INTERPRETATION OF INFLATION ACCOUNTING
[note: GAP IN PAGES 48-55.]
William C. Norby
Senior Vice President and Director (retired),
Duff and Phelps
December 17, 1981
[Introductory notes: William C. Norby
Financial Consultant; retired Senior Vice President and Director,
Duff and Phelps.
Past member of the Financial Accounting Standards Advisory Council
AICPA Commission on Auditors' Responsibilities
Comptroller General's Panel on Regulatory Accounting
Past President, Financial Analysts Federation
Accounting Editor, Financial Analysis Journal]
After a brief review of the objectives, concepts, and preferred
method of inflation accounting, the lecture will present and analyze
the impact of inflation accounting adjustments on companies and
industry groups over the last eight years; consider bow the data
can be utilized for investment decisions; and demonstrate managerial
uses of inflation accounting for internal control and strategic
decisions. The analysis will be based primarily on the author's
comprehensive data base covering the eight year period 1972-1980,
but FAS 33 data will also be considered. The lecture will conclude
with an appraisal of the advantages and limits of inflation accounting
for practical decision-making.
In the last three years, inflation accounting has been adopted as
a supplementary financial statement in the United States and the United
Kingdom. This comes after more than 50 years of debate about methods
of adjusting financial accounts for inflation. In a way, this is a
sad commentary on the state of inflation in the western world. Inflation
has attained a degree of permanence and consequently inflation accounting
is becoming a standard feature of corporate reporting. The debate
about methods continues but now theory is being confronted with actual
data. Therefore we should shift attention from methods to applications
and test the utility of this kind of accounting. Eventually the application
of this data to the real life problems of investment and business
management will forge one acceptable accounting method.
In this lecture, I will concentrate on a review of some actual inflation
adjusted financial results for industries and companies in several
diverse fields and show how this information can be interpreted and
applied to investment and business decisions. But in order to do this
I must first explain the theoretical framework I use to organize and
analyze this data. We cannot escape theory, for good theory is essential
to good data and substantive analysis. However, I will not rehash
all the other theories that have been debated over the years.
My inflation-adjusted financial statements cover the nine-year period
1972-80 and are much more comprehensive than Statement 33 reports,
and are arranged differently. This naturally leads to a critique of
Statement 33 but on this I will be brief.
In conclusion, I will evaluate the merits of inflation accounting
and try to provide some perspective on its future role in investment
and business decisions. Advocates of inflation accounting often seem
to be crusaders trying to change our entire view of the economic world.
I suppose I am one of those crusaders, too, but with reserve. I regard
inflation accounting as a desirable improvement in accounting but
not an engine of revolutionary change in financial analysis.
OBJECTIVES, CONCEPTS AND METHODS
Objectives of Inflation Accounting
Inflation accounting has two broad objectives:
These are quite different objectives which the Financial Accounting
Standards Board has attempted to satisfy by requiring two types of inflation
accounting adjustments in Statement 33. The first objective is generally
achieved by the current cost method which is also much more responsive
to the general objectives of financial reporting. These are stated in
Concepts Statement 1 to be: "to provide information that is useful
to present and potential investors and creditors and other users in
making decisions (and) in assessing the amounts, timing, and uncertainty
of prospective cash receipts from dividends or interest and the proceeds
from the sale, redemption, or maturities of securities or loans."
- To correct conventional historical cost accounts for the understatement
of inventory and plant used in production, i.e. the cost of goods
sold and depreciation, in order to prevent erosion of capital during
- To eliminate the "money illusion," the euphoria associated
with inflation, by reducing the accounts to "real terms."
The second objective is better met by a statistical procedure than
by accounting. The purchasing power or constant dollar method does
not meet the general objective and inflation accounting methods should
be consistent therewith.
There are limitations to inflation accounting and the failure to
recognize them has led to unnecessary complexity in some methods,
including Statement 33. Inflation accounting cannot isolate or condense
into one earnings number all of the effects of inflation on a company.
It is simply an improved system of measurement which brings financial
statements into harmony with current costs and values. Such improved
statements provide a foundation for analysis of a company's economic
earnings and financial position in an inflationary environment, including
any special effects of inflation.
SOME BASIC ACCOUNTING CONCEPTS FOR INCOME AND CAPITAL UNDER INFLATION
There are some basic concepts of economies and accounting that need
exposition in order to understand the data produced under the current
cost method and to support the particular approach I have used.
Income and capital: The economic concept of income, in fundamental
terms, was stated by Sir John Hicks as the maximum value which a man
can consume during a week (or period) and still expect to be as well
off at the end of the period as he was at the beginning. In other
words, income is the amount that can be consumed without impoverishing
the individual (or firm). (2)
Capital is a source of income and cannot be consumed without affecting
future income. The distinction between income and capital becomes
very important during inflation.
These ideas seem reasonably clear when applied to personal circumstances
or to a short-term business project, but they become more complex
in a going-concern continuum. Consequently, it will be useful to distinguish
the accounting theory for a project from a going-concern. Later I
will show how this distinction can be applied to inflation accounting
analysis of certain industries.
ACCOUNTING FOR INCOME IN A STABLE PRICE ECONOMY
Short-term business project: In a short-term project of, say,
a year, the following sequence takes place: capital is invested to
buy machinery and inventory, people are hired, a product is produced
or a service rendered, revenue is received and production costs are
paid. At the end of the project the machinery is worn out and junked,
without value. The inventory is liquidated in production. The cash
remaining is allocated by the proprietor first to his original capital,
which must be fully preserved, after which any surplus can be considered
net income, profit or earnings. The amount of income compared to the
amount of capital invested determines the rate of return of earnings
on the capital.
If a project runs for several periods, it may be desirable to know
what is earned in each period. In order to do so, it is necessary
to allocate some of the cost of long-lived assets to each period by
a depreciation charge, in order to insure that the total cost is recouped
over the life of the project. This insures that periodic income in
excess of the capital allowance can be paid out without fear of impoverishment.
At the end of the project, capital is reclaimed through cash in the
depreciation fund, the equipment being worn out and of no further
use. Depreciation is thus a means of allocating capital consumption
to earning periods. In the project situation it is not a reserve fund
accumulated to replace the equipment when it is exhausted. Although
in theory that could be done if another project were undertaken, that
would be a new capital investment decision. In any event, such accumulation
would be adequate because it is assumed that the new equipment could
be purchased at the old price under stable state conditions.
Capital can be measured in two ways: in money terms and physical
terms. Under stable price conditions financial capital and physical
capital are identical. Capital in money terms is intact at the end
of the project and it will command the same physical assets as at
The going-concern: This analysis of a project illustrates
the interrelationship of earnings and capital in microcosm. An oil
exploration and drilling partnership is an example of a project investment.
In contrast, a corporate business enterprise is composed of many projects
or earnings cycles overlaid one on the other with no final termination.
This is the going-concern. Periodic net income of the enterprise is
a composite of earnings from many projects and cycles. Each one is
charged for depreciation to recoup the original capital invested in
its long-lived assets, or, in effect, to provide for their replacement
when they are worn out, because the projects are continually renewed.
Since these measurements are imprecise, depreciation accounting entails
many conventions, some related to tax consequences. However, it is
assumed that in a stable price environment, depreciation provides
for capital replacement so that the business can continue without
a new infusion of capital. Financial and physical capital remain identical.
Stated in a different way, the ongoing enterprise in a stable state
economy is considered self-sustaining at its prevailing level as long
as adequate provision is made for capital consumption through depreciation
and no loss is shown. Hence, all net income can be paid out without
fear of consuming capital. However, if the enterprise wishes to expand
its business, it can convert some of its net income into new capital
by retaining it in the business and investing in additional earning
assets. Assuming the rate of return on capital is constant, the rate
of growth of capital and earnings is a function of the return on capital
and the percentage of earnings retained.
