thus, the dollar price of woods increases to the
point where the demand diminishes and the suonly and demand
factors are again equal.

As ittns been exolained by the layman, inflati<n exists
because there are more dollars chasine fewer woods and serv-
ices. Hence, the price of the availalle woods and services
increases. The effect of inflation unon the dollar is to
make it worth less in terms of what it can buy. Thus, the
exnression that "we now have a fifty cent dollar," arises
when we compare the wurchasin? rower of the dollar after
inflation with the same dollar before inflation. To deter-
mine the effect of inflation, it is necessary to think of the
dollar for what it is, namely, a medium of exchange for goods
and services. The true value of the dollar is. then, its
value in terms of what it will buy.

The fact that inflation is serious and sirnificent in

 

2. Paul A. Samuelson, 9g. Cit., D. 3&6

3

the economy cannot be overesphasized. It results in a hirhly
significant change in the relative positions of debtors and
creditors.3 The liabilities of debtors, which are expressed
in terms of the dollar, decline in real terns durine a period
of inflation. This is true because the debts are incurred at
a time when the nurchasina power of the dollar is high. They
are subsequently paid off in dollars of a lower nurchasina
power because of the inflation. The effect unon creditors is
just the reverse. They lose durina inflation because they
lend dollars of high nurchasinq tower and are repaid in cheaper
dollars.

Inflation is a serious economic blow to the neoole who
have fixed dollar incomes. Such individuals find that while
their dollar income remains constant, their ourchasina power
declines."L Probably the neoole that benefit the most from
inflation, other than debtors, are those oeoole who have assets
in the form of nrooerty rather than in the form of dollar
claims. Their advantage is that the prooerty will tend to
increase in dollar value as inflation orcgresses. As evidence
of this, it is not uncommon to find an individual who nurchased

a home in lQbO for $5.000 and sold it in 1956 for $10,000.

 

3. ."Inflation Race - Who's Ahead, Who's BehindJ' . §;_News
‘Q'World Report, Auaust 3, 1956, p. 97.

 

 

b. "It Now Costs More Than Ever To Live,". y:_§L_News
World Report, August 31, 1956, p. h5-

")0
(I

 

 

M

The layman may think the? he has mafle a nice "profit" on
such a deal. Actually, the whole "nrofit" may be fictitious
:ben the relative nurcbazine mower of the lQhO dollar is
ccmpared *0 *be 10$; collar.

The measurement 0? inflation nresents a difficult but
not insurmountable nroblom. Since the inflaiicn muss be
measured in terms of the rclative nurcbasinfi newer cf +he
dollar durinw a period 0? time, the nroblem of selectino an
adenuvfe yardstick is verv i nortanh. Probably tbe brst
nrocedure is +0 select a number of items wbose use is rela-
tively constant and whose eavresate chanrc in nrice can be
considered to be represcn+efive of fire chance in price levelg
Several such computations are made con*inuouslv by various
bureaus 0? *he soveynmcnt and other nrivafe enternrises.
Probably iho flost wifielv known of these devices are the
Consumer's Price Index anC *he Wholesale Price ndex. Both
of these measurements are compiled by takinr #he nrices of
a number of selected items and weiebfino than by formula and
then commutinn a weicbtcd averaqe which is the nrice level
at the narticular noint of time.

To illustrare the measurementcf inflnfiicn by these

nrice level indexes, it is necessary to assume a base period,

 

”w"-

 

5. Perry Mason, Price Level Cbanves and Fianauctd.8tatements
American Accounting Association, 10?6, v.1.

\n

and then calculate the index in “owns 0? the base period.
The table below shows the chanse in the Consumers'Price Index
for the neriod from 103? to 195? usins the 19?? index as a

base.

6

Consumers' Price Index
Yearly Averaqe

195? = 1007

Year Index Year Index
193? ,E‘l.)’ 191'?) 775.5
1936 Fl.8 19h? 83.b
1937 53.6 10b? 89.8
1938 FP.7 19b0 98.9
1039 $1.0 1050 89.8
19b0 F2.3 19Fl 96.9
10%1 Fb.9 1952 99.1
19b? 60.9 105? 99.9
19L3 6b.6 lQEh 100.3
19hr 65.7 IQFS 100.0
19%? 67.2

The fact that there is a certain amount of error en-
terinr into the calculati(n of nrice indexes is without
question. However, as a tool for measurinc inflation, it is
very dOJbthI if the narconteec of error in the nrice index
is sienificent. When an attemot to neasur~ inflation is
made, it is a relative measurement snc cannot be considered

to be absolute in terns of pennies whi h many Droolc believe

 

 

—— —-_.——. .u. u.—

6, U.S. Bureau of Labor Statistics, Monthly Labor Review,
Table D-l, years lQbO thru lQFé.

 

7. Converted by author bv'multinlvinn the averane index of
the years by 100/ the 1955 averaee index (11%.9), the

multinlier was .87336.

is tie e of conventional accountine erOCedures.

Q
B
L)
O
V)

The significance c“ inflation to the businessman should
be quite evident. As the husinessnan purchases and sells his
aoods and invcsus in his nhvsical nlant, he would notice
chances in the nrice level. The businessman really comes
face to face with inflation when dealine with his emolovees.
Certainly no seement of orvanized lator has talked about were

0 0 ‘fl

increases in recen' vears wittht Viewinn Vlt. alrra in”1s*-

ion and the resulting :rosicn it las causrd uron tie wares

v-Jo

maid to labor. The erosion is not in questihn, rather, it 8
low Win? lahcr lraders have viewed the inconc of corncrntions
durinr inflatirnaiv meriod with anythinn in mind exceni
absolute dollar terms. They have inn<red ccsnleielv the
inwact of inflaticn urcn cornorate income while usinw the
inflati<n as a bermainina issue for their own benefit.fi

The concern of the accountant with inflaticn seems to
revclve around one of the hesfc accountinn assumnticns.
This is that the dollar is of a constant velur and can be
used as a common yardstick 0? value. In a neriod of inflat-
ion such is n<t the case since the dollar chcnées in value

end thus becomes a "rubber yardstick”. Thus, the accountant

has not fulfilled his resuonsibility tc intereqrpa p8T+i(S

8. Charles E. Headlee, "Price Level Chsners - Challenee To
Accounting," NACA Bulletin, Vol. 29, No. 21, Section 1,
p. 1397.

 

7

because he has maintained his accountins records and submits
his accountinr renorts bpsed on information which is measured
with a yardstick of inconsistent 1ennth.9 There has been
some awakeninr to this nroblem. One only has to review the
accountina literatunaof the past ten years to find that
accountants are eivinr considerable thcunht to the matter.
However, such thinkine has received little supnort from
professional organizations such as the American Institute

of Accountants. In their research bulletin concernin:
"Depreciation and High Costs", the American Institute of
Accountants Research Committee went to some lenpth to state
that the inflation un to that time had been relatively
insignificant.loThe American Accountinn Accociation has
taken the view that the use of supplementary information
concerning the impact of inflation upon business would be of
some value and mieht be incorporated into the accountant's

reports.

Earning Rates and Inflation
The measurement of manacement's efficiency in the

'utilization of the assets of the business enterhrise may be

 

___._ '— “m-H” ’“m .-

 

.—

<9. Alden P. Well, "Fantasy of Figures - Rosocnsitilitv of
Accountants", The CommerCial and Financial Qhrgniglg,
Vol. 171, April 20, 19?6, p. 1627.

 

 

11). American Institute of Accountants, Restatement and
Revision of Accounting Research Bulletins, American
Institute of Accountants, New York, 1953, p. 69.

 

8

expressed in the form of an earnina rate.l2 While more
attention will be aiven to this matter later, it is signifi-
cant at this point to briefly describe the calculation of
earning rates. Basically, all earning rates mors re th
income of the business over a seriod of time as a nercentane
of certain balance sheet items. Sernine rates differ in the
emphasis they place unon certain income statement and
balance sheet items. In int(rnretation of these earninn
rates, interested narties mav make an annraisal of the
successcn'failure of the business during a certain noriod.
From such an interbretaticn, manarement, stockholders, and
other interested parties may arrive at sionificant decisions
with repard to the future of the business enicrnrise.

Since they are mathematical exnrossions of the relation-
shin of the income statement and the balance sheet, earninc
rates may not be considered to reflect all of the facts re-
pardinn the success or failure of a business entornrise.
Indeed, to do so, would olace undue emnhasis unon financial
relationshins. Before a decisicn retardine the success or

future success of a business entornrise can be fifldC, it is

necessary to evaluate such thines as the canabilities of

.n-A

 

11. Committee on Conceots and Standards Underlyina Cornorate
Financial Statements-American Accountine Association,
"Price Level Changes and Financial Statements Supole—
mentary Statement Number 9", The Accountino Review,
Vol. 26, October 1951, p. L72. ' ,

12. John N. Myer, Financial Statement Analysis, Prentice-
Hall, Inc., New York, 19§?, p. 155.

 

manaeement, the product development policies of the firm,
the size of the firm within its industry, and the signifi-
cance of the firm and industry in the national economy.
However, in defense of earninr rates, it is necessary to
state that they do express imnortant financial relationships
and when properly computed and used they can provide sign-

ificant informatirn to interested parties.

The Hypothesis

The hypothesis concerning the impact of inflation upon
the calculation of earnino rates may be briefly stated.
It is contended that in a period of inflation, the risina
prices bring on a considerable overstatement of earnings as
exoressed by conventional accounting principles. This is
due to the charging of certain costs expressed in terms of
dollars of a hiph purchasing power aeainst revenues which are
eXpressed in terms of dollars of a lower purchasing power.
Thus, the effect of the overstatement of earnings is to
overstate the earning rate calculated usine the exaaeerated
earnings. A further observation is that in periods of infla-
tion, the assets of a business as well as its stockholders
equity are understated. The reason for the understatement
of the assets of the business is that they are maintained on
the books based on historical cost. This procedure fails to
recognize that the dollars which paid for the assets and the

dollars which are in use after a period of inflation, are not

lO

exoressinr the same ourchnsins power. The understatement of
the stocktclders' eouitv results from the failure to recog-
nize the assets of the business in terms of the purchasing
Dower qiven uu to rrocure the assets. The unflersta‘enent of
the assets and the stockholder’s equity results in the
emoloyment of balance sheet fieures in the calculation of
enrni r rates which are also understated. The effect of
usinb such fieures will overstste the euininr rate so
calculated. When both overstated earninms and understated
assets or stockholder's equity are used in the calculation
of an osrnine rate, the obvious result is a double-harrelled
overstatement of the ssrninrT rete.l3' The earnins rate mes

th us Drove to to hichlv m3slor‘c13nv to int: leste6 osrtios.

The Objectives
The objective of this thesis, in accorosnce vith the
above hyoothosis, is to discuss and analyse theoretically
the sipnificsnce en6 imoscL of inflation on ccroorste errninP
rates. This discussitn will 3 nclu6e an analysis of fhe
ature of oarnina rates and the or oce<3ures concernin" the
measurement of accountin" data to reflect the chnnee in +he

orice level. Earnine rates will then be calculated based

Upon hypothetical conosnios in order to compare the results

—--—- - ——.——-- w".—

‘—

13. William A. Paton Sr., "Measurine Profits Under Infla-
tion Conditions: A Serious Problem for Accountants"
The Journgl_g£_Accountancv, Vol. 8,, Jan ssrv 10r0,rx2l.

 

 

11

obtained by usinr conventional accountins information, and
accountina data which has been adjusted to reflect inflation.
A further attenot will be made to measure the same results
upon an actual business durinr a neriod of inflation. EVi-
dence of the validity of the hynothetical examples will be
sought by comparison of the examoles with earninc rates based
unon certain studies undertaken by the American-Accountinc
Association and the contributions to the nrice level ques-

tion made by other nroninent individuals.

Cl h‘xi’l‘liR 1 I

The NatureUf Larning Rates

The Rea ons for Computing Larning Rates

The calculation and interpretation of earning rates is
an attempt to measure the earning power of the busincss enter-
prise. 'Ihe earning rate CfllCUlatLUn tics together signif-
iccnt figures from the balance Sheet and the Income statement.
It is necessary to consider uoth of these statements in order
to evaluate the performance of a business enterprise. 1f the
dalance Sheet is analysed as to its content, the analysis
will havt somc significance. The same may Dc said for the
Income Statement. howcvvr, in order to measurc the success
of management in the employment of the firm's assets and the
owners' investment, it necessary to measure the earnings as
related either to the corporate assets or stockholders'
equity. The calculation of an earning rate places emphasis
Ion the fact that the real value or assets is in the produc-
tion of earnings.1 This is a fundamental truth in our
capitalistic way of life where the motive of business is to
make a profit.

There are two general methods of computing earning rates.

1. A. C. Littleton, Structure oi Accounting Theorx, American
Accounting Association, 1953, p. 20.

13

The sifnificance of these methods Genomes noon the View taken

‘

of thp ccroere“icn. The ccroornte entererise mev he virMeC
1n tvc wars. The first is thct the corncratten is an entity
in itself. “he etrrr View is that the cernoratien is in

oeerntirn enl? in the interest 0? the connon stockholeers.

mhe flntitv Coneent

The entity via: holes that the cornora‘ion is an one in
itself. It censidrqv:*flae not iJnnfine e? t‘rm business to co
the income of the business entity. The entity View rewares
thc diatrirntirn of n cash rividrnfi to the strckholders as
a nayment for k*n use of canitel. T“e entity concrnt does
have a distinct loeal finstiftCHtirn. The laws novernind
cornere”e activity essentialln rerorfi tke cor errtitn as e
"lewal oerson” with the rirht to Carry (at snecifiee activi-
ties and witt the nrovisirns for linited lieculity for the
stockhcldvrs. The entity tteerv hence nlacea emnhasis unen
the utilization 0? the cevnorntn assets without recnrd to

a

the scarce ct the investee conitpl.‘ If it is flesirnble tr
CK?ress the onrninefi of a cennanv in tnrns C“ the entity
View it seems that tto errnincs erpresaod in terms of the
onterorise assets wonlfl constitute a sirw'riif‘irwrrL enrninn rate.

The nnxt orallen to be solved if we assume the entity

Conceot 18:"Whnt asset base shculfi iv used in calculatine the

—___

A

C' w' A° Paton, HDfl A. C. Littleton, §E_In+roducticn :9
QQPPOTBfe Accountinn Standards, American Accountino
Associatirn, lofo, D.WF.

 

1b

earninfl rate?" ThQOPC*10811Y: it seems that the asset base
should consist of all the assets emoloyed in the production
of the enternrise income. This would exclude from the total
enternrise assets any idle or abandoned nronertv. The total
assets emnloyod during a narticular period will vary from
time to time as the assets increase and decrease. Therefore,
it seems that the best method to determine the total assets
employed is to calculate the assets employed at different
points durinn the accountinn period and then averaee them
to determine the averace assets emolcyed in the nroduction
of revenue. There is a further nossibility that an asset
base consistine of the investment in slant, orooerty, and
equipment may provide a sienificant earninc rate when comoar-
ins companies in the same or closely relnted industries.
However, for the overall comparison of connenies in unrelated
industries and for reneral resortinz Durooses, it seems that
the asset base should include all the assets emoloved in the
production of revenue.

