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Unformatted text preview: Chapter 7 Financial Reporting and Changing Prices Discussion Questions Solutions 1. Historical-based financial statements may be misleading during periods of significant inflation. Many resources may have been acquired in periods when the purchasing power of the monetary unit was much higher. These expenses then typically are deducted from revenues that reflect current purchasing power. The resulting income number is unintelligible. Another problem for statement readers is that the value of assets recorded at their historical acquisition cost is typically understated as a result of inflation. Understated asset values produce understated expenses and overstated earnings. Financial trends are also difficult to interpret, as trend statistics generally include monetary units of different purchasing power. A positive trend in sales may be due to price changes, not real increases in sales. 2. A price index is a cost ratio, that is, the ratio of a representative “basket” of goods and services consumed by an average family, compared to the price of that same basket in a benchmark (“base”) year. The price index is invaluable in enabling a statement reader to translate sums of money paid in the past to their current purchasing power equivalents. 3. This statement is partly true and shows the confusion that surrounds inflation accounting. In accounting for changing prices, users must distinguish between general price changes and specific price changes. General prices refer to the prices of all goods and services in the economy. The object of accounting for general price level changes is to preserve the general purchasing power of a company’s money capital. Specific price changes refer to changes in the prices of specific commodities. The object of accounting for specific price changes is to preserve a company’s productive capacity or operating capability. 4. The congressman is wrong. The object of inflation accounting is to clarify the distinction between capital and income, not to minimize corporate taxes. Inflation accounting shows how much money the company can pay in expenses, taxes, and dividends, while keeping enough resources to maintain its capital. 5. Although it is generally conceded in principle that price level-adjusted financial statements are more useful than conventional accounting statements during periods of significant inflation, it is a judgment call to identify exactly when price level-adjusted statements become more meaningful. As a rule of thumb, executives in Brazil use an inflation rate greater than 10 % per month. Investors in Germany or Switzerland may believe that 5 % inflation per year is alarming. Unfortunately, no one has yet developed a formal, rigorous, easy-to-apply definition of meaningfulness....
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This note was uploaded on 04/07/2009 for the course ACT - taught by Professor Burks during the Spring '09 term at Troy.
- Spring '09