Accounting for periodic income in complex going-concerns is the principal
focus of financial accounting. The primary purpose is to continually
distinguish between return of capital and earnings return on capital.
It is fraught with difficulty.
Accounting for income and capital under inflation: In his
definition of earnings, Hicks uses the terms "maximum value"
and "well-off." These concepts become more difficult to
define under conditions of changing prices. Are "value"
and "well-off" to be expressed in money terms or real terms?
Prices change in a wide range of circumstances. A persistent rise
in almost all prices is called inflation and is a monetary phenomenon.
Prices of specific goods or services are determined by supply and
demand factors in the particular market. Both inflation and supply/demand
forces can operate at the same time so that all prices will tend to
rise but specific prices will rise more or less than the general average.
The relative importance of the two factors at any point in time is
not important because each individual project or firm must deal with
the specific prices affecting its sales and costs.
Although specific price changes occur in a stable state environment,
they have not been deemed of sufficient continuing importance to require
a recognition in accounting for income and capital for the project
or the firm, although logically they might be. When price changes
become persistent and pervasive due to inflation, the concepts of
income and capital must be refined. This can be demonstrated in a
parallel analysis to income and capital in a stable state.
The single project: Under inflation, the cash flow from operation
of a single project may increase over what was expected at the outset
due to higher selling prices. In addition, at the completion of the
project the equipment, which was deemed worthless under stable price
conditions, now has an unexpected residual value. However, the original
capital invested in the enterprise has been fully reserved through
depreciation and conversion of the inventory to sales and is returned
at the end of the project out of accumulated cash flow.
Net income for the project is greater than expected due to the residual
value of the equipment and the extra profit on inventory due to rising
prices. This income is called a holding gain while the income from
the project based on stable price conditions is considered operating
income. If this is a one cycle project the distinction is of no consequence
because all income can be distributed along with the original capital.
Financial capital has been preserved and physical capital is moot.
At the end of the project, the investor may want to know whether
his additional money resources, comprised of his original capital
and the earnings derived from the project, will buy as much as at
the beginning. This depends on how he wants to use the money. In general,
we say that, if the general price level has risen, the gain in real
buying power of these funds is less than the gain in money terms.
However, individuals are more affected by price changes in the specific
thing they consume than by the price change of a fixed basket of goods
purchased by a typical urban family. Thus, any measure of the investor's
wealth or well-being at the end of the project under conditions of
rising prices is imprecise and to some extent a personal equation.
It is one thing if he wants to travel to Japan and another if he wants
to buy a new model computer which has double the capacity at half
the cost of earlier models.
Despite this reservation, it is useful to show in a general way whether
the buying power of the capital and the accumulated income is as great
at the end as at the beginning. This could be determined by reference
to price changes for the specific goods the investor wants to purchase
but for convenience and general comparisons a broad price index is
used. No single index is representative of all price changes in the
economy but the Consumer-Price Index is a popular measure. Thus, financial
capital may or may not have been maintained over the life of the project
in terms of its buying power -- i.e., in real terms -- after adjusting
for the rise in general prices as measured by an appropriate price
A sequence of projects: In a sequence of projects under conditions
of rising prices, an increase in capital investment becomes necessary.
Upon completion of the first project, the investor wishes to embark
on a second project of the same scale but finds that his original
capital is insufficient to buy the necessary equipment and inventory.
In other words physical capital has been impaired. He must use some
of the earnings from Project 1 to provide capital for Project 2. The
necessary additional capital is measured by the holding gains in Project
1 because they represent the amount by which the cost of new assets
exceeds the original cost. Thus, only operating income from Project
1 can be distributed currently without impairing operating capability.
In sum, financial capital has increased by the amount of the holding
gains but physical capital remains the same. Under inflation, financial
capital and physical capital are no longer identical.
Over the sequence of projects, the investor will have invested successively
larger amounts of financial capital, the increment over the original
amount having been derived from holding gains. Operating income would
have been paid out. At the end of the sequence, his total capital
will be the sum of his original capital plus retained earnings (holding
gains) and will be higher than in the stable state economy. The retained
earnings can now be distributed and the original capital liquidated.
Physical capital is no longer pertinent.
During this sequence, operating income will be regarded as the most
significant measure of return because it is distributable currently
but at the end retained holding gains are also paid out. Thus total
net income constitutes the full return on capital for the total life
of the projects.
The investor's wealth has increased and, if desired, the buying power
of his wealth can be measured by application of the index of prices
most appropriate to the circumstances. It is not necessary to make
this calculation to manage the sequence of projects however. The investor
and the manager must make decisions in actual dollars.
The going-concern with its mix of overlapping and sequential
projects is more complex than a sequence of single projects but the
accounting for income and capital follows the same principles. The
first objective is to maintain physical capital, i.e. operating capability.
With rising prices, this requires greater financial capital which
can be obtained from reinvested earnings or new capital. In simple
terms, the amount of holding gains in each cycle will measure the
amount of earnings required to be retained. Operating income will
reflect the current cost of assets used in production and so can be
distributed currently. In practice, the separation of conventionally
calculated income into operating (current cost) income and holding
gains can be complex and imprecise because replacement cycles of some
assets are long, new assets may not be the same as retired assets,
and current prices or costs of complicated assets are not always readily
Income and capital redefined: These simplified analyses now
provide a basis for defining levels or layers of income and capital
under inflationary conditions. These definitions are comprehended
by the concept of capital maintenance. They form my model of inflation-adjusted
Income: In the ongoing business, income that can be distributed
currently has the greatest significance. This has been referred to
as operating income but current cost income is a better term because
it is distinguished from stable state (historical cost) operating
income. It indicates that all current costs have been provided out
of revenues, thus providing funds to replace production assets at
current prices. Operating capability is maintained or sustained and
therefore sustainable income is an alternative term. This income is
distributable except to the small extent that additional monetary
working capital may be required to carry additional receivables and
payables. These elements are not costs, however.
Holding gains are the second category of income. They reflect
the rise in value of inventory and fixed assets for the period. Current
cost calculations are based on these adjusted values. Holding gains
can be sub-divided into realized and unrealized but these terms are
useful only to reconcile reported historical cost income. Holding
gains cannot be distributed as long as prices remain at or above the
current level because they must be reinvested in the business to sustain
operating capability. They can be paid out only at liquidation or
when operating capability is reduced.
Economic income is the sum of current cost income and holding
gains, i.e. total net income. It conforms to the economist's definition
of income as the total increase in wealth for the period; hence economic
Real income is income adjusted for the rate of general inflation
using an appropriate price index. It can be applied to each category
of nominal dollar income defined above.
Capital: The two concepts of capital are financial capital
and physical capital. In the stable state environment they are
identical; the same dollars of financial capital represent the same
amount of physical operating capability over time. Under inflation,
the same physical operating capability will require increasing amounts
of financial capital as prices rise. In simple terms the required
financial capital will be the original capital plus accumulated holding
gains, sometimes called revaluation surplus.
The essence of inflation accounting is capital maintenance. The relevant
question is which kind of capital is to be maintained. Ordinarily,
a going-concern would be expected to maintain or increase its operating
capability. Hence both financial and physical capital must be maintained
in their respective terms, linked by the effect of specific price
changes on the firm. Under inflation, financial capital normally would
increase to maintain physical capital. However financial capital might
increase although physical capital declined because prices of existing
capacity rose sharply but the capacity was not fully replaced. Crude
oil reserves of oil companies are a current illustration. Conversely,
declining prices despite inflation would release some financial capital
for distribution although physical capital remained the same, e.g,
computers. In the real world of course, these relationships are far
more complex and difficult to measure. It turns out, however, that
the only accounting difference between two concepts is the recognition
of holding gains, which are included in income for financial capital
but are called a capital maintenance adjustment for physical capital.