The income figure to be used in calculating an earnino
Imte under the entity concept presents still another problem.
It seems best to take a broad View of income in this resnect.
”Wm net income fiwure used should reflect all extraordinary
pains and losses realized during the accountine nericd. If
this is not done, the analysis of the earninc rates over a
Period of time will trnd to lose its sicnificnncv. NOWRVFT:

it wnuld to nermissible to calculate two earninfi rates US1H¢

net ijicome before and after extraordinary veins and losses

if the? gains and losses would materially misstate the earnine

rate £18 CWherwise calculated. From the entity point of view,

it is; (lesirable to calculate the earnins rate based n the

incon1e- excludine_pavments made to the sunnliers f capital.

It is; riecessery to add lack to the net income interest pavments

to +}ie 'iolders of the corncrnte securities. The reason for

addin:T l;nck these amounts is that the amount of incoce which

ill]

tFP crit:lty earns is considered to result from the efficiency

wifle Ishzich.nnnanement utilizes the assets 0? the lusiness

Ir1 slxmnary, the entity view is a mnnhserial concont of

the Emissisness enterprise. An earnins rate based on this con-

cent V61£L1.noint un the efficiency of manecenent in utilizind

the 8.53'se1-g of the business. To differentiate this earnino'

+ o 1 1 ‘ * .
Ifi*e J~IH3N1the one cevelooec under the pronrietary concept,
it‘r1151 be referrred to as the earninr rate on averace total

assetsg

The Pronrietarv Ccncent

unhi? pronrie‘arv concent of the coroorate enternrise

essen-

str- , . . -
0538 sition of the common stockholcers. It

es the c

"'6

ti . .
RILL7¢ Views the coraorate structure as a tyne oi nnrtnership

8.83 . , , .
‘DCLLetion with the nain purpose 0? marini7inc tee earninss

\
3.
(3eorae R. Husband, "The Entity Concenf in Accountine",
The Accountinn Review, Vol. 29, October, 195%, n. F62.

 

16

of thc stcckholdrars. To stete the nronrietarv concept in
another way, it views the corooratien as havinrr an agency

relahicnshin with its stockh(:1ders.b While there has been a

great; deal of discussion in accountin'r literature concerninc’
the relative merits of the oronrietarv and entity concepts
of the business enterprise, it is not signifier-int here in

terms of the calculatirn of earning: rates excent as an

exclamation of fl‘v the carnine rates are calculated. An
earning- rate based on the pronrietery cencent of the business

entc-r-'g)rise will stress the earnincrs of the stockholders in

ccmnnrison to the stockholders! investment,
It 13 HOW necessnrv to determine what should constitute
the 00"7’1001'101'1“. factors in the earnine rate. rY‘he base of the

DTODI’ietary ccncent of an earnin'r rate is the common stock-

holders I investment in the business.5 The use of the common

StOCk‘r‘olders' equity seems to have merit even thmwh orefer-

red Shock is pro-sent. However, if it is desired, little

0 '1‘. .
OmecDir‘n can be had to the calculation of two earninw rates.

‘ Ch- . 9
One, "0 nomt out the effectiveness with terhich the total
st 3 .

0° melders' equity is beinc emnlovcd (includine Preferred
Stock)

The second earnins rate would then be hased on the

e u
q it? of the common stockholders.

\
h.

N“alson B. Seidmsn, "The Determination of Stockholder
Income", The Accounting Review, Vol. 31, Jan. 1981,1361»

Harry G. Guthmann,Anal sis g£_Financial Statements,
Prentice - Hall Inc., New Y0rk,419f§} p. ?36.

17

The finure to be used as common stockholder's equity in
the calculation deserves some attention. The use of the
original investment. by the owners has little merit. It is
interesting: to note that the original investment is used in
earnings: rate calculation in some EurOpcan countries. This
orocedure will not recoonizo the actual stockholder's equity
which is comoosed essentially of‘ the invested or paid-in
capital and the income retained for use in the corporation.
It is necessary to recognize as stockholder's equity this
original investment and the retained income. As in the case
Of the, asset base used in the calculation of the return on

average total assets, it is desirable to averacre the stock-
holder' 8 equity at the beginning! and end of the accounting:
period. This is done to determine the orooer‘i‘ir'ure for the
calculat ion of the earning rate. The averaqinp: will recomize
the 1“crease in stockholder's equity during the accountino:
period due to the ear-nines of‘ the ooriod. It will also
recoenize additional investment by thexstockholders and/or

the 1"3’7ler'ement of any of the caoital stock. If treasury
stock 18 present, it must be treated as a reduction of the
s’(’()C.“'fl"‘<>:|.der's equity since it is inconceivable that a cor-
DOPatIOn can own stock in itself. Therefore, in the final
81151137513, the stockholder's equity base used in calculating!

ear
hint? rates should crnsist of the avoraee mid—in canital

and,
7E“?-tairued income for the. accountinrr neriod involved.

18

lflqe income finure to be used in calculatinc earninc

rates besed on +he nronrietery conceni' differs from. that
used in the entity concent. Since the proorietery conceot
stresses the nosi-‘ion of the common stockholder, it is only
lopicgl flew- the income firvure used 3110116: to the income
accruinr’.’ to the common stookholders. This s‘nculd he troadly
conceived to include extraordinary rreins and losses. The
income ficure should also be the net incone aft-er Lhe deduc-
titn of payments to the suppliers of” other sources of canitel.
When thre extraordinzwj.r trains nnr‘ losses Wont materially
misstatc the earnino- rate, two carninr rates mev be calcula-
ted.6 The) second would exclude such mains and losses.

In brief, the nroorietary View stresses the oosition of
the comrnon stockholder. An enI-ninrr rate based on this con-
cent Will stress the efficiency of mnnevemen‘: in the emoloy-
ment 01‘ the corporate assets For the benefit cf.‘ the common
8’“—-C€‘ak}"Olders. The eerninc rate calculated under this View
will be referred to hereafter as the earnin'r rate on avorane

st ‘ -
CCU”- Olders' equity.

Miscellaneous Enrnino Rates

Eal‘nino rater“; other than the two already discussed do

 

not ('3 . 1 '

.le‘i‘n to be sir-‘niflcnn‘z‘. measures rf toe F‘ffiClClCV of
\
6.

Harry G. Guthmam,9_p_. Cit-fl”- 2Y3.

 

 

mgngnpment in carryout its task of” maximizinc earninrrs

One such earninrr rate is calculrrted b3: mrasurinr‘ the income
of the. business ontornriee as a norcont of the net sales.

This essentially shows t‘v‘c ncrcenter'e of the seles dollsr
fluid: is nrcfit. One difficulty with this celculntion is

bet it considc-wrs only income stri-enent items. It fails to
reserd the eernincs in treir nroner nersoec‘uive to the canitel
emnlovec‘; 13v Hr: business. A similar conclusion oen be reached

concerninv any other rttemnt to calculate r-nrninrs rates

based solely on rele’ric-nshins found in the income strflemr-‘nt.

Evelue’ion of *te Pronosofl ernine Hates

Per-fore tt‘e or‘rnirn‘ rater-s ”-1517,? be evelur‘ted, it is neces-
sary ’70 determine HA0} t‘w’y {11"(5; a*:tr‘f*‘-:»iinrv to reflect. It is
818C" necessery to consider t‘r‘re rurroses for vhic‘n tit-e7: are
calculated. The provitus discussion "‘53 nointec‘ out ‘STTP- CON-
CC‘C‘C'S llnclerlyinrv the onloulotion of returns on assets enO
returns on Stockholfigris eouitv. p01..;evee, Hm rooso‘fi por
calcul Shin-Pr tto earninrr rates 6063 deserve some attention.
Eager‘tiajlv all financial statement enelvsis attrmnts to
SXUI’QSS in terms of’ ratios nncl nr-rcentems the sionificant
PG'13”.1”~0nsl'wiios between certain finures. The reason for the

ana . .
131318 18 to orovicle information for comperinrr the finan-

Cia . .
1 Statements from one nerico to the next? Ratio GIN—11.37313

\ _ __--r_=

7. V!
W. A. Paton and A. C. Littleton, 92° Cit” Do 1’39).

 

 

20

3150 attemnts to noint un weaknesses in the. business enter-
prise. Such analysis also may be used T“o comnare different
corporations within the. same industry or different industries.
The use of the information orovided by financial state-

ment analysis does not end with the corooration itself.
Investors, bankers, supoliers, workers, qovornment, and the
general nublic are all concerned to some extent with the
information disclosed by ratio analysis. Possibly there has
been an over emnhasis placed on ratio analysis in the past.
Any mathematical analysis of accountint', information tells
only a part of the story of a business. Other significant
factors such as the. canabilities of management, the position
of the company in the industry, the prosoects for the future
0f the enterprise and the economy as a whole must be consid-
ered before an intelligent decision concerning the success or
failure of the business enternrise may be reached. However,
since financial statement analysis is one of the important
factors involved in the evaluation of business, it is the
duty 01“ the accountant to provide sionificant end reliable
infom’VISJTion for the analysis.

'I'he relationship between earnino‘s and averarro total
assets is significant and useful if it is nrooerly calculated.
11". max, b . . ,. .fl

-- e used to comnere the eff1C1ency of manmctment in the
emplovmenf of the. assets from one neriod to the next. It is
also . . _

Sicnificant 1n comnarino the business with other busi—

ne .
ages. The calculation of e€m1n? rates on oversee

21

Stockholder's equity is limited in its usefulness. This
gaming: rate is sionificant as a m-“asure of performance when
compared to the results of previous periods. However, it is
of limited value for comparino two different cornoroticns.
Differences in the capital structure of corporatirns is the
cause: of this limitation. Two businesses may be performinr“
in the: same way with different earninrr rates based on stock-
holders ' equity. The lovr‘raoe affect of the use of debt
financino‘ usually causes the difference.8 A lerrvo amount of

debt financinrr at a low rate will provide more ez‘rninrrs

available to the common stockholders then will the exclusive

use of‘ common stock financind. rE’his will be. true as lone as

the debt capital is employed to produce a hirrher rate of

[Erninrrs than the interest requirements on the debt. It is
the concept of borrowinc money at four percent and nuttino
it to work to earn six percent, thus re.li7ino a profit of

two percent .

Economic Concepts of Earninr Rates

The first concept to be discussed is l‘ivbl" f3-'|-9"113'Lf-’L091'1t

to in‘ififustries whose rates or prices are fixed by oovernmental
b00193 . This includes mg... qupgtion of what may he considered
as a *easonable return" on investment. In the determination

of 1- ..
"1:13 "reasrnable return" on investment, the financial

8.

Harry G. Guthmann and Herbert E. Douqall, Corporate
Financial Policy, Prentice-Hall Inc., New York,19FS

p. 103.

 

statenuants are very sionificant. The idea of "reasonable
rehnrnf' evolves from the economic concsnt of mononoly nrofits.
Economists believe. that it is imnromr for a mononoly such

as a pnntfllic utility to eern more than a "rcssonshlc return"
on its; :investment.9 The nroblom is then the determination of
what is "reasonable". The calculation of an earnincr rate is
one 313temnn+ to determine what is reasonable. The problem of
how ttie earnino rate is to be calculrted is the real ncint

of corrtxmovcrsy, esneciolly durinc periods of inflation. In
such <3exscas, it scons that the investors in the entornrice
31’0”le be entitloc‘. to a rot-o cf emininr“ whio‘:~ will nrcvido
f0r Stflnerthinp cvrr and abcvc tho maintenanco of the real
capita]_ :in terms of nurchvsinn nowcr.

T716' second eccncmic concoct of osrnino rates concerns
the alftenrna+1ve use of caoital. This involves the comnnrison
Of ”“9 czsjrflxurrm+e of one business with that of other
businesgag anc‘: industries to determine if the cpoital is
Ewing ‘93Toloved in the most efficient manner. The concent
Rwy bq‘ Iillustretcd by a simple oxamole. If a man is both a
309d accQImtant and the best cook in town, which caoacity
Shoulil lie utilize? The correct answer is his accountinc
IHKWTLQWise. He certainly can finfi someone to do his cookinn.

The

cchcept as armlied to business moons Hwat if the caoital

\

O
,. Arthur Stone Dewinrr, The Financial folio; of, gornorntions,
The Ronald Press Comoany, New York, 19,3, 0. 33?.

 

 

23

empjoyed in the business could be better emnloyed elsewhere,
it. should be shifted to the alternative use. The fault with
this concorpt is that capital has a certain amount of inertia.
Cnce it is emoloved nrofitablv, there tom‘s to be little

' V

inve 9 t '1. ref" ion of 81‘}_‘.‘%l‘n8_‘-‘ ives w‘n LC". may be more attract ive .

Earninv Rates and the Investor

The investor interested in corncrato securitirs is in a
position there he can, shift his investmrnts from one connany
to another. Investors may: employ the earninr, rates orooosed
or they may use an alternative ear—nine. rate which relates
the onr'ninrts of a company to the market orioo of its stock.
Probablv one reason for the widespread use of such price
efl-I’ninrrs ratios in recent veers is the fact that investors
have 1"derided to place less and less value on the coroorate
133181109 sheet. This may be cue in part to the fact that the
COPhornte ta] anco shr'et reflectshistorical cost rather than

com; in terms of Collars of eouivalent nurchnsinc power.

Sums ry

TIL“is ctanter has attemfited to discuss the reasons for

t1“:- 0 '
"'e calculation of carninr' rates and the. tyD-rs of earnins

I" t~ h c I
an“) in use. The nerticular choice of an accentfible

P O
arm-1T1”: rate must deoem‘: noon the nurooso for which it is

\ _ _

10' Harry G. Guthmam and Herbrrt E. Douaall, 92' Cit.,p.168.

2’4

calolilz3tngd° It should he remembered that any ratio analysis
is sicxrlificsnt only if sunnlehontod by a thorcu~h analysis
of all. ‘thG factors that contribute to a success of a busi-
ness. IEarninw rates should,of course, be based on meaninr-
ful fldTllreS. Conventional accountinr data may or may not
gupnlfir rnesninoful fioures,6eoendino ueon ‘

new it is assimi-
18.1100: 0

CE’APTTR II I
The Measurement Cf Accountino Data

To Reflect The Imnact Cf Inflation

The heasons for Adjustment
A basic asszmnticn of conventional accountinr: procedures
is thct the dollar is a constant unit of value. It is only
nGCCrssorfir to recall Hm (finance in ~ricpq Heat, has. occurred
durim the ast "ifteen verr-s tr. see that this assamotion

'I

nae orecit: weacnesses. As evidenced tr the Consumer's Price
Index, which mar be considered to measure the cleanse in the
cost of livin’“, the dollar that we are us‘no tc-defr in 1057
13 “Orth- on]?! sliohtlv more tho-n fifty? cents Horn cornered
on Purchasino r*owor terms to 4'he dollar of 10’0. If we do
“Qt 7353009111263. this indisnutalle fact in the. accountinp‘

record-s, We can at 13884.; nxnect to have a summation of annles,

oranrm. r3 ,

‘..J

«an Ursnofruit in tho accoimts. Cr at test 8
3

S 1‘}. 10 . O 1 _
utqation of (ifforent kinds of 8TT.‘>1"F§ snow as shirts, snow,

wol - . . .
f river anc de] lClCTUS. The dec131ons hosed unon such

fa . . o o 0 0 O O
cts Wlf‘hcut cm-sidora‘itn of lT‘.fl!‘.*l_Cn will to just as

vn- 1 "-f" a o o 1 0
‘11C so are ac’fllthn of ar‘hlfas, oranrros, r'nr M'rnefr-Uli‘ is

in 2*}

(D

e-Cccunts.

AS a result of our assumtion that thr‘ dollar is of

cOnS+QN-‘_- .‘ v- _V
““1” Value, the acorunts do not reflect 11!“? !">”’=‘;n"= “0

”110‘!" r- . L1
’ahital is hrinrv used up and restored, (r ,

Cettrioretion in tho surchesinr ocwor of non'tnrv rescurcvs
wticb haV“ ieon wreviously sot aside. In fsilins to recconize
this accountants defeat the surveic cf finsncinl sccountinb,
:flicb is to show that the orisinnl rvsl csoitsl c? the
business has been srcservod before a n-0fit is shown.
Therefore, if the dollars decline faster in value than
trey increase in hunter, the business has not esrned a pro-
fit but rather it has suffered a loss.2 In periods of infla-
tion, because of usino the dollar as a constsnt unit of value,
we have illusirns of nrofit rather than actual nrofit.

The fact tknt thr dollsr is nct a constant unit of
value is very evident when income is measured in eccnomic

‘

terms. Certainly no cn" use was earning fE,OOC per year in
19LC would find himsrlf in tho sane economic uosition if re
were still rsrnins ¢C,CCO nor ycsr in le£ Even tbcu~b
tbeir dcllnr income had remained constant, neosle would find
it impossille to maintain o? livinn at H‘e
same level as in lfibfi. It is ttis c“sn~r in ecrnonic
nositicn that is sirnifiC;nt to businesses as well as indi-
viduals. A new business with assets of $100,000 in lULO

would undcubtedly be in a more favorable nosition than a new

business with assets of $100,000 in 1956.

 

l. G. R. Lees, Stabilized Accounting, The Northern Publishinn
Co. Ltd., Liverpool, Ensland, IQFO, p. 1.

Stewart Freeman, "Genital Price Adjustment Method for
Deflatino Inflated Profits," NACA Bulletin, Volé?% Lo.ll,
Sec. 1, p. 63?.

 

n 1":
'1
O o‘ O

 

h
;
I-

The imnact of inflation noon the investor in a fixed
dollar oblieation cleerlv shows that the dollar is not a
constant unit of value. If, for exannle, on investor invested
51,CH)O at 3 1/2? compound interest in 10b0, he would find
that To wsuld have $1,67C in 197?. However, the (1,67? in

IQEE woulo only be worth about $3FO in terms 0? the lQPO

dollars invested. Thus, the investor has lost flfO of the
ourchasine nouer (91,0CF - KCIO) of his orieinnl investment.

0
I

As pointed out bv Francis Pick, when discuss_ne the olieht of
the investor durine inflation, "we havo eons thrcueb an era
of neeetive interest rates".3 Perbass one of the nost unfor-
tunate results of the inflation has concerned the peonle who
purchased sovernnent savines bonds in the lolfl's. Called
"the safest investment in the world”, at the tine, they have
proved to be at best a Door snoculation when tte eurctasine
Dower lossixlterns of real dollars is comnuted at maturity.
Accountants throuebout the neriod of inflation have
insisted on maintaining the orieinal or historical cost of
assets in their records. Indeed, when tte dollar cost of a
slant built in lQMO is added to the dollar cost of a slant
built in 1050, the result is like addine twr arnles and three

oranees and calline the result five anoles. The results

obtained from suc‘e a summaticn could conservatively be called

 

3° Francis Pick, "How Good Are Paner-Dollar Comoany Reports?3
The Commercial and Financial Chronicle, Vol. 17b,
November 53 T§E?, D. 1729.

28

mislead inc. Such procedure is just as inconsistent as adding
the values exnressed in foreign currencsr to dollars when
arenarinrt a consolidated statment for a count-1n}; with foreian
cmerations.LL Accountants would unanimouslyr acren that the
foreign currency should be converted at the exchange rate
before it is added to the dollars in the accounts. Their
justification for the conversion would be that the foreign
currency is not of the same value as the dollars. The same
situation exists when we add historical dollar costs in a
period when the value of the dollar has fluctuated. This is
a further reascn why accounting data should be converted into
dollars of a constant purchasing: power before. the swnmations
1n the accounts can be considered as valid renresentations
0f the fact.

It is an underlying princiole of accountinrr that the.
accounting records should reflect the assets of the business
on the basis of cost. Whether this orinciple is sound and
deSirable is not the question. The problem is in maintaining:
the hiE’vtOrical cost in the records. This procedure reflects
as the cost of the asset the number of dollars exnended for

it at the time of purchase. This concept of cost has meaning

0
nly 30 long as the purchasing nower' of the. dollar remains
\ .

h.
. William T. Baxter, "To Overcome Inflationary Distortion

m 0
treat Ordinary Accounts Like Those of a Foreign Branch",
Q

1hr; Journal of Accountancy, Vol. 90, November IQFO:
p0 2136-7 —

O

 

P9

stable-SDurinrr pmicds of infle‘nirn or deflation this his-
tor-1631 cost is invalidated by the rise or fall in the
purchasing mower of the dollar. Therefore, in order to
maintain the cost basis of the assets, it is imperative that
the dollars of“ orininal cost be stated in units of the same
purchaseins1 power.

The reflection of the real cost of the assets in the
above manner provides the proper basis for the matchi.nrr_ of
costs and revenues in the determination of income. The
revenues of a particular period are stated in terms of the
purchasing power of the dollar for that period. However,
in the determination of the costs to be matched aeainst the
revenue, a different situation exists if there has been a
change in the purchasing): power cf the dollar since the costs
were incurred. Generally the current costs of wages,
salaries, materials, and expenses incurred in selling; the
g°°d3 produced will be stated in dollars of the same
purchasing power as the revenue of the period. The alloca-
tion Of depreciation against current revenues will result
in a mis-matchinp: of cost and revenue if the purchasino‘
power- of the dollar has declined since the asset beinp:
depreciated was purchased. The historical cost of the
deDrBC-ta‘ied asset should be stated in terms of dollars of
\

5' willard J. Graham, "The Effect of Chaneinq Price Levels

Don the Determination, Reporting, and Interpretation
of Income", The-Accounting Review, Vol. 211, Jan.191:9,p16.

30

equivalent value to the dollars of revenue in order to pro-
nerly match the expira‘ion of cost and the revenue produced.
The use of historical cost durine periods of inflation
will cause earninrrs to be hirrhly overstated in terms of real
dollars. Durint: the year 101:6, it has been estimated that
the reported profits of all coroorations were shout twice as
large as they were in terms of real dollars. Durino 19b7,
the overstate-tent has been estimated at 51‘? and in 19118,
at about. SFffi Such overstatement can load to erroneous
decisions rermrdinc dividend policy, capital expansion and
the overall success of the business. Indeed, we miotht no
to 3106373 durinrr a period cf inflation only,r to wake up and
find a company which had been oneratinn profitatlv in terms
Of conventional accountinrr with the same dollar capital and
01313.7 half of its oricinal productive capacity.7 Since
accountinrr has rcsnonsibilitv to societv, it cert-8311113" seems
that it would be desira‘tle to chance the accountinrr. concept
or historical cost to a realistic concept of current cost.
This ”Child certainly prove easier than to attewmt to Chan?“

1-“ ‘
he habits of society as a whole which. could cause chanqfis

i ’ . . 8
n the purcha31na oower of the collar.
\\

6.
SW15 Slichter, "Business Profits Exa'trrerated," The

1Sommercial and Financial Chronicle, Vol. 169, D'éfi'flobg,

7 ' Samue
Nee
Ac (3

J O

l J. Broad, "DevelOpment of Accountinrr Standards to
*3 Channinn Economic Conditions," The Journal 9.1:
Ountanc , Vol. 87, May 19b9, p. 3W).

 

31

Problems of Adfiustinc the Acccuntine Records

To Reflect Inflation

T

r Y1
5

6 first, and a veryr ieportent, nroblen which is
encountered when adjustine accountine records to reflect

inflation is the determination of the method to use for

measurine inflation. Once this nroblem is settled, there is
relatively little difficult}? in convertian the accounts to

reflect. the inflation. The mfi‘f‘"00 Y"TC/"”0396 ‘5'." V. W. Sweeney

in his basic work on the sulfiect has been to 118° 8. price
0

level index.’ rWhis seems to be

3

a sound wetbcd.

The alternative to the use of a ‘erice level- index
would be to use the re‘elace'ncnt cost of the assets. The

Fenlacement cost idea can be dealt with rather briefly

because it would violate the aoinp: concern concept, 0:!" the

business entereriee. It is not the purnose of the nurc‘easinp;

power adjustments to reflect renlacement cor-$.10 Rather, it

is tc hroeerlv measure the historical COS‘T OxnI’GGSE’d in terms

of current dollars. To determine renlacement cost would be
im‘fiossible because of technological advances and cleanses in

”‘3‘- methods of eroducticn. It would also he inconceivalfle

 

t + o 0
ha, a business enter-arise wculd want to renlace its (misting
\ __ v—
8. E.

Stewart Freeman, "How to Show Effects of Chance in
alue of the Dollar and Yet Preserve Cost Basis in

Ccounts," The Journal of Accountancy, Vol. PE, Feb.
19b8, p. 116.

9. Pin:
P

 
    

1’37 w. Sweeney, Stabilized o'cuntinet, Harper 8c Pros.
ublishers, New York, 1936, n. 2..

1’1? Mason, _C__t_~. Cit., P. 12.

 

DJ
“J

assets in like kind and quality.

The adjustment by: the use of a price level index
presents the protlem of the type of index to be used. There
are two choices possible. A menerel price level index such
as the Cc-nsumers' Price Index, the thlesale Price Index, or
the Gross National Product Deflator is one possibility. The
other is tc- use a soeci"ic price index such as the Construc-
tic:n Cost Index. The use of a seneral price index does net
Covert frcm tI‘e oricinsl cost principle. Instead, it merely
refit—479.3 the orieinsl costs in terms of the current purcha-
sins ‘ooxnver of the dc-ller.lllf this method is adopted, the
cmpar’ability of the current cost and the replacement cost
of an asset would be only a coincidence. Thus, it is not an
atteth to reflect replacement cost, but rather, an attempt
to. reflect historical cost in current dollers. It is for
this l"eascn that a senerel price level index seems to fill
the b1121 as a yardstick of inflation.

The specific price index essentially reverts to the
replacement cost concept. Its adoption would be a violation
of the Poingr concern concept of the business enterprise.

Net Income determined by using a specific price index would

\
11.

Business Executives' Research Council of Greater Chicago,
Business Profits -— Fact or Fable? -- The Studv’ in

WTRWhTthbl-Tsm EFF?” . 1? -

33

amount to a matching of current revenue and current costs
which would be partly composed of the current cost of
replacing capital items. The use of a specific cost index
for the measurtment of changes in the price level may have
some merit if we are trying to approximate replacement cost.
However, it seems that it is not a valid yardstick for
awasuring the impact of inflation upon all of the accounts
for the purposes of income determination and balance sheet
presentation.

The limitations of using any sort of index number to
adjust the accounts is that the index number may not be a
valid measure of purchasing power. As discussed previously,
the general index number seems to be the most valid. How-
ever, the decision remains as to which general index number
should be used. Each of the three most readily available,
the Consumers' Price Index, the wholesale Price Index, and
the Gross National Product Deflator, is determined in a
different way. However, over a twenty-five year period
from 1930 to 1955 the behavior of the three indexes is
relatively comparable. The Consumers' Price Index seems to
be the most stable and conservative of the three. The
Wholesale Price Index and the Gross National Product Deflator

have slightly wider swings than the Consumers' Price Index.12

E .._..._._

12. Perry hiason, 9-20 Cit. ’ P. 4.6.

f"
if»
r,
I

34

It seems in light of their comparability that it makes
little difference which of the general indexes is used for
conversion. To the degree that the indexes are not true
reflections of the price level, the results obtained by
converting acouunting information by the indexes will be

an approximation. Even with the inherent approximations,

it must be admitted that the accounting information will

be closer to showing in real terms the results of operation;
and the financial condition of a business, than will the
statements prepared assuming that the dollar is a unit of

constant unchanging value.

Conversion of the Balance Sheet

In adjusting the accounts to reflect price level change,
it is necessary to ascertain how the dollars in the accounts
are stated in terms of purchasing power. The assets may be
divided into categories: Monetary Assets and Non-Monetary
Assets.

The Monetary Assets are composed of those assets which
are always stated in terms of current purchasing power.
They may also be referred to as money-value items. Such
items as Cash, Accounts Receivable, Notes Receivable, and
Government Bonds may be properly classified as Monetary
Assets. Each of these items represents purchasing power in
terms of current dollars. When the value of the dollar

increases or decreases, the value of the Monetary Assets

also increases or decreases. since they fluctuate with

the value of the dollar, during times of inflation when

the value 01 the dollar is failing, the purChasing power of
thC Monetary Assets also declines

a further proolem concernsi1nu3.rea1i2ation of the gain
or loss uecause or the Change in the price level.
Accounting traditionally only recognizes gains and losses
when a transaction its<nnngleteo uitix:&yneone outsfixh313f the
business entity. If this View is strictly held, it seems
that the gains and losses are not realized.13 This point
is n)t too signitiCnnt vdmnlnmwiuiring the effect of Changing
prices. l’he real point involved, when even those Who hold
the traditional Concept 01 realization must admit, is that
even it we do not regard the gains or losses as realiZed,
the com -any certainly benclits {If-MI) an "economic windial L"
or sufters an "economic blow" when such gains or losses
exist.

The Non-Monetary assets are the assets «hose Value
rises in terms of dollars during inflation and whose value
falls in terms of dollars druing deflation. Into this
Category fall such items as inventories, fixed assets, in-
tangibles, and short term payments. Traditionaliy, all items
which are classified as Non-Monetary Assets are recorded in

the aCCounts at their historical cost. It is necessary to

KL. American Institute of Accountants, Changing Concepts 9i
dusiness Income, Macmillan Co., New York, 1952, p. 23

 

36

convert these historical costs from the dollars in which they
are stated to the current value of the dollar in ordar to
properly reflect all of the assets in terms of dollars of
the same purchasing power.14This procedure can be quite
involved. The conversion reauires that the date of histor-
ical purchase be determined for each 3f the assets as well
as their historical costs. For example, assume that we have
Non-Monetary Assets stated at a historical cost of $100,000.
It is determined that these assets were purchased when the
price level was 100. If we wish to state them in terms of
the current price level, which is 200, it is necessary to
multiply the historical cost by the present price level and
divide the result uy the price level at the time the assets
were purchased. This calculati:n may be presented as
$100,000 X %88.= $200,000. The resulting figure of $200,000
is then the historical coat of the Non-Monetary Asset stated
in terms of current dollars.