For information analysis of the firm, capital ought to be examined
from both viewpoints.
Real capital measures the command of financial capital over economic
resources in general, as measured by an appropriate index of general
Purchasing power gains (losses) on net monetary position:
I have not incorporated a purchasing power gain or loss on the net
monetary position in the foregoing concepts of income. I consider
this idea the great delusion of inflation accounting, although it
engenders more analysis by economists and accountants than any other
aspect of the subject. I have never understood their fascination with
this idea. It is an economic truism that debtors benefit and creditors
lose purchasing power during inflation. But accounting generally,
and inflation accounting as well, focuses on the firm and is based
on transactions or potential transactions. Transactions are conducted
in actual (nominal) dollars; purchasing power dollars have no objective
reality. Constant dollars, another term, are not dollars at all; they
are constant prices measured by an index. In other words, purchasing
power dollars, or constant dollars, are statistics which have all
the limitations of general price indexes. They are not the precise
monetary measures that accountants have assumed. In the last three
years a constant dollar based on the GNP deflator has differed significantly
from a constant dollar based on the Consumer Price Index which, in
1983, will be superseded by a new constant dollar based on a revised
Consumer Price Index. In sum, purchasing power is not an independent
entity that can be quantified in a transaction.
Furthermore, the concept of purchasing power gains on debt is erroneous.
There are no gains on debt unless debt is actually retired at a discount.
Few firms can manage to retire debt during inflation even though their
bonds are selling at a discount in the market. What actually happens
in transaction terms is not that a debtor pays off an obligation with
cheaper dollars, but that he invests borrowed money in assets that
appreciate in value due to inflation. All of the gain accrues to the
shareholder; the lender gains none of the appreciation. Changes in
asset values vary widely, except monetary assets, which are simply
assets that do not change in price. The purchasing power adjustment
on debt implicitly assumes that all non-monetary assets appreciate
at the rate of the general price index, which is fallacious. So, it
is assets that should be measured, not the debt.
The advantage of debt during inflation is merely an exaggerated case
of leverage. The gain (or loss) from leverage is recorded as a proportionately
greater increase in earnings for the common stock than in total earnings
before interest expense, or in the book value of the common equity
than in total assets. Inflation generally enhances these gains, although
the interplay between interest rates and inflation may mute the expected
This view of the purchasing power gain on debt concept may seem iconoclastic
but I think it is a realistic view of the way investors and managers
think. They have never accepted earnings derived from purchasing power
gains on debt as a meaningful indicator of financial progress. It
is often noted that under this concept the most profitable firm is
the heaviest debtor who is one step away from the bankruptcy court.
INFLATION ACCOUNTING DATA BASE
Based on the foregoing concepts, which are essentially the current
cost method, I have developed an inflation accounting data base for
the nine years 1972-1980, although 1972 data is not complete. Most
of the data is based on ASR 190 or Statement 33 reports, to which
I have added some estimates for earlier years. The effects of inflation
on a company can be determined better by historical trend analysis
than by cross-sectional analysis for one year, as is necessary when
using Statement 33 data. The data base encompasses 112 industrial
companies in 30 industry groups and 12 electric utility companies
in a regulated sector. A similar index for 10 banks is in preparation.
Except for the omission of oil companies, in the index (due to the
difficulty of calculating the current cost of reserves), the list
is fairly representative of institutional portfolios. The index was
constructed to provide analytical insights and does not purport to
be an index of the market parallel to, say, the S&P 500 index.
Due to slight differences in accounting methods between ASR 190 and
Statement 33, there are discontinuities in the data for a few companies.
Generally, however, the data are sufficiently reliable to provide
both the historical continuity and detailed ratios necessary for interpretation.
The industrial sector is shown in Exhibit A.
Although only four figures are used to adjust the historical cost
statements to a current cost basis -- inventory, cost of goods sold,
plant and equipment, and depreciation -- the financial statements
are presented in a comprehensive format. This provides a better perspective
on the scope of the adjustments in relation to the enterprise as a
whole. The key inflation accounting elements in each statement are
Cost of goods sold adjustment
Current cost income
Current cost value of inventory
Depreciated current cost value of plant and equipment
Stockholders' equity at current cost
Capital maintenance requirements for monetary working capital, inventory,
and plant and equipment
Real returns to the shareholder
Discretionary cash flow
Expenditures for volume growth -- monetary working capital, inventory,
and plant and equipment
Current cost income per share
Dividends per share
Retained current cost income per share
Economic income per share
Current cost book value per share
All data are expressed in nominal dollars. These are the dollars
in which investors and businessmen transact business. Investors live
in a world of nominal dollars. Since investment analysis is a comparative
process there is little to be gained from dividing all of these nominal
dollars by a constant divisor, i.e., some general price index. In
a second, statistical step, however, the key figures for the stockholder
are reduced to real terms, using the C.P. I. on a 1972 base. This
is a useful exercise to give some historical perspective to the ability
of business to protect stockholders from inflation.
INFLATION-ADJUSTED FINANCIAL TRENDS, 1972-1980
Complete current cost financial statements for nine years for 112
diversified industrial companies provide many figures for analysis,
far beyond the time available in this lecture. I can only summarize
a few trends which illustrate the dynamic effects of inflation over
this period. Keep in mind that this was a volatile period for the
inflation rate, as briefly illustrated by year-to-year changes in
the Consumer Price Index or the GNP Deflator, take your pick.
||% Increase, December-December
||Consumer Price Index
Composite Industrial Earnings --- Chart I
This first chart shows the trend of composite reported earnings per
share compared with current cost earnings, retained current cost earnings
per share, and the composite market price for the 112 industrial companies.
Four aspects of these earnings should be noted: the reduction in reported
earnings due to inflation adjustments; divergencies in the trends
of the two measures of earnings; relative growth rates; and dividend
Inflation adjustments reduced reported earnings an average
of 44% to arrive at current cost earnings for the high inflation periods
1974-1980. In 1972 and 1973, the adjustment was only 25% but it leaped
to 64% in 1974, when the inflation rate rose sharply and unexpectedly.
The reduction was 52% in 1980, partly because of another year of high
inflation and partly because of a relatively heavy weighting of the
auto industry's disastrous year. A rising rate of inflation in 1979
and 1980 might have been expected to cause even larger current cost
adjustments, were it not that more companies now use LIFO accounting
and that business managers today better anticipate inflation. Also,
there are discontinuities in the data for some companies due to the
shift to the less rigorous Statement 33.
Divergencies between reported earnings and current cost earnings
are important because they give a different perspective on the outlook.
They occur when there is a sharp change in the rate of inflation.
In years of high inflation reported earnings may continue to rise
while current cost earnings decline. The reverse occurs when the inflation
rate subsides. 1974 is the most notable example of the first effect;
1981 and 1982 may illustrate the second.
Growth: For this mix of companies the composite annual growth
rate in reported earnings per share was 8% between 1972 and 1980,
whereas current cost earnings rose less than 2%. Measured only to
1979, the comparative growth rates were almost 12% for reported and
9% for current cost earnings per share.
As already noted, holding gains are the other side of current cost
adjustments. Economic earnings per share grew at 9% annually during
the 1973-1980 period, (3)
but with considerable year-to-year variation due to fluctuations in
the inflation rate. Economic earnings were 68% above reported earnings
for this eight year period, representing unrealized holding gains,
and were 188% above current cost earnings, of which 120% was realized
holding gains. (In effect, current cost adjustments to reported income
are realized holding gains.)