Consideration of the Liaoility and Stochholder's Equity
side of the Balance Sheet reveals that there is a distinct
division in terms of current dollars between the Liabilities
and the Stockholder's hquity. The liabilities are nearly
all expressed in monetary terms. The possible exception to

this would be adVances by customers. These advances could

_

14. William Blackie, "What is Accounting for Now!", VACA
Bulletin, Vol. 29, july 1, 1948, p. 135..

 

 

37

not he considered Monetary Liaoilities because they are
obliVations to render services rather than to pay out money.
All of the other liabilities are monetary since they repre-
sent obligations to pay money in terms of current value of
the dollar. The Monetary Lianilities like the Monetary
Assets are automatically stated in current dollars by thrir
very nature. As the value of the dollar declines during
inflation, the liaoilitivs are discharged in "cheaper
dollars" than tLOSG in which they were incurred. The
existence ot liauilities during an inflationary period will
thus tend to offset the losses of purchasinb power caused
by investments in Monetary Assets.

The prnulem of realization of the gains or losses
IQSUltiU§ from Monetary Liabilities is much the same as it
was for Monetary Assets. The gains or losses are not
realized traditionally, nut they are very real in terms
of purchasing pouer. The existence of uonds Payable of
other long-terms liauilitics is of particular interest.

It may he argued that since they will not discharged

until sometime in the future, there is no gain or loss
involved. howeer, the long-term liabilities are monetary
in nature. 'They are promises to pay a certain number of
dollars, and, as such, a change in the purchasing power of

the dollar will make the debt a lighter or heavier load for

38

the business to hear.15

The Stockholders' Equity presents little real problem
of adjustment if there is no preferred stock outstanding.
The common stock account, which represents the original
investment by the stockholders, is stated in terms of the
original dollar invested. It must be adjusted forward to
the current value of the dollar in order for it to be stated
in the same terms as the assets and liabilities.

The Retained Income is a summation of the earnings
retained by the business since its inception. To properly
adjust the retained income account, it would be necessary to
restate all of the factors which entered into the determin-
ation of income since the beginning of the business into
current dollars. While this could be accomplished with the
expenditure of consideraole effort, it is actually not
necessary to undertake such a calculation. dy its nature,
the balance sheet must balance. This holds true with balance
sheets converted to current dollars just like it does with
conventional balance sheets. Since we can determine all the
items except the converted retained income, it is only
neCessary to "plug" the converted retained income figure.
lhis "plug" can be proven by converting the conventional
income statements and adding to the converted net income the

k

15- Ralph C. Jones, Price Level Changes and Financial
étatements --- Case Studies of Four mepanies, American
Accounting Association, 1955, p. 178.

 

 

 

39

finagains and/or losses on the Monetary Assets and Monetary
liabilities. This mechanical Operation can be seen in any
(n the cases in Chapter IV.

‘The conversion of the Stockholders' Lquity is compli-
cated by the existence of preferred stock. The type of
preferred stock outstanding is highly significant. If it is
an ordinary preferred stock which has preference only to
assets and dividends without any call or redemption provision,
it should be treated in the same manner as the common stock.
However, if the preferred stocl is callable, or has a
redemption date, it should be classified as a Monetary
Liability. The reason for this treatment is that a callable
preferred or one which may be redeemed is, except for
certain leg 1 restrictions,the same as a long-term bond.16
This characteristic is even more evident if the preferred
stoch is cumulative as to dividends.

The treatment of the asset valuation accounts such as
allowance for bad debts and allowances for depreciation
should be the same as their related asset accounts. The
allowance for bad debts should be treated as a reduction of
a.Monetary Asset. The allowance for depreciation will have
to be converted in the same manner as the related asset
account. ’This means that the allowance for depreciation

‘

16. Samuel J. Broad, "Effects of Price Level Changes on
Financial Statements", NACA bulletin, Vol. 29, No. 21,
Section 1, p. 1333.

 

 

40

must be recalculated on the historical cost of the assets
converted to current purchasing power. It of.course, should
be deducted from the related asset account in the Balance

Sheet.

Conversion of the Income Statement

In order to convert the Income Statement into dollars
of the same purchasing power, it is first necessary to
analyze the nature of its components. The revenues are
stated in terms of the price level when they are earned.
Thus, to convert the reVenues, it would be theoretically
necessary to convert them each day by the daily‘price level.17
This procedure is not feasible since it would be virtually
impossible to calculate the price level each day. Hence, it
is necessary to determine the average price level over a

period of time and then convert the revenues of the period

by the average price level. If it is desired to convert the
revenues of a particular year, it would be possible to take
the average of the price level at the beginning of the year
and at the end of the year and use it to convert the revenues.
Although the yearly average would approximate the revenues

in terms of current dollars, it would more desirable to
convert the revenues by the monthly averages which would tend

-.

to show less error, especially if there was a wide fluctuation

17. Perry Mason, 92, Cit., p. 16.

 

41

in the price level during the year.

The costs of goods sold during the period may be con-
verted by determining the historical cost basis of the
beginning inventory and then converting it into current
dollars- The purchases of goods may be converted in the
same manner as the revenues. The ending inventory must be
calculated to determine its historical cost which then should
be converted into current dollars. The expenses of the
PGriod may reasmably be considered to have occurred at the
average price index for the period. They should be con-
verted in the same manner as described for the revenues.

The remaining account which must be dealt with con-
cerns the: expiration of the cost of the Non-Monetary fixed
assets which is charged against revenue in the form of
depreciation. here, it is necessary to return to the asset
accounts and determine the historical cost in terms of
current dollars and then calculate the expiration of the cost
in the current period. This amount should, of course, be
the same as the addition to the asset valuation account
€>£pressed in current dollars during the period.

The net income stated in terms of current dollars must
be reduced 9y the dividends paid in terms of current dollars.
The diviClends ma b- ‘ ‘

y e converted to current dollars by the use
of the price index at the date of payment. here it should

be no
ted that if the price level falls after the date of

leide
“‘1 declaration, the gain on the dividend liability

¥

42

will be offset exactly by a loss on the Monetary Assets at
the time of payment. The remainder of the converted net
income, after the dividends are deducted, represents the
convert Cd addition to Stockholders' iiquity. This must be
adjusted by the gain and/or loss on the Monetary Assets and
Monetary Liabilities in order to determine the net increase
in Stockholderg‘ Equity for the period in terms of real
dollars-

In summary, the process of adjusting accounting data to
reflect changes in purchasing power is not overly complicated.
The results Obtained should not be regarded as completely
without bias because of the use of index numbers and
averaging of certain factors in the calculations. however,
the converted statements will be a much closer approximation
of the actual economic position of the firm than statements
Prepared under the assumption that the dollar is a constant,

unchanging, unit of value.

 

ChAPThR IV
The Application Of Price Level
Changes In Ihe Calculation Of Corporate

harming Rates - hypothetical Cases

The Methods Used and the Assumptions Made

Tile cases presented in this chapter have been developed
assmmhu; that the corporate Balance Sheet may be divided in-
to fix“: categories. These categories are Monetary Assets,
Non-Moncrtary Assets, Monetary Liabilities, and Stockholdena'
t5C1Uity. 'rhe Specific accounts WLiCh are considered to be
in these: categories were discussed in Chapter III. The cases
have beren developed in an attempt to discover the change in
the earriing rates due to inflation caused by relative changes
in.the :structure of the assets, liabilities and stockholders'
‘Xfidty C>f the business. All of the cases have comparable
Income citatements except that the other expenses and taxes
3”? adillsteddepending upon the expiration of the Non-Mone-
tary Assets to reflect a conventional net income of $200,000
in each Case.

Each case is treated as a separate company beginning
ifs opelhation on January 1 when the price level index is 100.
It is assumed that the price level index doubles to equal
Zwo at tile end of the year. The original relationship

06 .
twecn~the Monetary and Non-Monetary Assets and between the

44

Monetary Liabilities and the Stockholders' equity is assumed
to remajmlconstant throughout the year. It is further
assumed. that the price level changes evenly throughout the
year so» that the current Income statement items are assumed
to have: occurredzflzan average price level of 150. It is also
assumed, for purposes of simplicity that the assets on
January' 1 and December 31 do not include any goods held for
sale. Ilence, all of the goods sold during the period were
purchasxed during the period and all of the goods so purchased
were so 1d .

Idue summary journal entries which give rise to the
changes. between the bC5inning and the end of the year are
as follcows for Case I. 1‘he entire process of conversion
Will DC? illustrated for Case I. The same procedures have

been apualied in develOping the other cases.

 

Date: Account & hxplanation Debit Credit
January 1 Monetary Assets 500,000 '
Non-Monetary Assets 500,000
Monetary Liabilities 500,000
Capital Stock 500,000

To record the formation of
the Corporation Price
Level Index 100

January :1 Monetary Assets 200,000
D" to‘ Non-Monetary Assets - 157,895
Ccemoel: 31 Merchandise Cost of bales 900,000
Other Expenses and Taxes 342,105

Revenue 1,500,000

Monetary Liabilities 100,000

To record in summary the
income, expenses and the
increases in the asset
and liability accounts
occurring? throughout the
year average Price Level
Index 150

45

 

 

Date: Account & Explanation Debit Credit
December' 31 Dividends 100,000
Monetary Assets , 100,000
To record the payment
of dividends, Price
Level 200
Decemoer' 31 Expiration of Non-Monetary
Assets 57,895
Asset Valuation Accounts 57,895
To record the depreciation
at a rate of 10% per annum
calculated as follows:
Historical Cost of the Assets $500,000 $157,895
Depreciation Period 1 year -§— year
Depreciation Rate Per Annum 10% 10%

Depreciation

The necessary closing
entries to close the
income, expense, and
dividend accounts and
to transfer the balance
to retained income

December' 31

$ 50,000 $ 7,895

Thez‘Trial Balance (before the closing entries) would

appear as follows on December 31.

Trial Balance
December 31

 

Debit Credit
Monetary Assets ,
Eon-Monet ary Assets 657,895
“:39: Valuation Accounts $ 57,895
0 Sea‘Y‘I-iabilities 600,000
apltal btock 500,000
M2322; ‘ , 1,500,000
Other Bxlbe Cost of bales 900,000
Expiratigense and faxes 342,105
inflidendsrl <>f hon-Monetary Assets 57,895

100,900

 

Tbtal

$2,657,895 $2,657,895

 

 

46

‘flmrproczezss of converting the Income Statement was then

tmdertalcezn as follows:

 

 

 

Price
Index Balance
Conventional Conver- Converted To
Accounting sion December 31
Account Balance Factor Price Level
Revenue: 51,500,000 ZOO/150 $2,000,000
Merchandise Cost of Sales 900,000 200/150 1,200,000
Other Expenses & Taxes 342,105 zoo/150 456,140
Expiration of 50,000 200/100 100,000
Non-Monetary Assets 7,895 200/150 10,526
Dividends 100,000 zoo/:00 100,000

Trrle:conversion of the Balance Sheets to December 31

dollars was the next step.

convert ed as follows:

The January 1

 

Balance Sheet was

 

Price
Index Balance
Conventional Conver- Converted To
Accounting sion December 31
Account: Balance Factor Price Level
Monetary Assets is 5007000 2007100 $1,000,000
Non-Monetary Assets 500,000 zoo/100 1,000,000
Monetary Liabilities 500,000 200/100 1,000,000
Non-Monetary Liabilities 500,000 zoo/100 1,000,000

131G conversion of the December 31 Balance Sheet was

rElatively simple since the Monetary Assets and Monetary

Llablllties are by their nature stated in terms of December

31 doLlars. The calculations as folloWs were made to con-

vert131e> iJecember 31 oalance Sheet to December 31 dollars.

47

Price
Index Balance
Conventional Conver- Converted To
Accounting sion December 31

 

 

Account Balance Factor Price Level
Monetary Assets $ 600,000 2007200 $ 600 ,000
Non-Monetary Assets 500,000 ZOO/100 1,000,000
157,895 zoo/150 210,526

Asset Valuation Accounts 50,000 zoo/100 100,000
7,895 zoo/150 10,526

Monetary Liabilities 600,000 200/200 600,000
Capital Stock 500,000 zoo/100 1,000,000

In.the converted December 31 Balance Sheet, the Pur-
chasing Power Adjustment Account takes the place of the
conventional Retained Income Account. To reconcile the
balance of this account, it is necessary to calculate the
gains and/or losses on the Monetary Assets and Monetary
liabilities. To calculate these gains and losses, it is
necessary to analyze the transactions in those accounts and
convert them by the applicable index. The gains or losses
are then determined by comparing the balance in the account
in terms of conventional dollars with the balance determined
97 the conversion of the transactions.

The loss on the Monetary Assets was determined as
follows.

(The transactions in the Monetary Assets Accounts

sue taken from the journal entries previously illustrated.)

48

 

 

 

 

 

 

 

Amount
Price Index Converted
Price Conversion To Dec. 31
Date Index Amount Factor Dollars
(immersion of the Debits: .
)amuuy'L 100 $500,000 zoo/100 51,000,000
Jan.1.to Dec. 31 150 200,000 200/150 266,667
Converted Debit Total $1,206,667
Conversion of the Credits:
December 31 200 $100,000 200/200 5 100,000
Converted Balance (Debit minus Credits) $1,166,667
less.Actua1 Balance, December 31 600,000
Loss on Monetary Assets $ 566,562;

 

The Gain on the Monetary Liabilities was then calcula-

ted as follows:

 

 

 

 

Amount
Price Index Converted
Price Conversion To Dec. 31

Date Index Amount Factor Dollars

Conversion of the Credits: (No Debits made)

January 1 100 5500 ,000 200/100 $1 ,000,000
.km. 1 to Dec. 31 150 100,000 200/150 133 333
Converted Balance $1,133,333
less Actual Balance, Dec. 31 6004000
Gain on Monetary Liabilities 5 533,333

 

 

The purchasing power adjustment to Stockholder's
imuity on December 31 was calculated by adding to the con-
\Hrted net income,Cain on the Monetary Liabilities,and
dmhmting the Loss on the Monetary Assets.

The earning rates based on the conventional and con-
1mmted statements were then calculated. The following
muuysis indicates that two sets of earning rates were
cahndated for the converted statements. The first earning
ranauses as the earnings figure the converted net income.
'Dnasecond set uses the net income adjusted by the gains

andlosses on the monetary accounts. The second calculation

 

r e . ~ A II A — . I I .n r c I
1 y l v > I.
r A r u , v u 1 e l . t
. e r v
1 l.|3li1 \ I ‘

 

 

 

49

isnmre significant than the first because it measures the
real:hmyact of inflation upon the business. It may be argued
unn.the monetary losses and gains are not realized, but
‘flmw certainly have an economic impact on the corporate
enterprise.

In calculating the earning rate on average total

assets, the average total assets were determined as follows:

 

 

 

 

 

 

Conventional Converted

Balance Sheet Balance Sheet

Total Assets January 1 $1,000,000 $2,000,000—
Total Assets December 31 1,200,000 1,700,000
Dividends Paid December 31 100,000 100,000
Total $2,300,090 $3,800,000
Average Assets Employed (%) $1;150,000 §1,900,000

 

 

 

 

It should be noted that the dividends are added to the
asset figures. The reason for this is because the dividends
rmre paid on December 31, and the assets relinquished by the
dividend payment were actually in use throughout the year.

The average Stockholders' bouity was calculated as
follows for use in calculating the earning rate on stock-

holders inVestment.

 

 

 

 

 

Conventional Converted
Balance Sheet Balance Sheet
thockholders! Equity January 1 $ 500,000 $1,000,000
inockholders' Equity December 31 600,000 1,100,000
Lflvidends Paid December 31 100,000 100,000
Total $1,200,000 $2,200,000
Average Stockholders' Equity (-5) 5 600,000 3W

 

 

 

 

 

Here again the dividends have been added back since
the stockholders investment included the dividends until

December 31.