Dividends: The crux of inflation accounting is determination
of the earnings that can be distributed without consuming capital,
as measured by maintenance of operating capability. These 112 companies
on average have enhanced capital in all but two years --1974 and 1980
-- as shown by retained current cost earnings. For the nine-year period,
the average payout ratio on current cost earnings was about 75% compared
with 44% on reported income. In effect, these companies retained sufficient
reported earnings to absorb the current cost adjustments and still
leave something for growth. There was considerable variation between
companies, of course.
Holding gains are not considered distributable except upon liquidation
of the firm. Hence they do not weigh as heavily in investment decisions,
except in special circumstances, such as property companies.
Market comparison: It is evident that the market tended to
follow the trend of current cost earnings more closely than reported
earnings in the 1973-1976 period, but since then the market has been
somewhat independent of the trend of both measures. I will explore
the market to earnings relation again but will note here that current
price-earnings ratios are sharply lower than at 1972 year-end for
both measures. At the end of 1980, the P/E on reported earnings was
10.3 times and on current cost earnings was 22.2 times. The P/E on
current cost earnings will almost always be higher than on reported
earnings, of course, but that is to be expected, not only from the
arithmetic, but from the higher "quality" of current cost
earnings, which provide for all current costs. So a P/E is a ratio
without real significance -- merely the result of a division.
Composite Capital and Return on Capital --- Charts II and
As inflation continues, holding gains accumulate and asset values
rise. It is not practical to revalue assets by market prices every
year so current (replacement) cost is used as the measure of value.
In principle, this measurement basis is comparable to historical cost,
which is appropriate in a stable price environment. They are both
accounting numbers. The value of individual assets in the market place
depends on many factors but cost measures of value can provide useful
approximations in many instances. In Chart II, reported composite
book value per share for the 112 companies is compared with current
cost value. Reported book value grew at 9% compound rate between 1972
and 1980 while current cost book value grew at 13% and exceeded reported
book by 64% at the end of 1980.
These current cost book values may seem theoretical until one reads
with increasing frequency that the merger and acquisition wave is partly
engendered by the sizable discounts from replacement value at which
many companies are selling today. Chart II shows that while the composite
market price was 133% of historical cost book at the end of 1980, it
was only 81% of current cost book. Many factors enter into acquisition
calculations but in some cases the opportunity to buy existing assets
at a discount from current cost apparently is more attractive than building
new assets at current prices.
Return on investment: One reason for the discount of market from
current cost book value lies in the low return on current cost. Chart
III shows that from 1974 onward, the return on historical cost equity
ranged between 13% and 17% and averaged 15%, whereas on current cost
equity the return has been only 4% to 7% with an average of 6%. Correspondingly,
the reinvestment rate on current cost has been around 2%, but it was
about zero in 1980. This is a measure of the real internal growth
of these companies after providing for capital maintenance.
The current cost return should give some indication of returns on
new investment because both assets and costs are stated at current
prices. Most companies set "hurdle" rates for new investment
projects at a substantially higher rate and I have not investigated
the discrepancy. Possible explanations are non-productive investments,
e.g., pollution control, greater productivity of new investments,
or overly optimistic projections for new projects. But if companies
are actually achieving these hurdle rates on new investments, the
current cost return ought to be rising.
If holding gains are considered part of the current return on investment,
analogous to a total investment return, the economic income return
on current cost soars to an average of 17% for the period. However
there is no allowance for capital gains taxes on the unrealized portion
and the timing of realization is problematical. Hence, this return
should be heavily discounted.
Real Returns to the Stockholder --- Chart IV
One ultimate purpose of inflation accounting is to determine how
the shareholder has fared relative to inflation after the company
has provided for maintenance of its operating capacity. Statement
33's constant dollar method attempts to do this by adjusting all financial
statement elements by a general price index. This concept has not
been found useful or meaningful by investors and many companies are
now reaching this same opinion. Analysts prefer to work with nominal
dollars for analytical purposes and deflate the key figures of interest
to the stockholder to so-called real terms when the analysis is completed.
Although the CPI has not been a good index of inflation in recent
years, I have used it because Statement 33 uses it. On this basis
"real" current cost income declined between 1972 and 1980,
although it was fairly well sustained for a few years after 1975.
Dividends were a little ahead of inflation until 1980. From a wealth
perspective, real current cost book value per share showed a compound
growth of 3% from 1972 to 1980, but at the same time the real market
price was declined 10% per year. These results could be improved by
using the GNP Deflator, but with either index the common stockholder
in these 112 companies has not been able to stay ahead of inflation
in recent years.
Current cost adjustments --- Chart V
The current cost adjustments to match costs with current prices and
volumes are relatively small in relation to sales, but they go right
to the bottom line where they have a substantially depressing effect
on net income. To gain a better understanding of these adjustments,
they should be analyzed in relation to sales. Chart V shows them in
relation to sales and the reported margin on sales.
The largest impact occurred in 1974 when high inflation was largely
unanticipated and most companies were still on FIFO accounting. The
cost of goods sold adjustment was 2.06% of sales and the total current
cost adjustment was 3.15%. In 1974, more companies moved into LIFO
so that the effect of rising prices on inventory was partially absorbed
in reported income thereafter. (4)
But the depreciation adjustment rose to around 1.45% of sales from
1975 onward due to the cumulative impact of inflation on long-lived
assets. Consequently, total current cost adjustments have run a little
over 2% of sales since 1975. Although the inflation rate hit its peak
in 1979, the ratio of both current cost income and reported income
to sales did not change much from the previous several years. Apparently
managements were better able to anticipate inflation and pass cost
increases through in price increases. In 1980, however, current cost
adjustments rose to 2.27% of sales, which was 57% of reported income,
due primarily to the sharp profit margin decline in the automobile
In summary, current cost adjustments have run at a fairly steady
ratio to sales but they have a big leverage effect on net income.
The cost of goods sold adjustment is more variable year-to-year because
changing prices are quickly reflected in inventory. The depreciation
adjustment resembles a long term fixed cost. These characteristics
vary somewhat from company to company, depending on accounting methods,
and from industry to industry, depending on economic factors.
Results in industry groups --- Chart VI
This composite data obscures a considerable diversity in the impact
of inflation on industries. I have divided the 112 company composite
into a number of industry groups based on their economic characteristics,
of which four are shown in Chart VI. The durable goods manufacturing
group consists of 38 companies in such industries as automobiles and
parts, electrical appliances and equipment, machinery, diversified
manufacturing, rubber, and steel. The consumer marketing group covers
14 companies in the beverage, food and toiletries-cosmetics industries.
There are 17 technology companies including electronics, office equipment-computers,
and specialty companies. The nine retail companies include both food
claims and general merchandising. More groups and industries were
developed but these four are sufficient.
The durable group suffered the greatest inflation impact with an
average current cost adjustment to reported earnings per share of
60% over the 1973-1980 period. There were two deficits in current
cost income out of eight years. The average return on current cost
equity was 6.6%.
In contrast, the technology group's current cost adjustments were
only 12% of reported income per share for 1973-1980 and its average
return on current cost equity was a favorable 12.5%.
The inflation rate in the two groups and the rate of sales growth
explain the differences. Prices in the technology group generally
rose more slowly than the rate of inflation and some components actually
declined in price. In the durable goods industries, heavy equipment
and new plant costs rose faster than inflation and most other costs
advanced at least as fast as general inflation. Strangely, the ratio
of fixed assets at current cost to sales is about the same in the
two industry groups but depreciation expense is a higher percentage
of sales in the technology field, reflecting a faster depreciation
rate on gross plant. However, because of more favorable current cost
experience on fixed assets, plus the shorter life and relative newness
of plant, the current cost adjustment is a smaller percentage of sales
than for durables.