50

The net income figure of $200,000 was used in the
cxdculation of the earning rates based on the conventional
sunemerrts. For the calculations based on the converted
shfiements, the converted net income of $233,334 was used
for one series. The second series was calculated by adding
to the converted net income of $233,334 the gain on the
bbnetary Liabilities of $533,333 and deducring the loss on
theihnnrtary Assets of $566,667.

After determining the various factors to be used, the
actual earning rates were computed as follows:

Based on the ConVentional statements:
The return on Average Total Assets

_ Net Income 5 200,000 _ 17 4w
- Average Total Assets $1,150,000 " ' b

The Return on Average stockholders' equity

= Net Income ,$200,000 _ 33 39
Average Stockholders' Lquity $600,000 ' ° ”

Based on the Converted Statements:

The return on Average Total Assets not considering gains
and losses on the monetary accounts

= JNet Income $ 233,333 _ 12 3%
Average Total Assets $1,900,000 _ ’

The return on Average Total Assets including gains and
losses on the monetary accounts

_ Purchasing Power Income $ 200,000 _ 10 57
" Average Total Assets $1,900,000 " ° °

The return on Average Stockholders! Equity not considering
gains and losses on the monetary accounts

_ Net Income $ 233,333 _ 21 27
“ Average StockholderS' Equity $1,100,000 ' ° °

51
The return on Average Stockholders' Equity including the
gains and losses on the monetary accounts

Purchasing Power Income $ 2094000 __ 18 2
Average Stockholders}! Equity $1,100,066 - - /°

The calculation of the earning rates completes the
discussion of the assumptions made in the cases and the
procedures used in converting the statements. It is now
preper to discuss the cases to determine if any conclusions

may be drawn from the analysis of the earning rates.

Case I
This case was developed assuming equality of the Mone-
tary Assets and Non-Monetary Assets. Equality was also
assumed to exist between the Monetary Liabilities and Stock-
hOIdezsv isquity. An attempt to relate this balance Sheet

structure to a real business might prove to be difficult.

however, it is possible to conceive a wholesale business

when grants liberal credit to be in such a situation. A

Significant fact brought out in the analysis of this case,

15 that the gains on the Monetary Liabilities nearly offset

th . .
e losses on the Monetary Assets. The conventional earning

rate " , . . .
a S haVQ been overstated because of the historical basas

use ' . ‘
d 1“ recording the Non-Monetary Assets. The amount 01‘

Overst . . . .
atement of the conventional earning rates is quite

Signifi ,, . . .
Cant. The conventional return on assets is 17.4% or

abOUt ‘ m
106/0 of the converted return on assets including the

mOHEtar ,
y gains and losses which is 10.5%. The converted

¥

52

Case I

Equality Of Noneterv And Non-Monetary Assets
IkuufiLity'Cf Monetary liabilities And Stockholders‘ Equity

Balance Sheets

Conventional Accountine

Meneterjr Assets
Non-Monprterv Assets
Asset Value 4‘ ion Account 3
Total

Monete ry 1.1 a}: i 1 i 1". le s

Genital Stock

Retained Inccne
Total

Price Level Index

100
January 1

1'- (‘1-

EC0,00C
500,000
_.:9:._
31:0001909

 

 

t 500,000

500,000
-2:

$1.000,000

 

 

 

200
Decembrr 31

f 600,000
697,895

 

-o-uo fl

a (00,000
500,000
100 000

allegozfififi

 

Converted tc December 31, Dollars

Monetary Assets
hon-Monettenrv Assets

Asset Va luation Acccunt 3
Total.

Monetary Liabilities

Purchas inp- Power Ad 311 s tment
Total

Note:

January 1

$1,000,000

1,000,000
- (j, ..

LE}..- 991.032

 

$1,000,000

1,000,000
-0-

$2566635§§

 

 

Items in Parenthesis ( ) Are DeGUCtiCns

Decemter 31

f 600,000

1,210,;26
1.19.. 53.6.2.
$.1299i999.

 

1,000,000
100 000

Case I

Eouality of Monetary and Non-Monetary Assets
twnufiLity'of Noneterv Lintilities and Stockhclders' Unuitv

Income Statements

Ccnventional Converted To
Accounting Decemhrr 31
Dollars
Total heavenne $1,500,000 -2,000, 000
Less:: Merchandis 9 Cost of Sales (900,000) (1,2CO, OOC)
Ctter Ernens % .axrs (3L2,10§) (h56,1b0)

knir at1on Cf al.cn-

Monetary Assets _( C7 90?) 1C L'P6)
Net Imcme PW ”Ff?

 

 

 

 

 

 

Less IDividends (Paid Dec. 31) (10C,OOO) (1091000)
Addition to Retained Inccme EEC—171774000 __
Balance ""“’
(kdn an Iionetarv Liabilities
TOtal '. 3 ‘
L08s<ni Iionetary Assets (566 667)
Thnvfiasisinv Power Adjustment WT ICO, CCC

 

Earning Rates

Converted
Monetary Gains and Losses
Conventional Excluded Included
0n Aver—rye Total
Assets 17.bas 19.3% 10.5%;
01"— AVere we Stock-
h01der=3 lkniitv 37.??- $1.??T 15.7?

N - a
Ote' ItN?le in Parenthesis ( ) Are Deductions or bed Firures

54

return on Stockholders' Equity is ab1ut 183% of the real
return. Such an overstatement is certainly misleading,
although when compared to some of the other cases develOped,

it proves to be rather small.

Case 11

In this case the assets were assumed to be largely (80%)
of a monetary nature. This situation would tend to approx-
imate that of a finance company. The Stockholders' equity
and the Monetary Liabilitirs were again assumed to be equal.
The earning rates based on the conventional statements are
the same as in Case 1. however, a very real difference
exists when the earning rates:¢e calculated on the converted
figures. Rather nice returns on Total Assets and Stock-
holders' Lquity are determined to be, in reality, negative.
The gross overstatement of the conventional earning rates
is explained by their failure to recognize the losses in
purchasing power suffered on the Monetary Assets. What
appears to be an increase in Total Assets and Stockholders'
Equity, turns out to be a real decrease in terms of pur-
ChaSing power. The business has, thus, failed to keep pace
thh the increase in the price level. The conventional
earning rates certainly present a misleading view of this
enterprise which is actually worse than not making any

earning rate analysis at all.

55

Case II

Heavy Investment In Monetary Assets
Equality Of Monetarv Liabilities And Stockhclders' Equity

Balance Sheets

Conventicnal Accountinv

Monetary Assets
Non-Monetary Assets
Asset Valuation Accounts
Total

{onetery Liabilities

Capital Stock

Retained Income
Total

Price Level Index

100
January 1

t 800,000
200,000
-0-
31,600;990
a 900,000
500,000
-p-
mm

 

 

 

200
Docemlcr 31

e 060,000

:36 3 , 1F8
--.(,2.3i.1£§l

£1,200,000

 

f (€0,000
500,000
199.2929.

ET. $991929.

Converted to December 31, Dollars

Monetary Assets
Non-Monetary Assets
Asset Valuation Accounts
Total

Monetary Liabilities

Capital Stock

Purchasing Power Adjustment
Total

Note: Items in Parenthesis ( )

January 1

91,6c0,ooo

b00,000
-0-

sagmggmo

 

 

 

51,000,000

1,000,000
-0-

FEQQQQJQEQ

Are Deductions

December ?1
hfh,211
(3h,211)

flJLOOgCOO

 

 

6 600,000

1,000,000
(20319991

311L991000

 

Case II

Heavv Investment in Monetarv Assets
Enualitv of Monetary liabilities and Stock*cldrrs' Eouity

Income Statements

 

 

 

Conventional Converted To
Accountinv December 31
Dollars
Total Revenue $1,EOO,CCC §?,CCH,CCC
less: rercr'nfiise Cost 0C 89 les (QCC,O( T) (1,?CC,CCO)
Cther Crnenses 1 T{.xes (?7(,F"9) (‘0‘,LF6)
aniretion of Nrn-
Eonetarv Assets 23,1CP) ( b},? 1)
Net Income C 200, 000 37"§§§I§§§T
Less Dividends (Paid Dec. 11) (10C COG) __(lOC,CCO)
Addition to Petained Income 3 ICC, CCF . '
Balance 7' ' 3 1F39333
Gain on Monetary Listilities 533,gg£
Total §—.EFE: ‘C
loss on Monet .rv Assets (F'E6 6(6)
Purchasinr fewer Adfiustnent CC” 900 000
mafifl
Earninn Rates
Converted
Monetary Gains and Losses
Conventional Eycluded Included

0n Averane Total ‘

0n AVON}? StCCk-
holders acuity 30.3% :6.7% (10.55)

Note: Items in Parenthesis ( ) Are Deductions or Red Fisures

57

Case 111

The business is assumed to have a large investment in
Non-Monetary Assets. This is probably typical of a manu-
facturing company, although it Could certainly be in the
retail or service trade. The excess of Monetary Liabilities
over Monetary Assets may be eXplained if the Monetary
Liabilities are considered to long-term.
The conventional earning rates in this case are the same as
in the two preceding CRSLS. This is due to the similarity
in capital structure. The converted earning rates present
quite a different picture. because of the excess of Monetary
Liabilities over the Monetary Assets, the converted earning
rates are actually higher than the conventional earning
rates. The value of the Non-Monetary Assets has been main-
tained because oi their nature. This fact is not reflected
in the conventional statements. Indeed, this is a situation
where a business is actually better off by going in debt and
purchasing assets of a hon-Monetary nature. A comparison
of [His case with the two previous cases indicates that the
heavy investment in Non-Monetary Assets is to be desired

during inflation.

Case IV
This company would traditionally be considered to be
in rather poor financial position. The high proportion of

Monetary Liabilities to the stockholders! Equity would cause

8

L1".

Case III
Heavy Investmrnt In Non-Monetary Assets
EQUalitw'Cf Monetary Iiahilities And Stccktclderfl .douity
Balance Skeets

Conventional Accountinn

Price Level Index

 

 

 

 

100 200
January 1 Decemher 31
Monetary Assets 5* 200,000 3' P)-'O,COO
Non-Monetary Assets 800K300 1’OF2’632
Asset; Valuation Accounts -0- (92,622)
Tot a1 madam T..._c.9.9.9_<29.,
Monetary Liabilities 9 500.000 “ 600.000
Capital Stock 500,000 500,000
Retained Income -0- 190,009
Total $1,000,000 $200,009

 

 

 

 

Converted to December 31, Dollars

 

 

 

 

 

 

 

 

January 1 December 31

Monetary Assets $- b00,0r0 :1 210,000
Non-Monetary Assets 196009000 199369FI 3
Asset Valuation Accounts :9- (176 @233),
Total fi,000,000 -.:"(.,OO0,000
gonetary Liabilifies $1,000,000 3; 600,000
Papitel Stock 1,000,000 1,000,000
lgmhaSiJIOf Power Adjustment -0- __ Egglggg
Total $2,000,059 33530902000

 

 

'w’-.-‘

Note: Itennss in Parenthesls ( ) Are Deductiona

59
Case III
Heavy Investnent In Non-Monetary Kssets

Enualitv of Monetary Liabilities and Stockholders' Equity

Income Statements

 

 

 

 

 

Conventional Converted To
Acceuntinn December 31
‘ Dollars
Total Revenue 5:1 500,000 r’? t‘,000,<“00
less: Merchandise Cost of Sales (900,000) (l,?00,¢00)
Cther anensrs & Taxes (307,369) (LCC,F?h)
“xniratien of Non-
Monetary Assets ( Q?,§32) 5W3)
Net Income 3 200,000 ?-. il£5r
Less Dividends (Paid Dec. 31) (1C0,000) (10P1000)
Addition tc Retained Income ?— 100,000—
Ihlance $ 113,333
fiain on Monetary liabilities 933,333

Total
£039 on Monetary Assets
Purchasing Power Adfustment

 

 

 

Earninn Rates

Converted
Monetary Gains and Losses
Conventional Excluded Included
0n Averece Total
Assets l7.bfii 10.b§ 2b.h§
Cn Aver we Stock-
holders Wsuity 33.3% 17.1% h0.0f

Note: Items in Parenthesis ( ) Are Deductions or Red Finures

Heavy Monetary Liabilities

60

Case IV

Equality Of Monetary Assets And Non-Monetary Assets

Balance Sheets

Conventional Accounting

Monetary Assets
Hen-Monetary Assets
Asset Valuation Accounts
Total

Monetary Liabilities

Capital Stock

Retained Income
Total

Price Level Index

100
January 1

i 500,000

500 ’OC‘O
-Q-

$fi,000,000

 

 

s 800,000

200,000
-0-

§§3000,000

 

 

 

200
December 31

$ 750,000
815,789
(6‘ 789)

 

.$1,200,000

200,000
100,009
35,500,909

 

 

Converted to December 31, Dollars

Mcnetary Assets
Non-Monetary Assets
Asset Valuation Accounts
Total

Monetary Liabilities

Capital Stock

Purchasing Power Adjustment
Total

Note: Items in Parenthesis ( ) Are Deductions

January 1

$1,000,000
1,000,000
-0-

 

 

 

$1,600,000
b00,000
-0-

 

December 31

$ 750.000
1,421,052
(1211052)

$2,0s0,000

$1,200,000
h00,000
550,000
3? 0‘0 000

 

 

61
Case IV

Heavy Monetary Liabilities

Equality of Monetary Assets and Non-Monetary Assets

Income Statements

Conventional
Accountina

$1,500,000
(900,000)
(33h.211)

g 65,7892
00,000
(100 000)

37'100f000'

Total Revenue
Less: Merchandise Cost of Sales
Other Expenses & Taxes
EXpiration of Non-
Monetary Assets
Net Income
Less Dividends (Paid Dec.
Addition to Retained Income
Balance
Gain on Monetary Liabilities
Total
Loss on Monetary Assets
Purchasing Power Adjustment

31)

 

Earning Rates

Converted To
December 31
Dollars
92,000,000
(1,200,000)

(bb9,615)
1?1 0‘2
1- Q
(100,000)

$ 133,333
9332333
#5 so 1 ' ‘
5616,6661
t J 02000

 

Converted
Monetary Gains and Losses
Conventional Excluded Included
On Avereae Total ’ (
Assets 15. % 11.2% 26.5%
On Average Stock- ,
holders Ehuity 66.7% 3b.6% 91.9%

Note: llmrns in Parenthesis ( ) Are Deductions

or Red Figures

02

concern, 65pecially if the liabilities were of a short term
nature. As the earning rates indicate, much of this fear

is unfounded during prriods of inflation. The conventional
earning rate on Total Assets of 15.4% indicates rather
satisfactory performance. however, when the gains are
calculated on the Monetary Accounts, in the conversion
process, the earning rate on Total Assets nearly doubles.
The earning rate on the Stockholders' Louity is high both on
Conventional and converted basis. The high rate on the
conventional basis is caused by the lev<ragc provided by the
Monetary Lianilities. The leverage also keeps the converted
earning rate on Stochholders' Eouity high. This case again
points out the fact that liabilities are desirable in a
period of inflation since they are paid back in cheaper
dollars than the money borrowed. Again the earning rates
calculated on the conventional statements prove to be
misleading in terms of economic realities. In two of the
following cases, the earning rates based on the conventional
statements will be the same as in this case. It will be
seen that these cases provide converted earning rates which

are far from similar.

Case V
‘rhe assumption in this case is that the business is
financed primarily by the stockholders investment. This is

a common occurrence.fl1nearly every line of business. 1n many

12'4““, ° M‘ ‘1' _ '4- am

 

63

Case

Heavy Stockbolders' 3.0uity

V

ZEqualitv Of Monetary Assets And Non-Mone1zazy Asse' 3

Balance

Conventional Account inc:

bbnetalry Assets
IkmrMorletary Assets
Asset; Valuation Accounts
Total

Monetary Liabilities

Canital Stock

Retained Income
Totua].

Converted to December 31, Dollars

MOHGWPy Assets
Non-Monetary Assets
Asset Valuation Accounts
Totsal.

Monetary Liabilities
Capital Stock

Purchasing- Power Adjus .ment
Total

Note:

Sheets

Price Level Index

100
January 1

a 500,000

500,000
-0-

$fl,000,000

a 200,000

800,000
-0-

 

 

 

 

$1,000,000

 

 

January 1

$1,000,000
1,000,000
-0-

 

32,000,000

 

 

f" LOC,OOO
1,600,0CC

 

 

 

Items in Par-enthesis ( ) Are Deductions

200

December 31

'1

(of

cg; EDP
€18, b21
(r5 921)

 

711195: F00

 

 

$ 225,000

800,000
1n0,000

 

$1,1233000

 

December ?1

 

562,500

 

 

??F,OOO
1,600,000

(212,:00)
'i I (1200*

 

 

1%
3
‘15
I

64

Case V

Heavy Stockholders' Equity
Enuality of Monetary Assets and Non-Monetary Assets

Income Statements

Conventional Converted To
Accountino December 31
Dollars
Total Revenue €1,FCO,CCO CP,CF0,000
Less: Merchandise Cost of Sales (QCC,OOC) (1,2CO,COF)
Other Expenses & Taxes (3LL,C70) (b53,77P)

Exoiration of Non-
Cf 921)

Monetary Assets (
Net Income 3 ;BO:666

Less Dividends (Paid Dec. 31) (100 OOC)

Addition to Retained Income e‘ 00,550
Balance

Gain or Monetary lialilitias
Total

loss on Nonetary Assets
Purchasinc Dover Adfiustnent

 

 

 

 

 

Earninr Rates

Converted
Monetary Gains and Losses

Conventional Excluded Included

Cn Average Total ‘
Assets 19.0% 12.6% (6.1%)
On Avernpo Stoch- J , ’
holders Equity $2.2p 17.1% (7.39)

Note' Items in Farenthesis ( ) Are Deductions or Red Figures

65

cases this situation may exist because the owners of the
Lmsiness regard debt as undesirable. While no quarrel can
be had with this phiIOSOphy, it has its limitatigns during
periods of inflation.

The earning rates calculated on the conventional
statements appe r to oe nuite adeeuate. iany businessmen

would be very hapgy to earn 22.2% on the stockholders

investment. however, wuen the earning rates are calculated

on the converted statements, the business is less profitable
because of the deficiency in the depreciation charges.
Considering the economic impact on the Monetary Assets, there
has actually been a depletion of the Stockholders' Equity.

This poses an interesting oroolem of taxation. The business

would be taxed on its conventional profit when in reality
the enterprise has suffered a loss. Thus, any income taxes
paid by the business will amount to the confiscation of
capital. The business is thus effectively caught between

the iron jaws of inflation and taxation with both extracting

a measure of the real investment of the stocnholders.

Case VI

11 business with a large investment in Monetary assets

and a higfix preportion of Monetary Laibilities is the subject

of this case. The large monetary gosition makes the business

extremely vulnerable to inflation. However, in this case,

the Nknustary Liabilties act as an effective hedge against

66

Case VI

Heavy Monetary Assets And Heavy Monetary Liabilities

Balance Sheets

Conventional Accountinn

Menetary Assets
Non—Monetary Assets
Asset Valuation Accounts
Total

Monetary Liabilities

Canital Stock

Retained Income
Total

Price Level Index

100
January 1

$ 800,000
200,000
-0-

V—L OCUJOOO

 

3 800,000
200,000
-0-

t1;000,000

 

200
December 31

:1,200,000
2:1:
2 11

§;;§00,000

 

 

$1,200,000
200,000

100,000

 

Converted to December 31, Dollars

Manetary Assets
Non-Monetary Assets
Asset Valuation Accounts
Total

Monetary Liabilties

Caoital Stock

Purchasiiuz Power Adjustment
Total

Note: Items in Parentbesis (

January 1

$1,600,000
u00,000
-0-

 

Eg,000,000

 

 

$1,600,000
L00,000
-0-

 

$2,000,000

 

 

) Are Deductions

December 31

$1,200,000
568,b21
(b9 '91)

$1,720,000

 

 

$1,200,000
L00,000

120,000

 

 

67

Case VI

Heavy Monetary Assets and Heavy Monetary Liabilities
Income Statements

Conventional Converted To

 

 

Accounting December 31
Dollars
Total Revenue $1,500,000 $2,000,000
Less: Merchandise Cost of Sales (900,000) (1,200,000)
Other Expenses & Taxes (373,680) (h98,?b§)
EXpiration of Non-
Nonetary Assets ( 2§1316) ( b8 h21)
Net Income $200,000 m 2 3, 313'":
Less Dividends (Paid Dec. 31) 100 000 (100,000)
Addition to netained Income 00,0 0
Balance ‘-"—"""" $ 153,330
Gain on Henetary Liabilities 933,333
T0138]. 5.“ , J‘, 7
Loss on Monetary Assets §¥6626672
Purchasing Power Adjustment ’ ,0

 

 

Earning Rates

Converted
Monetary Gains and Losses
Conventional Excluded Included
0n Average Total , _
Assets 15.h% 13.3% 11.5%
On Average Stock- '
holders Ehuity 06.7% 00.7% u3.1%

Note: Iftems in Parenthesis ( ) Are Deductions or Red Fivures

08

the Monetary Assets. The earning rates as conventionally

calculated are the same as those in Case IV. with the small

Stockholders' Equity, the earning rate is quite high. how-
ever when the converted earning rates are calculated, the

picture is not quite so rosy. The 00.7% return on stock-

holders investment drOps to 43.1% when the gains and losses

are considered on the Monetary Accounts. The understatement

of the Non-Monetary Assets, with the resulting understate-

ment of depreciation, caused a portian of the misstatement

in the earning rate. The Monetary Accounts tend to offset

each other.Thus, the conclusion is that the understatement

of the Non-Monetary Assets and corresponding understatement
of the Stockholders' hauity has caused a great deal of

misstatement of corporate earning rates.

Case V11

lfluis company has a large preportion of Monetary Assets

and a large pr0portion of Stockholders' Equity. Essentially,

it is ill a situation where the stockholders have invested

cash in tflus corporation and the corporation has held the

investnmnrt in the form of cash. The conventional earning

rates ixl'this case are the same as in Case V. When the
statements are expressed in terms of year-end dollars, a
similar':$itua¢ion also exists between this case and Case V.

The loss.CH1 the Monetary Assets of $800,007 is only partially

offset C07 the gains in the Monetary Liabilities. hence, the

09
Case VII
Heavy Monetary Assets And Heavy Stockholerqt Equ1+y
Balance Sheets

Conventional Accountino

Price Level Index

 

 

 

 

 

 

 

 

 

100 200
January 1 December 31
anetary Assets 0 800,000 : 90C,000
Non-Monetary Assets 200,000 2b7,368
Asset Valuation Accounts -0- (22,368)
Total $1,000,000 §_,12§:000
Monetary Liabilities 0 200,000 0 2?§,000
Capital Stock 800,000 800,000
Retained Income -0- 100,000
Total Vl,000,0007 Elli§0,000

 

 

 

Converted to Decemler 31 Dollars

 

 

 

 

 

 

 

 

 

January 1 December 31
Monetary Assets $1,600,000 0 000,000
Non-Monetary Assets 000,000 063,157
Asset Valuation Accounts -0-___ fi__j£3,l:ll
Total t“2',000,000 ,3 ,320,000
Monetary Liabilities :1 b00,000 .1: 2253000
Capital Stock 1,600,000 1,600,000
Purdhasino Power Adjustment -0- _, fl (505,000)
Total § 10001000 t1,320,099_

 

 

 

Note: Items in Parenthesis ( ) Are Deducticns

70

Case VII

Heavy Hone,ery Assets and heavy Stockholders' Equity

Income Statements

 

    

 

 

 

 

 

 

  
   

Conventional Converted To
Accountina December 31
Dollars
Total Revenue 3:1 , 5’00 ,000 92,000 ,000
Loss: ierchandise Cost of Sales (900,000) (1,200,000)
Other RXpenses % Taxes (377,632) (503,509)
Erniration of Non—
Honetary Assets ( 2?,30?) 1??)
ikt Income 0 200,000 0 2; ,“33
Less DividenCs (Paid Dec. 31) (100,000) (100,000)
Addition to hetainod Income T 100,000—
Balance "" h' 153,33U
Gain on Monetary Liatllities 333_
Total ‘ 7

321,1
866,067

loss on M notary Assets
Purchasinr Power Adjistment

 

 

Earnino Rates
Converted
Monetary Gains and Losses
Conventional Excluded Inc:1"o

0n Averace Total

Assets 10.0%» 10.0% (2?.7g).
0n Avorere Stock- .
'holders Ehuity ?£.2f 19.1? (29.0?)

Note: Items in Parrnthesis ( ) Arc [eductions or Red Fioures

71

business reports conventional net income of $200,000 which
is actually a loss of $405,000 in terms of economic value.
This difference is unaVoidaple when conventional accounting

procedures are used. Certainly such a deviation is material

and should oe pointed out by the use of converted statements.

This situation,if carried to an extreme, could result in the
business reporting a favorable net income and a high earning

rate over a ptriod of inflation, only to find itself in a

vastly impaired position in terms of economic value. In such

a situation, the businessman may find himself forced to pay
higher taxes, higher wages, and generally higher costs

because his ousiness appears profitable while the real

capital of the nusiness is being dissipated by the inflation.

Case V111
'Ihis case presents a rather happy extreme to the cases

previously discussed. here it is assumed that the assets

are primarily of a Non-Monetary nature while the nusiness

has a large proportion of Monetary Liabilities. The really
unfortunate thing about this business is that it would be

considerrxl as in extremely poor financial condition by most
businessmen. In actuality, it is impossinle to conceive of
a business in this position. The puolic utilities would
probatfljl apprOximnte this situation because they generally

lean_txnuard fined dollar obligations when financing increased

plant and equipment.

72

ase VIII
Heavy 1(n-Lene1ery Assets And Heavy Menetnry Liatili‘ies
Balance Sheets

Conventional Accountinr

   

 

 

 

F“
Price Level Index ‘.a
100 200 |
January 1 December 31 ‘
15:01'194'.P_1”?f {5,363,133 f5. 200,00p :2: 300, 0&0 !
Non-Monetary Assets 800,000 1,305,?(3
Asset VM nation Aeee unts -0- g
Total II?) 7000 1
Monetary liabilities S 900,000 51,200,000
Caeitel Stock 200,0e0 200,000
Retained Income -0- 100,000
Total :1,§§:JEQQ_ 71,700,0FO

 

 

 

Canvorted to Deceiber 31 Dollars

 

 

 

 

 

Jannirv 1 December 31
Monetary Assets )F 0,0U) 330, 0“O
Non-Noneterv “see 9 1,600,0F0 ?, ’73, (f)
Asset Valun icn Accounts ~m-0L{1o1 (Pl)
Total 22,0000 7717*‘370
Monetary Liabilities $1,600,000 Fl, ,- :,OQQ
Canital Stock b00,000 b00,000
Purchasijur Power Adjustment n-O- 780,000
Total 7% $000 £3,380,000

 

 

 

Note: Itmwms in Parenthesis ( ) Arn Deductions

 

Ca

Hoavy Non—Konc*:fy “ssefs
Incone
"7C“ ,, ol hie venue
Iess : Iorc.anc W1: 001* of
04* V Tinoans ” ‘a.~
Txniraticn of Ecr—

Monohary Assets

110*", Incor'le
S (193“16

IM DivificnflP Tea.

73

.80 VIII

anfi IWPQKPI IkflleI?lfif Iii“ 11717392
Statevmr, :13
Conventional Converted To
ACCounting Dcccnhcr 31
EcllInW3
01,?0:,000 £2,000,000
Sales (OCC,000) (1,200,000)
I s (29b.737) (302,9v3)
2;
0

 

(Z.’,_,
(100,000)

0
(100,0(0)

 

 

 

 

 

 

Aoflition to Rota inrd Income I 100 FOO
'1. ’

IIGINICQ 8 113,333
Gain.cn1?fnnetP1y Lin.111'1ofi 933 ,333

(110138]- ,0
Loss (mllkchfiary Aseets ;Lg((, 66 6t)

Purchaqinw Pom)? [10.111113771711112 #0 000

“Pr11nP lakes
Convez'ec
Ion t Iv Gains nnO Iosees
Convcn+1rnalrc1uded Inclunod

On AVCTRTG To“al V

Assets 15-Jfl 9.5% 39.3%
On AverPPe 3*Cck- ’ 3 b

holc:cI%; uaL 1*? 66.7% dSoLV 10h.c$
Note: 'Itenuz.hq Parenthosis ( ) Are Deductions or Red ViPrrPG

74

In this exaMple, the conventional earning rates are

the same as in Cases IV and V1. However, unlike the others,

this company has had a significant understatement of its

real earning rate. The company has maintained the value of

its assets because they are primarily of a Non-Monetary

nature. The Monetary Lianilities have proved to be extremely

desirable in times of inflation because of their fixed dollar

‘

nature. The company “85,

 

thus, increased its real capital

as a result of the inflation. The conventional earning rate

of 15.4% on the assets is in rnality 39.3% when the net gain

on the Monetary Accounts is considered. A similar situation

likewise exists with respect to the earning rates on
Stockholders' equity.

It may be concluded from this case that in order to
benefit from inflation, a company must go into debt and
invest the funds in assets which will increase in dollar
value along with the infl tion. The real problem involved
in carrying out such a decision is that of finding people
willing to lend money to the business. Traditionally, such

a busiruass would be considered as a poor credit risk.

Case IX
Tina large preportion of Non-Monetary Assets and the

heavy financing by the stockholders in this company would

seem tc>tm3 typical at a small manufacturing company. 'The

conventignnal earning rates in this case are the same as in

Heavv Hen-Henetavv Assets And

75
Ca~e

IX

Balance Sheets

Conventional Accenntine

Monetary Assets
Non-Monetary Assets
Asset Valuatirn Accounts
Total

Monetary Liabil't i0

Capital Stoc.c

Retained Income
Total

Converted to Decemter

honetery Assets
Non-Monetary Assets
Asset Valuation Accounts
Total

Monetary Liabilities
Canital Stock

Purchasifuz Power Adjustment

Total

Note: IRnyns in Parenthesis ( )

poavy Stockhclaarsc Remit?