Although 80% of the durable goods companies are predominantly on
LIFO, whereas only 17% of the technology companies used LIFO, the
cost of goods adjustment was a higher percentage of sales for the
durable goods. The steady to declining prices of many technological
products, e.g., semi-conductors, made it unnecessary for the technology
group to provide much for higher replacement costs for inventory.
Sales growth in the technology group was faster and steadier than
for durables, permitting easier absorption of rising costs and maintenance
of margins. As noted, the depreciation adjustment is a kind of fixed
charge; hence when sales growth slowed in the durable goods group
in 1980, the depreciation adjustment had a leverage effect on current
cost net income.
There is not sufficient time to explore all of the variations in
the impact of inflation on companies and industry groups. The accounting
impact is a product of the interaction between the accounting methods
used for financial reporting, the structure of the industry and the
specific price experience. Each company or group requires individual
analysis. For example, both the consumer marketing and retail groups
showed average current cost adjustments of about 45% for 1973-1980.
Yet all of the retail companies were on LIFO by 1980 whereas only
14% of the consumer companies used LIFO. Clearly other factors were
at work to produce about the same end results for these two industry
Cash flow and inflation accounting --- Exhibit B
It is often said that business is "overstating" earnings
by continuing to use historical cost accounting. Yet, cash flow is
the same under current cost and historical cost accounting. Exhibit
B on the following page is a Funds Statement (Statement of changes
in Financial Position) rearranged on a current cost basis to show
how the capital maintenance concept impacts cash flow under inflation.
It extracts four selected years from the comprehensive statement on
page 5 of Exhibit A. In my opinion, it explains inflation accounting
better than the adjusted earnings statement.
The table begins with gross cash flow, which is calculated the same
way under any accounting method. Inflation accounting assumes that
the first demand on that cash flow is capital maintenance. Additional
monetary working capital (receivables less payables and accruals)
is needed for the higher dollar value of the existing sales level
but for these companies payables exceeded receivables so there was
a net gain in funds. For inventory, companies on FIFO accounting must
provide for the additional cost of replacing inventories at higher
prices whereas 100% LIFO companies have made this provision in the
Plant and equipment must also be replaced at a higher cost than the
historical cost of retired plant. The annual cash requirement is measured
by current cost depreciation, which may be regarded as a theoretical
figure but it is the only measure available. In 1980 it was more than
double 1974. Few companies divide capital expenditures between replacement
and new capacity but one company that now does so has told me that
its actual replacement expenditures have exceeded current cost depreciation
in 1979 and 1980.
Funds for discretionary expenditures -- dividends and growth -- are
available only after providing for capital maintenance. In these selected
years discretionary funds amounted to only 32% to 45% of gross cash
flow. Besides dividends, these discretionary expenditures support
growth in real volume with additional monetary working capital, inventory,
and fixed assets. Stated another way, changes in working capital and
inventory have been divided between price and volume.
When total capital expenditures are split between replacement and
growth, it is apparent that real growth in capacity has been well
below the impression given by the gross figure. In 1980, only 36%
of total capital expenditures was allocated for growth and for some
companies it was negative. Of course, the actual classification of
replacement and growth expenditures is more complex than portrayed
The net cash flow to be financed is the same under either accounting
method. Thus, inflation accounting merely rearranges the priority
of cash expenditures. It does not reduce cash flow or increase the
amount of financing as compared with historical cost cash flow.
Taking a cue from these relationships, British inflation accounting
(SSAP-16) introduces a gearing adjustment to current cost earnings.
The theory is that part of the increased replacement cost of fixed
assets can be financed with debt, thereby relieving the common stockholder
of part of the inflation burden. The amount is determined by the ratio
of debt to total capital -- the "gearing ratio" -- and has
the effect of raising current cost earnings. It is a dubious concept
to incorporate borrowing as an element of earnings but from a cash
flow viewpoint this argument has some practical validity. Although
cash is fungible, it is apparent from Exhibits A and B that debt financing
is an important funds element which enables these companies to finance
both capital maintenance and growth expenditures and still pay dividends.
They have been able to do this with very little change in the ratio
of debt to total capital over the entire period -30% low (1976-1978)
to 33% high (1974) on a historical cost basis and 21% low (1978) to
26% high (1973) on a current cost basis.
CAPITAL MAINTENANCE CASH FLOW TABLE INDUSTRIAL INFLATION
ACCOUNTING DATA FOR 112 COMPANIES Selected Years, 1974-1980 (in billions
|Gross Cash Flow
|Reported Net Income
|Depreciation at Historical Cost
|Gross Cash Flow
|Capital Maintenance due to Inflation
|Monetary Working Capital
|COGS Current Cost Increment
|Fixed Asset Replacement Requirements(a)
|Total Capital Maintenance Requirements
|Discretionary Cash Flow
|% of Gross Cash Flow
|Additional Monetary Working Capital
|Additional Inventory due to Volume
|Capital Expenditures above Replacement
|Total Discretionary Expenditures
|Net Cash Flow before Financing
|Net Change in Cash and Other Items
|(a)Current Cost Depreciation
|Extract from Exhibit A.
Electric Utility Inflation-Adjusted Results --- Chart VII
The electric utility industry presents dramatically different inflation-adjusted
results since 1972 than does the industrial sector. Chart VII on the
next page is based on an index of 12 geographically diversified utility
companies developed on the same current cost model used for the industrials.
This is sufficiently broad for analytical purposes because the effects
of inflation are fairly homogeneous throughout the industry
Generally only depreciation and plant and equipment are adjusted
to current cost. Sometimes a small adjustment may be made for fuel,
analogous to cost of goods sold. Utilities are very capital intensive
and depreciation is a large cost factor, even though the depreciation
rate is low relative to industrial properties. Consequently, the cumulative
impact of rising construction costs on plant investment has become
substantial. The current cost of fixed assets of the index was 90%
over historical cost at the end of 1980. The Handy-Whitman Index of
public utility construction costs rose 121% from 1972 to 1980, compared
with 103% for the CPI.
It is obvious from Chart VII that utilities have failed badly to
keep their stockholders even with inflation. "Real" reported
earnings, dividends, and market price have declined steadily since
1972. Our inquiry here concerns the significance of generally non-existent
current cost earnings and the theoretical reduction in current operating
capability implied by the continuous deficit in retained current cost
earnings. Enormous holdings gains which produce high economic income
provide a theoretical but unrealizable future offset. In an industrial
company such a combination would imply reorganization, retrenchment
Electric utility companies are highly regulated on a cost-of-service
basis. Regulation is the key to earnings. The allowed rate of return
is based on the historical cost of assets, and is geared to covering
operating costs, depreciation and interest expense plus a return on
the common equity. When new plant comes on line, the depreciation
charge and the cost of capital becomes a cost to be covered, possibly
by higher rates. In essence, regulation takes a project view of a
utility company. Employing the accounting framework for a project,
we can say that each plant unit is an individual project allowed to
earn enough to recapture its cost and earn a return thereon. If, at
the end of its useful life, this capital is insufficient to build
a new plant because of inflation, regulation will allow higher rates
to finance the additional capital required. Thus, regulation assures
that adequate generating capacity will be available to serve the public
which, meanwhile, does not pay rates commensurate with rising current
value of the generating plant.
Conversely, the stockholder's capital in real terms is steadily consumed
during the life of the plant. At the end of the generating station's
life cycle, his equity capital is recouped in nominal financial terms
but not in real terms. The substantial holding gain in the current
cost of plant is not available to the stockholder because the facility
cannot be moved or sold and the present value of its future cash flow
must be calculated on historical cost.
Statement 33 provides for a purchasing power gain on net monetary
position and here the utilities shine because they have large debts
and very few monetary assets. In all inflation accounting models using
a purchasing power adjustment, utility companies show the most favorable
results. This is fallacious because regulated utilities do not benefit
from inflation, either in earnings' growth or asset appreciation.
The burden of debt remains unchanged from the start. It is the ratepayer
who gains a purchasing power benefit from these fixed costs in the
rate base. In my opinion, therefore, the Statement 33 reports of utility
companies are contradictory because on the one hand they reduce the
holding gain to "net recoverable cost" (i.e., historical
cost), but yet claim a purchasing power gain on debt.
Inflation-adjusted financial statements do not provide any useful
insight to the operation of the regulated utility business in an inflationary
environment. But they do indicate that the stockholder is severely
penalized, far more than in unregulated industries. This data ought
to have probative value in requests for higher rates but it is seldom
advanced. The fair value approach to rate making is rarely employed
today. Hence the value of current cost accounting for utilities is
moot although the stockholder ought to be made aware that his real
capital is being consumed by this industry.
Banking Inflation-Adjusted Results -- Chart VIII
The banking business is affected by inflation but the financial statements
do not require significant adjustment. Indeed, banks are the conduit
for inflation; the expanded money supply moves from the Federal Reserve
to the public through banks, expanding bank assets and liabilities
in the process. Substantially all assets and liabilities are monetary;
hence they do not change in price as do non-monetary assets. A bank's
only non-monetary asset is normally its banking premises, which is
commercial real estate. It is a very minor percentage of total assets,
although it may be a significant, e.g., 50%, proportion of stockholder's
equity. Bank premises will give rise to a current cost adjustment
which is only 5 % to 10% of reported income in most cases. This is
not significant for analysis.
Banks are thought to be disadvantaged during inflation because they
experience a purchasing power loss on their net monetary assets -
which are largely equivalent to stockholders' equity. Statement 33
requires such an adjustment. However, Chart VII demonstrates that
banks do relatively well during the inflation. This chart shows only
one bank -- Security Pacific Corporation of Los Angeles -- because
my bank inflation index is not completed. Like utilities, however,
banks are very homogeneous with respect to inflation.
Security Pacific's reported and current cost earnings are close to
and parallel with growth rates of over 13% for the 1972-1980 period,
well ahead of industrials. Current cost book value grew somewhat faster
than reported book but the lines are essentially parallel. However,
there is one adjustment that should be added for banks -- unrealized
gains or losses in the bond portfolio account. The present accounting
convention reflects only realized security profits (losses), which
are typically nominal. Unrealized gains are shown only in the financial
statement notes but to fully measure the impact of inflation they
should be recognized. Inflation generally causes interest rates to
rise, not necessarily by the inflation rate as is popularly supposed,
and thereby causes a decline in bond prices. In 1979 and 1980, the
unrealized losses (after tax effect) in Security Pacific's bond account
amounted to $2.16 per share in 1980 and $0.48 per share in 1979. If
the maturity structure is relatively short, the losses will be recovered
without difficulty but some banks have suffered a permanent impairment
of capital due to bond losses.
Typical of most banks, Security Pacific's dividends have grown more
slowly than earnings as the payout ratio dropped. This is another
effect of inflation, although no adjustment to the accounts is required.
The inflation induced expansion in bank assets and liabilities, which
requires more supporting capital. Banks have had to retain more earnings
to build their capital accounts but nonetheless capital ratios for
many banks have declined somewhat, although not for Security Pacific.
This need to build capital is to support asset growth and differs
conceptually from an industrial's need to build capital to sustain
operating capability at the prevailing level.
In real terms, bank results are generally more favorable than industrials.
For Security Pacific, its real reported and current cost earnings
per share both rose about 4% annually but dividends were flat. Stated
and current cost book value were about even with inflation. The real
market price declined only 6% annually compared with 10% for industrials.
While in theory banks may lose purchasing power on their net monetary
assets during inflation, their asset expansion and higher interest
returns, also due to inflation, more than offset this loss.
I have shown this bank example to emphasize the importance of first
developing a comprehensive analysis in nominal terms and then comparing
the final consolidated result over time with some index of inflation.
A single point analysis is inadequate and the purchasing power loss
by itself is misleading.
Recapitulation: Inflation-Adjusted Financial Trends, 1972-1980
This long, and perhaps exhausting, review of inflation-adjusted financial
trends has only touched the surface of the analytical possibilities.
Nonetheless we can draw some general conclusions about the effects
of inflation on the financial results of the corporation and the real
returns to the stockholder. The central concept is that capital and
operating capability should be maintained in current cost terms before
current earnings that can be distributed to stockholders are recorded.
The key points:
- The current cost adjustments to historical cost financial statements
are small in relation to sales for the average industrial company
but they cause a substantial reduction in net income. In recent
years, the reduction has averaged over 40%, with year-to-year
variation due to changes in the rate of inflation and business
- The greatest reduction occurred in 1974, a year of high and
unexpected inflation. Wider adoption of LIFO accounting and anticipation
of inflation have mitigated the impact somewhat in recent years.
- The cost of goods sold adjustment is smaller but more variable
than the depreciation adjustment which, in effect, becomes an
additional fixed charge on earnings. Hence, current cost earnings
are more volatile than historical cost earnings.
- There is a considerable range of results between industries
and companies arising from their varied price experience, economic
characteristics, growth, and profitability. Technological industries
are in the most favorable position.
- Current cost accounting separates current operating income
from holding gains. Holding gains expand under inflation but their
realization must await sale or liquidation of the business. Hence
they must be essentially discounted in the market price.
- Current cost accounting does not change cash flow but it reallocates
it between capital maintenance and discretionary expenditures.
In this inflationary era, the composite industrial company has
been able to finance capital maintenance out of earnings, pay
increasing dividends, and finance investments for growth without,
through 1980, expanding debt leverage in the balance sheet.
- Current cost accounting does not provide useful information
for regulated utilities although it does show that the stockholder
suffers a substantial erosion of real capital.
- Current cost accounting is not significant for banks (and other
financial institutions); historical cost statements provide relevant
information for inflation analysis because substantially all assets
and liabilities are monetary.
- In real results, the composite industrial company has not been
quite able to maintain current cost earnings and dividends even
with inflation over the past eight years. A typical bank has done
a little better than inflation in these respects but the utility
stockholder has fallen far behind. Industrials have recorded the
best real gain in asset value per share.
INVESTMENT A PPLICATIONS AND INTERPRETATIONS
The crucial issue about this inflation accounting information is
what investors can do with it. If the kind of analysis I have just
made has no utility for investment decisions it will get little attention
from analysts no matter how many theoretical studies develop from
the data that accumulates.
So far most analysts have not done this kind of inflation analysis,
partly because the data has not been readily available. ASR data was
hidden in the Form 10-K reports and Statement 33 reports are confusing,
incomplete, and have no historical record. Further, there is a learning
curve which has yet to be tackled.
I do not mean to imply that analysts are lazy; they concentrate
on the most dynamic factors in projecting future earnings. There are
many other important elements besides inflation in a company's performance:
products, competition, market share, sales, costs, productivity, management,
and others. The analyst now assesses these within a familiar system
of accounting measurement and he is reluctant to convert to a new
system until its merits are proven.