Price Level Index

100
January 1

e 200,000

800,000

-0-

 

 

Ti,000,000

ECC

December 31

9 27?,000
0:60,}!7}!
(PQ,%7L)

C1117§}OCO

 

 

 

f 200,000
800,000
-0-

 

91,039,000

January 1

t b00,000
1,600,000
-0-

31 Dcllers

 

 

 

a £00,000
,600,000

-0-

 

$2,000, 000

 

 

Are Deductirns

 

? ??§,roe
800, 000
100 000

—El_

o—----..—... m --

Decemhnr 31

? fr. 000
1,;52,632

(17?, (3?)
’1 905 ,000

 

 

 

3 225,000
1, £00, 000
00,000
71,005,000

 

 

 

 

Case II

Heavy Hen-Nenotary Assrts and Heavy
Income Statements

Conventional
Accountine

1 Revenue $1, 500, 000
Less: Herenare so 0133 f Sales (900, 000)
Lther*3b?vnise - es (310, ?2()
Erniration of ion-
s

 

~~ {ionetajy’il so’s ( €01b7i)
not Incese %7 ?D0,000

(100,000)_
TT'100,000

less Dividerrs (Paid Dec. 31)
Addition to hetaihed Income

 

 

Stockholders' Qatity

Converted To
December 31
Dollars

;7,0 .0, 0
(1,200,000)
(hih,039)
(172 637)

‘ , .z/

 

 

 

 

Ealance "' 3 113,333
fiain on Henetary Iiatilitios 20C, 3°
Total 5 3P1 666
Loss on Henotnry Assets (2U1, 6€()
Pnrchesinr Dower Adfiustment C 80, 000
Earning Rat es
Converted

Monetary Gains

Conventional nxclu<ed

holders Oinuity gd.g% 12.6%

Note: :Lhems in Parenthesis ( ) Are Deductions

or Red

and Losses
Included

0 0 Of.’

10.72

 

Ficures

 

77

Cases V and VII. The earning rates oased on the converted
shnxmwnts, as in each of the previgus cases, uifiers
materially from the Conventional earning rates. fhe return
on total asaets is cut in half. The conventilnal 18» is out

9% when the statem\nts are converted. The earning rate on

 

Stochholdcrs' Lcuity behaves in a similar manner. The
change in these earnine rates is caused primarily by the

s)

gross understatement of the Non-Monetary Assets, the corres-

i
3.
l:
g
‘

J

punding understatements of the Stockholders' Lquity, and
depreciation chargis. The Monetary Accounts are of rela-
tively little significance. They tend to offset each other
with the brunt of the error caused oy the historical cost
basis of conventional accounting. The conclusion may then
be drawn that the historical cost basis of accounting will

provine an overstatemcnt of the earning rates curinfi periods

of inflation.

summary and General Conclusions
Reached From the Analysis of
the Hypothetical Companies
To illustrate the comparative effect on earning rates,
the conventional and converted earning rates for each

company are tabulated in the tables on the following page.

 

78

Rehnn on AVerage Total Assets

Converted
Excluding Including
Monetary Monetary
Gains and Gains and

 

 

 

Case Number Conventional Losses Losses
I 17.4% 12.3%w 10.5%
11 17.4% 14.5% ( 5.7%)
III 17.4% 10.4% 24.4%
IV 15.4% 11.2% 26.5%
V 18.0% 12.6% ( 6.1%)
V1 15.4% 13.3% 11.5%
VII 18.0% 14.8% (23.7%)
VIII 15.4% 9.5% 39.3%
IX 18.0% 10.7% 9.0%

 

Return on AVcrage Stockholders' Equity

Converted
Excluding Including
Monetary Monetary
Gains and Gains and

 

 

 

Case Number Conventional Losses Losses
1 33.3% 21.2% 18.2%
11 33.3% 26.7% (10.5%)
111 33.3% 17.1% 40.0
IV 66.7% 34.6% 81.5%
V 22.2% 15.1% ( 7.3%)
V1 66.7% 49.7% 43.1%
V11 22.2% 18.1% (29.0%
VIII 66.7% 25.4% 104.8%
11 22.2% 12.6% 10.7%

Note: Items in Parenthesis ( ) Are Negative Figures

.lt is obvious from these taoles that conventional
accountijn; provides highly misleading earning rates during
a perirxi of inflation. It may be concluded from these cases
‘presentcxi that the nature of the assets and the capital
essentially account for these changes.

lhxring a period of inflation, the business which does
the best job of maintaining its position will have its

assets in the form of real goods and prOpQrty rather than

79

in the form of cash or other Monetary Assets. The capitali-
zation of the business should include a generous proportion
of Monetary Liabilities since it will be easier to discharge
them as the inflation progresses. The business which suffers
the most from an inflation is the one which holds Monetary
Assets and is capitalized by the use 01 stockholders invest-
ment.

The most striking fact about the earning rates
presented is that they vary so greatly from the conventional
rates. Thus, any use of the conventional ratvs during a
period of inflation may cause highly misleading conclusions
with respect to the efficiency of the business enterprise.
Certainly the demands on the business in the form of higher
taxes by tin govermnent and higher wages by the workers may
constitute a threat to the existence of the business during
periods of inflation. The business is in reality being
subjected to pressures brougit on by the failure of
accounting to recognize that the dollar is not a constant

unit of value.

 

 

'cuABTaR v
The Impact of Inflation On The Earning

Rates Of an Actual Business

Case Study of a Manufacturing Company

'fhe chapter attempts to determine the effect of infla-

 

tion on the earning rates of an actual ousiness enterprise.

 

The selection of the company to he studied was undertaken
without any bias. however, the following reservations were
made when selecting the company. In order to make the
conversion to common dollars as simple and meaningful as
possible, the company should have only one class of stock
outstanding. It was likewise decided to eliminate all
companies having subsidiaries. The company selected was a
manufacturing company located in the middle west.

The company appears in Fortune's Directory of the 500

 

largest industrial corporations in the United States for 1956.
The company has two principal lines of activity. It produces
parts for the automobile industry and small motors for use on
power equipment such as air compressors, lawn mowers, and
water systems. Nearly all of the company's products are

sold to other manufacturing companies. The company has all

—-._.

1. because of the nature of this study, it was decided that
the name of the company studied should not oe disclosed.

 

81

of its manufacturing plants in and around a major midwestern
city.

The company's financial statements as reported for
1945 through 1955 appear in LxhibitWN'at the end of this
chapter. In converting these statements to reflect infla-
tion, the Consumers' Price Index was used. The following

tables shah the Consumers' Brice Index and the purchasing

power factors which were used in the adjustment.

 

’3

Consumers' firice Index“

1947-1949=100 1947-1949=100 1947-1949=100

Average December Last Quarter
Year Index Index Index
1945 76.9 78.4 78.4
1946 83.4 92.5 90.1
1947 95.5 100.9 98.8
1948 102. 102.9 103.1
1949 101.8 100.9 100.8
1950 102.8 106.9 105.8
1951 111.0 113.1 112.7
1952 113.5 114.1 114.2
1953 114.5 114.9 115.1
1954 114.8 114.3 114.5
1955 114.5 114.7 114.9

 

 

 

Consumers' Price Index
Purchasing Power Factors

Index for December 1955 (114.7)
Index to be converted

 

 

 

 

 

December Last Quarter
Year Average Index Index Index
1945 149.2% 146.3%» 146.3%
1946 137.5 124.0 127.3
1947 120.1 113.7 116.1
1948 111.6 111.5 111.3
1949 112.7 113.7 113.8
1950 111.6 107.3 108.4
1951 103.3 101.4 101.8
1952 101.1 100.5 100.4
1953 100.3 99.8 99.7
1954 99.9 100.3 100.2
1955 100.2 100.0 99.8

82 .,

The procedures used in the conversion were essentially
the same as those used in the cases in Chapter IV. It was
assumed that the Balance Sheet at December 31, 1945 was

stated in terms of common dollars. To the extent that this

1* "3

'1‘
i

assumption is invalid, the results obtained are biased.
In converting the inventory, each year it was assumed

that it was composed of purchases made in the last quarter

Ci

at! -h “1“...“
- 9““. ‘

iaur

of each year. This seems reasonable since the company uses
the first-in first-out method to value its inventories.

They also apply the "cost or market" concept to value their
inventories, but it was impossible to determine if any
departure from cost was actually made. however, since the
price level showed a general increase throuahout the period,
the cost or market rule would generally reflect cost.

The conversion of the fixed asset accounts was accomp-
lished by aging the accounts to detwrmine the year in which
the additions were made. An analysis of the gross book
value of the accounts for each year was obtained. The assets
were then conVerted by the index for the year in which the
additions were made. The converted depreciation was then
calculated using the same rates as were used conventionally.
The disposals of the fixed assets were assumed to be on a

first-in first-out basis. The conversion of the accounts

 

2. U.S. Bureau of Labor Statistics, Monthly Labor Review,
Table D-l, Years 1940 thru 1950.

 

was undertaken as follows:

Monetary Assets ----------- By the year end index

Non-Monetary Assets ------- By the index of the year of
acquisition

Monetary Liabilities ------ By the year end index

Sales --------------------- By the average index for the
year

Cost of Goods Sold -------- By the avarage index for the

year with the discussed
adjustment for the inventories

Other Expenses & Taxes ---- By the average index for the
year

Dividends ----------------- By the average index for the
year

The converted Balance Sheets and Income statements
appear as Exhibit "B" at the end of this chapter. The
earning rates based upon conventional and convcrted statements
were calculated in the same way as in the cases in the
previous chapter. The following table presents the con-
ventional and converted earning rates. The converted
earning rates include the gains and losses on the monetary
accounts. As discussed previously, they should be included
in order to preperly reflect the real success or failure of

the business.

X Manufacturing Company
Earning Rates

Return On Average Return On Average
Total Assets Stockholder's hquity
¥§§§ As Reported Converted As Reported Converted
o 0

 

 

 

i

“Pi—1" _ fin: ”din-st
LI; “-

24.0% 41.4% 30.2%,
1947 38.6 30.8 49.6 39.2
1948 39.8 34.4 48.6 42.7
1949 29.8 29.6 35.8 35.6
1950 22.9 19.0 28.3 23.4
1951 21.1 16.7 27.6 21.8
1952 20.0 18.1 25.6 23.1
1953 19.8 17.6 23.9 21.3
1954 25.4 24.7 31.3 30.6
1955 26.7 25.9 33.2 32.4

84

The converted earning rates in every single year
are lower than the ConVrntional earning rates. This is due
to two factors. The first being the historical basis of the
fixed assets in the conventional statements. The second

reason is the failure of the conventional statements to take

into account the gains and losses on the monetary accounts.

  

As can be seen in the Balance Sheets, the structure

of the company is similar to Case IX in the preceding

‘13:“ f‘1‘rfi fle' ' W

”3" {

chapter.

'Ihe company has a rather large investment in Non-

.

Monetary Assetszmd.the capital is predominately in the form
of Stockholder's houity. Although the proportions of the
Non-Monetary Assets and Stockholder's hquity are not euite
as large as in Case IX, nor the price level change as great,
the results art essentially the same. It might be argued
that the variation between the conventional and conerted
earning rates for this company are rather small. howev:r,
when talking in terms of a misstatement of net income of
several million dollars over a period of years, the error
becomes ouite significant. Especially since the error may
cause many invalid decisions on the part of interested

parties.

harming Rates and Other Case Studies
In connection with their conversion of actual financial

statements to reflect the impact of inflation, a few authors

85

have attempted to compare the conventional and converted
earning rates of the companies. Donald A. Corbin, while
measuring the impact of changing prices on a department

store found the following results.3

 

Earning Rates Earning Rates E l
On Total Assets On Common Stock Equity , '.
Year Conventional Converted Conventional Converted a
1646 13.7% 11.8% 16.5% 14.1% 1
1947 22.1 15.4 27.3 18.6 ,
1948 16.9 9.5 19.8 11.0 3 m'
1949 13.7 10.4 16.9 12.5 in!
1950 10.5 10.1 12.9 12.3 is
1951 10.5 6.6 13.3 8.0
1952 9.2 3.9 9.3 4.7
1953 6.6 4.8 8.3 5.9

His results seem to follow the same trend as the results

for the manufacturing company. The converted earning rates

in every case are lower than the conventional earning rates.
Similar results were also found by Ralph C. Jones in

his analysis of nine steel companies.4 He found that the

earning rates on the average equity of all bondholders and

stockholders were as follows:

 

1941-1945

Average

Per Year 1946 1947
Conventional 5.25% 6.21% 357%
Converted 3.38 (3.23) 1.63

i

3. .Donald A. Corbin, "The Impact of Changing Prices on a
Department Store," The Journal of ACCountancy, Vol.97,
April, 1954, p. 435-6.

 

4. Ralph C. Jones, "Effect of Inflation on Capital and
Profits: The Record of Nine Steel Companies," The
[ournal of Accountancy, Vol.87, January, 1949, p.18a23.

‘L
h
,.

 

 
 

 

86

The study of four companies by Mr. Jones for the
American Accounting Association revealed the following
5
earning rates for the New York Telephone Company. These

earning rates were calculated on the average eauity of all

 

 

investors.
Year Convgntional Converted
1946 7.7 4.8
1947 6.2 2.9
1948 5.1 2.1
1949 4.5 2.0
1950 5.9 3.3
1951 6.2 3.0
1952 6.4 3.3

The other companies in the case study of four companies
showed similar results.

With respect to the results obtained by the conversion
of the manufacturing company and in view of the similarity
to the results of other case studies, the assumption that
earning rates are overstated during an inflation seems to
be valid. It is not proposed that statements reflecting the
change in the price level should completely supplant the
conventional accounting statements, nor should the converted
earning rates completely supplant the conventional earning
rates. However, it certainly seems desirable that such
information should be presented as a part of the annual
report to the stockholders. The use of the purchasing power

information would certainly be valuable to all interested

parties.