An important test of the merits of any new accounting or financial
reporting requirement seems to be whether it can cause a reaction
in the stock market. Under the efficient market hypothesis, the only
information that is important is that which is impounded into the
market price. I don't have that much faith in the market's immediate
discernment of information nor in the statistician's ability to sort
out specific connections between information and price changes. So
I don't regard a market connection as a proper basis for determining
the utility of current cost information. Nevertheless, possible relationships
should be studied.
A number of studies have been unable to find much connection between
replacement cost data and prices. However, in our early work at Duff
and Phelps, we ran a series of correlation studies that indicated
a closer relationship between annual changes, in current cost earnings
and total return on the stock than with changes in historical earnings
for considerable number of companies. (5)
With the passage of time many of these correlations have now faded
out and no defined pattern prevails any longer. The 1973-1975 period
of parallel current cost earnings and price movement apparently caused
the earlier high correlations but that sequence has not been repeated.
Utility for investment
I see four uses of current cost data for investment analysis:
- It can assist research by providing more systematic data for
comparative analysis of company earnings power under current price
conditions -- inflationary or stable. It eliminates the significant
non-comparability between companies arising from differences in
inventory and depreciation accounting.
- It can provide useful insights to the relative effects of price
changes on revenues, costs, and financing requirements across
industries and companies.
- It can provide screens to classify stocks as hedges against
- It can provide an improved basis for estimating long-term dividend-paying
capacity and internal growth, as compared with the historical
Current Investment Applications
I am now beginning a survey of present practice in the use of this
data but a few applications over the past two years can be mentioned.
- A bank trust department has constructed a dividend valuation
model using a normalized payout of projected current cost earnings
based on a normalized rate of return on current cost book value.
The model did improve investment performance.
In the long run, current cost income should be a better indicator
of dividend capacity than reported earnings under inflationary
conditions. But in the short run, current cost earnings do not
appear to predict dividends as well as reported earnings because
they are more variable while dividend polices are generally fairly
stable. However, cash flow is the best predictor. For the 112
companies, dividends are an almost unvarying 24%-25% of gross
- An investment advisory firm has based issue selection on the
highest rates of return on equity, calculated by current cost
earnings return on current cost stockholders' equity.
- An investment banking firm evaluates the credit quality of
bonds using current cost financial statements. This may be theoretically
correct but it does not provide much incremental value for credit
analysis. Cash flow is crucial for credit analysis and inflation
accounting does not change cash flow.
Common stocks as a hedge against inflation
Are common stocks a good hedge against inflation? This is the central
question that inflation accounting should help to answer. Our concern
here is limited to stock behavior during the inflation period and
not over a longer period encompassing both price stability and inflation.
As investors, our objective must be to find companies that maintain
both the price of the stock and our required total return in real
terms while the company maintains its operating capability as measured
by current cost accounting.
To maintain operating capability in times of inflation and pass the
positive fruits of inflation through to the investor, companies must
maintain their profit margins on the basis of current cost accounting.
This means that in historical cost terms, profit margins must rise
in order to absorb increased replacement costs for inventory and fixed
Maintaining operating capability is not sufficient however. Companies
must increase current cost earnings and dividends enough to not only
maintain the shareholder's real return but also to offset the corollary
rise in the discount rate. Altogether this is a formidable task.
Issue selection based on the foregoing objectives will seek companies
that offset added costs by increasing selling prices or reducing other
costs. Companies which have pricing flexibility due to proprietary
products, market leadership, or supply shortages are in the most favorable
position. Strong growth in demand is often important. However, companies
whose products have some political sensitivity, for example steel
prices, in the past, have found it hard to advance selling prices
sufficiently. Also cost increases can be partially offset through
increased productivity, faster turnover, and the like.
Analysis of these factors, coupled with current cost measurements,
will enable the investor to appraise a company's "pass-through"
capability. Subject to further study, I believe that current cost
measurements will tend to reorder the relative attractiveness of some
stocks near the top or bottom of the list but the broad middle group
will not change much. Tentatively, some of the industry groups which
are relatively least affected by the current cost accounting adjustments
to earnings and thereby may offer the best chance of staying ahead
of inflation, other things being equal, are:
|Drugs ---health care
||Office equipment and computers
||Toiletries and cosmetics
Conversely the most severely affected and hence least attractive
BUSINESS APPLICATIONS FOR CONTROL AND PLANNING
Although investors have not yet made much use of inflation-adjusted
financial data, business management has been showing increasing interest
in it recently. Both the Conference Board and the Financial Executives
Institute have sponsored meetings on the subject. Up to now, however,
the list of companies actually making inflation adjustments to internal
accounting data is short. General Electric's adoption is widely known.
American Standard and Federal-Mogul have installed similar systems
in the last five years. TRW began one this year and Union Carbide
has been developing one. Other companies may make partial inflation
adjustments or reset objectives to overcome inflation.
All of these internal systems are based on the capital maintenance
concept and use the current cost accounting method. In brief, division
capital assets are shown at current cost and income is usually calculated
using current cost depreciation, although there are variations. Standard
costs are used for inventories and these may be raised during the
year if price changes are substantial. In any event, the division
is not given credit for price variances during the year. LIFO accounting
is usually done at the corporate level.
These inflation-adjusted systems are regarded as more rigorous measures
of division performance. Older divisions enjoying lower historical
cost depreciation are put on the same basis as newer divisions --
both are required to show a return on the current value of the assets
in their custody. Formerly, a return on sales was usually the measure
of division performance. This approach can stimulate division managers
to adopt more aggressive pricing policies, improve turnover of receivables
and inventory, and get rid of assets and product lines. All of these
measures can be adopted without adjusting for inflation, of course,
but current cost accounting apparently provides a sharper focus when
This kind of accounting is also pertinent to strategic planning.
There appears to be an accelerating trend toward redeployment of assets
in many large companies based on return on capital investment objectives.
Low return divisions are being sold or liquidated. Current cost accounting
provides a more rigorous test. Of course other measures are also used.
The companies that have adopted internal current cost accounting seem
to have had success with it because they have demonstrated improved
financial results in the past several years. This is another indication
that it is worthy of investor's attention.
THE FUTURE DIRECTION OF INFLATION ACCOUNTING
Inflation accounting sometimes has overtones of a crusade and I want
to conclude this lecture by trying to place it in a more realistic
A better measurement system
Continued inflation is rendering historical cost accounting obsolete.
The general price level has doubled in the past eight years and at
the current pace will double again in the next eight. Current cost
accounting is conceptually a better measurement system under these
conditions but there are practical difficulties in costing some types
of assets. The replacement cost method of pricing is well understood
and accepted for inventories because the turnover time is short and
new purchases quickly provide new prices. Fixed assets, which are
often unique or special purpose structures with long lives, are more
difficult to price each year. Technological change may introduce other
problems. Nevertheless, as businessmen and accountants continue to
develop current cost data, accuracy will improve.
Inflation accounting can aid economic decisions by providing better
measurement and eliminating some of the euphoria that is generated
by inflation inspired historical cost results. But it is not going
to change the basic thrust of most of these decisions because the
fundamental content of accounting statements will tend to be the same
under either method. Sales are the same, and most costs and expenses
are the same and cash flow is the same, Current cost accounting separates
operating income and holding gains and this becomes more important
to capital maintenance as the rate of inflation rises.
Factors in user adoption
Investors and analysts have been slow to adopt inflation adjusted
financial statements because the additional information they provide
is viewed as marginal compared with all other factors that affect
company earnings and financial position -- management, markets, new
products, competition, labor costs, etc. Adopting new financial measures
is analogous to learning to convert from gallons to liters at the
gas pump: we continue to translate liters back to gallons until eventually
we get used to metric measures. Likewise, the advantages and insights
provided by current cost accounting will become better understood,
more data will become available, and communication about financial
statements will gradually shift from the old to the new system.
Inflation accounting will have to deliver different messages than
historical cost accounting from time to time and these messages will
have to prove meaningful. If the trend of current cost earnings merely
parallels historical cost earnings at a lower level, they will not
add much information. That was the composite pattern between 1976
and 1979. The 1973-1975, or possibly the 1980, divergencies provide
opportunities for current cost earnings to prove their value.
The future course of inflation will determine the pace of adoption.
If the Administration's current monetary policy persists for another
two years or so, we should see a much lower rate of inflation and
the impetus for a change in accounting will lapse. But if the current
rate of inflation continues, interest in current cost accounting should
FASB Statement 33
The FASB recently published some summary data from its new data base
at Columbia University which provide cross-sectional analyses of some
1100 companies for 1980. (6)
Of "blockbuster" proportions, these inflation adjustments
reduced aggregate earnings from continuing operations by 66% on a
current cost basis and by 53% on a constant dollar basis. The current
cost impact was greater than for my 112 company index but, in general,
the same patterns appear that I have discussed in this lecture.
The FASB is now promoting major research on inflation accounting
using this new data base. This will no doubt stimulate interest among
academicians but most of the ideas, principles and facts about inflation
accounting are already well known. This is an appropriate place to
express my views on Statement 33. Although it provides the four numbers
I need for my model, I consider it a poor standard. Born out of a
compromise on the Board, it requires two different inflation accounting
methods but produces only limited information from each. The result
is confusing and I am sure it is a cause of user disinterest. I also
believe the treatment of holding gains is hard to understand and the
purchasing power adjustment erroneous.
I see no application of constant dollar accounting to investment
analysis. The principal advantage of this type of inflation accounting
is to puncture the "money illusion." This may be desirable
for discussions of public policy but it has only secondary value to
the investor in making investment decisions. As I have shown, this
objective can be accomplished very easily by deflating the principal
earnings and wealth results produced by the current cost method. Statement
33 does this in its five year summary.
To gain user interest, I believe it is important for the FASB to
improve Statement 33 disclosures by: (1) eliminating the constant
dollar method in order to simplify the presentation; (2) reducing
the measurement latitude now existing in the standard by requiring
straight line depreciation and inclusion of operating assets not in
the books; (3) moving to a comprehensive set of adjusted financial
statements; (4) prescribing a standard statement format, and (5) requiring
nominal dollar as well as real dollar current cost historical data.
Hopefully, some of these steps can be taken before the full five year
experimental period runs its course so that investors and analysts
will begin to make use of this information. If Statement 33 fails,
we will need South American rates of inflation to ever revive interest
in inflation accounting.
Some companies fare better than others under inflationary conditions.
The task of the analyst is to sort them out. Even after sufficient
consistent data is accumulated over the next several years, inflation
accounting alone will not be decisive in investment policy. All of
the other factors an analyst normally evaluates in appraising a company
will still need to be evaluated. But the analytical framework I have
outlined here and the data already available suggest that the analyst
should begin now to factor inflation accounting into his valuation
analysis, even if the inflation rate continues to decline. Current
cost accounting is simply more realistic.
(1) Financial Accounting
Standards Board, Statement of Financial Accounting Concepts No.
I (Stamford, Connecticut, November, 1978)
(2) Accountants and
economists have elaborated on and dissected the Hicksian income
definition endlessly. I am content to use it as a starting point
and avoid pointless debate. I was advised by an Australian accounting
professor that in a lecture in Australia, Hicks inferred that he
wished he hadn't made the statement in the first place.
(3) Economic income
could not be calculated for 1972 because 1971 balance sheets were
not developed. A prior year balance sheet is needed to calculate
unrealized holding gains.
(4) In 1973, only
24 out of 112 companies were on LIFO, but by 1975 the number had
increased to 58. In 1980, 63 companies were on LIFO for more than
half of their inventory. Most foreign inventories are still carried
on FIFO. In 1980, 26 companies used some form of accelerated depreciation
in financial reporting for a major proportion of fixed assets.
(5) See Easman, Falkenstein,
Guy and Weil, "The Correlation Between Sustainable Income and
Stock Returns," Financial Analysts Journal, September-October
1979, for earlier calculations that demonstrated this same relationship.
(6) Anthony Phillips
and Beverly Welch, "The Real News Behind Those Cheerful Headlines,
"Financial Accounting Standards Board, Highlights of Financial
Reporting Issues, October 14, 1981.
The data bank was developed by the FASB and the Columbia Business
School Accounting Research Center to facilitate research on inflation
accounting. It is being marketed by Value Line (Arnold Bernhard
& Co., 711 Third Avenue, New York, N.Y. 10017).
INFLATION ACCOUNTING INDEX
1973-1980 Developed by William C.
- This index is comprised of 112 industrial companies in 30 industry
categories. There are no oil companies due to the difficulty of
developing current cost data on reserves.
- Current cost adjustments for 1980 are based on FAS 33 data;
for 1979 on eitherFAS33 or ASR 190, whichever was reported; for
1976-1978 on ASR 190; and for earlier years on estimates by the
author. The adjustment methods employed by the reporting companies
are not entirely comparable through these years, with significant
discontinuities between ASR 190 and FAS 33 depreciation for several
companies. In all cases but one the shift is toward lower depreciation
in 1980. Nevertheless the trends are reasonably indicative on
an aggregate basis.
- Partial data was developed for 1972 but is not published here.
December 17, 1981
NORBY INFLATION ACCOUNTING DATA
(Millions of Dollars)
|Cost of Goods Sold-Reported
|Current Cost of Goods Sold
|Current Cost Increment to COGS
|Depreciation, Depletion, Amort.-Reported
|Current Cost Depreciation
|Current Cost Increment to Depreciation
|Balance for fixed charges- Reported
|Balance for fixed charges-Current Cost
|Total Interest Expense
4552.1 5070.6 4963.4
|Less: Total Current Cost Increment
|Current Cost Pretax income
|Current income tax
|Deferred income tax
|Total income tax
|Net income before Extra items-Reported
|Current Cost Income before Extraordinary
|Reported Net Income for Common before Extra
|"LIFO" Earnings (COGS Adjustment Only)
|Current Cost Net Income for Common
|Reported Net Income for Common after Extra
|Dividends on Common
|Retained Net Inc.-Reported (before extra)
|Current Cost Retained Net Inc (before extra)
|Holding gain-plant and equipment
COMMON SHARE DATA
SHARE WEIGHTED INDEX
|Stock Price Index-Fiscal Year End
|Reported Income per Share
|"LIFO" Earnings per Share (COGS Adjustment)
|Current Cost Income per Share
|Economic Income per Share
|Dividends per Share
|Retained C.C. Income per Share
|P/E Reported Income (before Extra)
|P/E "LIFO" Income
|P/E Current Cost Income (before Extra)
|P/E Economic Income (before Extra)
% OF SALES
|Cost of Goods Sold Adjustment
|Depreciation Adjustment 0.81
|Total Current Cost Adjustment
|Reported Net Income
|"LIFO" Net Income
|Current Cost Net Income
|Depreciation Rate on Gross Plant
|COGS Adjustment % Reported Income
|Depreciation Adjustment % Reported Income
|Current Cost Adjustments % Reported Inc
|Current tax rate-Reported
|Deferred tax rate-Reported
|Total Tax Rate-Reported
|Current tax rate-Current Cost
|Deferred tax rate-Current Cost
|Total Tax Rate-Current Cost
|Dividends % Reported Net Income
|Dividends % Current Cost Net Income
|Dividends % Cash Flow
GAP IN PAGES (48-55).