 

 

5. Ralph C. Jones, Price Level Changes and Financial State-
92. Cit., p. 18. . .

87

EXHIBIT A

X Manufacturing Company
Reported Balance Sheets Reclassified lnto

Purchasing Power Components

(000's Omitted)

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Dec. 31 Dec. 31 Dec. 31 Dec. 31
1945 1946 1947 1948
Assets $ 3 $ 3
Monetary Assets
cash 390 1,181 1,681 2,074
U.S. Treasury Notes -0- -0- -0- 32
Accts. Receivable (Net) 838 889 1,086 1,256
Cash Value of Life Ins. 131 139 .14; 149
Total Monetary 1,359 2,207 2,910 3,511
Non-Monetagy Assets
Marketable Securities 278 ll 11 11
Inventories 2,356 2,614 2,926 3,468
Plant, Prgperty, & Equip. 3,139 3,284 3,736 4,449
Allow. or Deprec. 1,955 1,969 2 063 2,157
Net Property 1,184 1,315 1,673 2,292
Patterns, Tools, etc. 50 50 50 50
Prepaid Expenses 17 19 30 23
Total 3,886 4,009 __£,691 5,843
Total Assets 5,245 6,216 7,601 9,354
Liabilities & Stock Equity
Monetary LiafiilitIES
Accounts Payable 540 620 848 825
Accrued Payroll 136 223 369 435
Accrued Taxes 310 581 441 496
Total Monetary Liab. 986 __1,424 1,658 1,756
Stock Equity ‘ .
Capi t al St ock 300 300 300 300
Retained Income 4,029 4,562 5,713 7,368
Total 4,329 4,862 6,013 7,668
Less Treasury Stock 70 7O 70 70
Stock Equity 4,259 4,792 5,943 7,598

 

Total Liabilities &
Stock Equity

 

 

5,245 6,216 7,601

9,354

 

 

 

 

 

88

 

 

 

 

 

 

 

 

 

Dec. 31 Dec. 31 Dec. 31 Dec. 31 Dec. 31 Dec. 31
1949 - 1950 1951 1952 1953 1954 1955
$ $ 4 $ $ $ 4
3,360 2,367 2,447 3,138 3,034 4,949 1,908
204 -0- “'0" 599 1,121 1,376 112
1,193 1,440 2,229 1,730 1,513 2,133 2,365
155 160 166 171 177 -0- -0-
‘7479f3 “3:967’ "4j842f 5, ‘ 5:845’ “8:458""Zj385
11 11 11 11 -0- -0- -0-
2,965 5,067 6,229 5,763 6,539 6,046 8,867
4,872 6,088 6,657 6,920 8,010 11,307 17,924
2 318 2 461 2 689 2 971 3 241 3 579 4 310
"2fi554 “‘3f627 “'3f968’ “3f949 “‘4f769’ "7f728’ ‘TifETZ
50 50 50 50 '50 50 50
30 41 49 52 61 71 63
‘3‘609 “8‘796’ ‘10'306' “9‘827’ 'II‘ZIV' ‘13"896 “22‘393
‘10f322‘ '12f763' “15:148' ‘IBfZEB’ '17f262 “22:35? "26f978
671 1,674 937 1,191 1,122 2,128 2,448
421 496 466 605 717 1,011 1,038
498 618 2,467 960 1,037 1,439 1 514
1f;590 2,788 3,870 2,756 2,876 4,578 "5f600
8 300 300 300 300 300 300 300
702 9 745 11 048 12 479 14 086 17 476 21 678
'__§ftfifiz ‘1fiffifir5 'Tfff348 ‘12f779 ”146386' ‘T7f776' ”21f978
. 70 70 70 70 -0- -0- -0-
“8532 ”—9,;73 . 111218 122169 1711386 1:1”6 219918
._1943§gg 12,763 15,148 15,465 17,262 22,354 26,978

WWW-WW“

 

«1r. -7

89

EXHIBIT A

X Manufacturing Company
Reported Income Statements
(000's Omitted)

Calendar Year 1946
3
Net Sales ,
Cost of Goods Sold 11,393
Selling & General Expense 1,061
Depreciation . 114
Net Operating Income ,
Other Income 72
Total 3,180
Other Expenses & Taxes 1,310
Net Income 1,870
Retained Income 1/1 4,029
Total 5,899
Dividends 1 337
Retained Income 12/31 4,562
EXHIBIT B

1947

___§__
21,776

15,380
1,764
129
'37303
74
'74,577
._112£Q
2,637
4,562
7,199
486

1
5,713

X Manufacturing Comapny

Income

Statements
Converted To December 31, 1955 Dollars

(000's Omitted)

Net Sales
Cost of Goods Sold
Selling General EXpense
Depreciation
Net Operating Income
Other Income
Total
Other Expenses & Taxes
Net Income
Retained Income 1/1
Total
Dividends
Loss on Monetary Items (Gain)
Retained Income 12/31

1946
$
21,555
16,137
1,459
225

99

1947
___3L_.
26,152

1948

24,046
16,445
1,872
158

98
5,669
._§1§§Q
3,289
5,713
9,002
1 634

7,368

1949

1950

1951

90

1952

1953
$

#*m“*

40,534
28,341
2,904

1954
5
497099
34,932
2,840

1955
___3L__
58,136
40,129

2,722

W***“*W

mwflflflflw

1949

26,318
18 ’ 31'J
2,197
341
‘75:?fl5
‘5I768
2,468
3,300
3,340
’640
1,842
(52)
9,850

“mmmww

 

2,627
482

10,327

 

Wflmmmw

6,175
22,931
2,405
2
20:524’

1. 4 .W“
- fi 3 . . _
u- a ’
I
_-1
w' - ‘
-.‘ .
o
. :-

mna-w t.-

 

91

EXHIBIT B

X Manufacturing Company

Balance Sheets

Converted to December 31, 1955 Dollars

(000's Omitted)

Dec. 31 Dec.

 

 

 

 

 

 

 

 

 

 

 

 

 

 

1945
. Assets $
MonetaryrAssets
Gash 571
U.S. Treasury Notes -0-
Accts. Receivable (Net) 1,225
Cash Value of Life Ins. 192
Total Monetary 1,988
Non-Monetary Assets
Marketable Securities 407
Inventories 3,447
Plant, PrOperty, & Equip. 4,592
Allow. for Deprec. 2,862
Net Pr0perty 1,730
Patterns, Tools, Etc. 73
Prepaid Expenses 25
Total Non-Monetary 5,682
Total Assets 7,670
Liabilities g Stock Equity
Monetary Liabilities
Accounts Payable 790
Accrued Payroll 199
Accrued Taxes 450
Total Monetary Liab. 1,439
Stock Equity
C—apit a1 Stock 439
Retained Income 5,894
Total 6,333
Less Treasury Stock 102
Stock Equity 6,231
Total Liabilities &
Stock Equity 7,670

 

 

 

 

 

 

31 Dec. 31 Dec. 31
1946 1947 1948
6 $ $
1,465 1,911 2,313

-0- -0- 36

1,102 1,235 1,400
170 163 166

2.737 3.309 3,915

16 16 16

3,328 3,397 3,860

4,783 5,315- 6,088

2,916 3,142 3,348

1,867 2,173 2,740

73 73 73

28 41 31
"‘5'3I2 5 700 6 720
._._.1..._._.. .._.....1.__..

8,049 9,009 10,653
768 963 920
277 420 485
721 502 553

1,766 1,885 1,958
439 439 439

5,946 6,787 8 340

6,385 ‘7,226 "‘8f779
102 102 102

6,283 7,124 8,677

8,049 9,009 10,635

 

1'

 

 

 

92

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Dec. 31 Dec. 31 Dec. 31 Dec. 31 Dec. 31 Dec. 31 uec. 31
1949 1950 1951 1952 1953 1954 1955

$ 5 $ $ $ $ $
3,820 2,540 2,482 3,153 3,028 4,964 1,908
232 “O“ “U“ 002 1’119 1’38U 112
1,356 1,545 2,260 1,739 1,510 2,139 2,365
176 172 168 172 176 -O- -0-
5,584 4,257 4,910 5,666 5,833 8,483 4,385
10 16 16 16 -0- -0- -0-
3,374 5,493 0,341 5,786 6,519 6,058 8,849
6,552 7,881 8,445 8,700 9,764 13,040 19,603
3,643 3,966 4,349 4,803 5,340 5,958 7 026
2,909 3,915 4,096 3,897 4,424 7,682 12,577
73 73 73 73 73 73 73

39 61 69 72 8 91 79
6,411 9,558 10,595 9,844 11,097 13,304 21,578
11,995 13,815 15,505 15,510 ._16,930 21,787 _§§,963
763 1,797 950 1,197 1,119 2,135 2,448
479 532 473 608 716 1,014 1,038
566 063 2,501 965 1,035 1,443 1,514
£1,8(H5 2,992 3,924 2,770 2,870 4,592 5,000
439 439 439 439 439 439 439

9 £550 10 48 11 244 12 403 13 621 16 756 20,524

'135,289 10,923 11,683 12,842 14,060 17,195 , 0
. .102 102 102 102 -0- -0- -0-
1 ,187 10,823 11,581 2, 40 14,060 17,195 20, 63
11.9“%§_ 13,815 15,505 15,510 16,930 21,787 25,963

 

 

 

 

93

EXHIBIT B

X Manufacturing Company
Reconciliation Of Purchasing Power
Gains And Losses On Net Monetary Assets

Conventional Net Monetary Assets
Balance December 31
Less Balance January 1
Increase During the Year
Average Purchasing Power Factor%
Increases Converted by Average
Purchasing Power Factor
Converted Balance January 1
Total
Converted Balance December 31

Loss on Net Monetary Assets (Gain)

783
373

410
137.5%

564
549

‘13113

971

142

1947

___1__

1,252

783
_ 469
120 .1/0

563
971
1,534
1,424
110

 

1949
___1__

3,323
+1223
112.7%

1,767
1,957
9

3,776

Z 52)

1951
9

972

1 179
Z 207)

10 3 o 32/0

( 214)

1,265
1,051

986

94

1952

..__.§__.

2,882
972

119.11),

101.1%

1,931
986
2,917

1953
___§__
2,969

2,882

87
100.3%

87

2 896
2:633

.2129;

1954
___JL_.

3,880
2,969
911
99.9%
910

2,963
9

1955
9 .

( 615)
z31.8.81)

4,495)
100.2%
(4, 504)

3891
1‘13)

615)

W m * *-—— I --- -_
m W m m I

 

Ch APT 15R VI

Summary And Conclusions

Validity of the Original hypothesis
The hypothesis as expressed in Chapter 1 is that in
a period of inflation the earning rates calculated on
conventional accounting statements are overstated in terms

of the real income and assets of the business. The cases

developed in Chapter IV bear out this hypothesis in part.
From the analysis of the hypothetical companies, it was
determined that the earning rates developed from conventional
accounting data are misleading during periods of inflation.
however, the degree to wnich they are misleading varies
according to the nature d?the assets and equities of the
business.

It should be noted that the conventional earning rates
of some of the hypothetical companies were actually under-
stated. This situation existed when there was a large gain
(M1 the monetary accounts. When this gain, caused by the
(Existence of large prOportion of Monetary Liabilties, greatly
e>«:eeded the overstatement of net income due to insufficient
chapreciation chargedcnlthe historical Cost of the Non-Mone-
however,

tzrry Assets the earning rates were understated.

ir1 actuality this situation would be unusual because busi—

ruessmen generally like to avoid excessive use of the Monetary

 

96

Liabilities.

The businesses which were hurt by the inflation were
those who had large proportions of Monetary Assets. There
is a striking example of an actual business which found
itself in such a situation. The Montgomery Ward Company
under the direction of Mr. Avery built up a large reserve
of cash immediately following World War II. The philOSOphy
of Mr. Avery was that the costs of expansion were too high
and that it would be wise to wait for a drop in the price
level. Thus, the company suffered a large loss of purchasing
power during the period of inflation following the war.

The analysis of the manufacturing company also
supported the original hypothesis. The earning rates of the
company were overstated throughout the period from 1946
thru 1956. The overstatement in this case was not as great
as in the hypothetical cases because the change in the price
.level was not as great. While the assumptions mentioned in
the discussion of the cases might invalidate the results to
some extent, it is certainly doubtful if they would
Inaterially offset the conclusions reached.

The earning rates developed from the study of the
funerican Accounting Association and by other prominent
acrnauntants also tend to support the hypothesis. In all of
tflne companies investigated by these authorities, the earning
rtrtcs based upon the conventional accounting statements were

xuatnerially overstated. The converted earning rates in some

 

 

97

cases actually reflect a loss of capital. As a result of
this and other facts brought out by the conversion of the
statements to reflect inflation, one of the companies studied

included in its annual report statements converted to

reflect the effect of inflation.

The Significance of the Results
The evidence presented in this thesis should certainly
be of interest to acc»untants. The use of historical cost
by accountants may certainly be challenged. The assumption

that the dollar is a Constant unit of value may cause a very

real hardship on business during a pnriod of inflation. A

business enterprise may be subjected to undue pressure be-
cause of its indicated high earning rates when in reality
the earning rates are materially in error.

'Ihe accountant and the accounting profession should
strive to present real and meaningful statements and reports.
Ijnieed, this is the true responsibility of the accountant.
13x15 would not recuire a Complete depwrture from the tradi-

tienial principles of accounting. It would be necessary to

keen) the accounting records in the traditional way in order

to liave a basis for adjustment. however, it seems imperative
thal: supplementary statements to reflect the impact of
inflation should oe included in the accountant's records.

.Siru:e :it is only logical to regard the business enterprise as

311 ecu)nomic unit, the accountant should report to the

 

98

interested parties the successes or failures of the business
as an economic unit. If the real earning rate of a business
on its Stockholder's Enuity is 5%, let it not be said that
the accountant was at fault by reporting it as 10%. If the
acCountant cannot make his records reveal the true facts in
financial terms, it is certainly doubtful if the accounting
information is of any real value. In fact to the extent

that it is misleading, it may be aorse than no information

 

 

at all. This is a rather broad indictment of accounting,
out to the extent that the accountant adds together apples,
oranges, and bananas and calls the total apples, it is true.

The information provided by the calculation of the
converted earning rates would certainly be of value to the
stockholders of a corporate enterprise. It would provide
them with additional information which they could use in
evaluating the stock and in comparing it to stocks of other
companies. As pointed out in Chapter IV, it is certainly
better to invest in a business having a large proportion of
Non-tionetary Assets during a period of inflation. Since the
stockholders are interested in the business enterprise as
zni economic unit, it seems that they would more than welcome
irdhormatiun based on economic reality.

Management would also be served by the calculation of
cxnrverted earning rates. While it is to be eXpected that
management would realize that inflation is in existence,

tlmrtuonverted earning rates would provide a means of

 

99

determining the impact of the inflation upon their business.
For example, it would be helpful in decisions concerning the
method of financing prOposed expansion, in matters concerning

wage increases, and in determining the full burden of taxes

on the business.

Other interested parties such as the government might
well View the real earning rates with great interest.
Certainly the corporate income taxes have caused an
inequitable burden upon some business during the past few

years. The excess profits tax in existence a few years ago

was certainly a burden upon corporations wnose reported

profits were materially overstated in real terms. Of course,
it has to be admitted that the government must raise enough
revenue to carry out its activities. however, in a period
of inflation it seems that many businesses and individuals
bear an unfair share of the burden of taxes because of the

accounting procedures which are used. It must be admitted
tlurt the accelerated depreciation and the adop ion of LIFOT
ifiar tax purposes has helped avoid some of the inequifies.
Ehit, irrespective of these methods, many businesses have
stifill borne an inequitable burden of taxes. ‘

The labor groups would also do well to consider the
real earning rate of the business when making demands for
hi4;he1'umges. As pointed out earlier, a business might
‘reIMDIT conventional earnings for a period of years only to

:fjrui that its real capital has been dissipated. Indeed, the

 

100 ’

demands of labor might effectively work against them in the
long run.

Although this thesis has discussed only the impact of
inflation on corporate earning rates, some mention must be
made concerning the possible effect of deflation. It is
the firm belief of the author that it the adeption of the
converted earning rates and financial statements is made, it

must be made during times of deflation as well as inflation.

 

 

In such times the effect on earning rates would no doubt
be the reverse of the situation during inflation.

While this study of earning rates and inflation has
discussed many important aSpects of the oroblem, there
certainly is room for furtLer work in this area. It would
be desirable to undertake a broad study to determine the
effect of inflation upon the whole area of ratio analysis
(of financial statements. Such a project would take a great
(deal of time and effort. howev r, if the results were as
:startling as those uncovered concerning earning rates, the
information would certainly add to the knowledge of the

siggnificance and shortcomings of accounting information.

()3
0

1L).

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