UNDERSTANDING
INFLATION'S IMPACT
By Allen
H.Seed111
Double-digit inflation
has been a fact of life for the past several years. What may not be
under-stood, however, is that this inflationary trend is almost 100
years old—interrupted only by the Great Depression of 1929-1939.
Exhibit 1, a chart prepared by General Electric and used in its
management education programs, dramatizes the persistence of
inflation. The horizontal axis shows the years from 1855 to 1990; the
vertical axis shows the consumer price index on a log scale.
Inflation heated up in 1914-1918 as a result of World War I, dropped
off when the war ended, but steamed up again following the Depression
and has not let up since.Therefore, if significant, persistent
inflation is a fact of life, the key questions are:
• What do we do about
it?
• How do we manage our
business differently?
• What are others doing
to cope with this problem?
The
Problem: Accounting for Inflation
As one of
the early accounting thought leaders, Livingston Middle ditch, put it
in 1918, "Accounting with historical costs as its basis has the
effect of mixing dollars of different value . .it is like mixing
inches and centimeters or measuring a field with a rubber tape line."
Another ac-counting giant, Professor William Paton, said in 1918, "It
is not the cost of the building or power unit or machine which is
significant to the man-ager interested in a wise utilization of
available Sixty one years
later, in 1979, the Financial Ac-counting Standards Board (FASB)
issued its much-debated statement (No. 33) that reflects the two
notions expressed by Professors Middle ditch and Paton. FASB
Statement No. 33 requires: A supplementary
statement in the annual report of selected data on the constant
dollar and cur-rent cost basis for current year;
• A
five-year comparison of selected data adjusted for the effects of
changing prices; and
•An
explanation of data to help users
Two
Solutions:
Constant
Dollar
Constant
dollar accounting is based on the concept of converting all dollars
to units of constant purchasing power. Elements of the balance sheet
and income statement are adjusted by an inflation index, so that a
dollar shown in 1981 will be roughly comparable to a dollar shown in
1976. Because purchasing power, and not specific values, is relevant
in constant dollar accounting, general inflation indices, such as the
consumer price index, are used to caluclate constant dollar amounts.
Current
Cost :Current cost accounting, on the other
hand, is based on the concept of updating balance sheet items to
their estimated current value (current replacement cost of assets or
net recoverable amount) and adjusting the income statement to reflect
these changes in value caused by inflation and other changes in price
levels. Whereas the constant dollar concept is centered on what the
dollar will buy, the current cost concept is focused on what a
specific element is worth in nominal dollars. Constant dollar and
current cost figures are derived from underlying adjustments to
historical costs.
Net monetary
assets and liabilities are assets and liabilities with fixed monetary
values. They include cash, marketable securities, and accounts
receivable, less amounts owed. Purchasing power gains on net monetary
items occur because a company is able to repay amounts owed with
cheaper dollars. Pur-chasing power losses occur for holding net
monetary assets that decline in value.
Five
Factors to Watch:Type of business. The type
of business determines the proportion of assets to revenues employed
in cash, receivables, inventories, and fixed assets inventory
valuation methods and turnover rate.
The
selection of the last in, first out (LIFO) or first in, first out
(FIFO) valuation methods can be important in some companies. The use
of LIFO decreases the impact of inflation on the income statement,
but it increases its impact on the balance sheet.
Age of
business and assets.Business age is likely to
have an important bearing on the age of the assets employed and the
need for the reinvest-ment of funds. The earnings of new businesses
and growth businesses in their early years are often only moderately
affected by inflation, be-cause of the relatively recent vintage of
much of their plant and equipment. Inflation can distort the reported
results of older businesses in different ways, depending on whether
the fixed assets involved are going to be replaced. Some older
businesses, such as steel companies and utilities, have major
requirements to reinvest their cash flows in their existing business
in order to remain competitive or serve customer needs.
Composition
of expenditures: It is axiomatic that
inflation does not affect all types of expenditures in the same way
capital structure of business. The capital structure of the business
is significant, because firms are hurt by inflation if their monetary
assets exceed liabilities. Firms theoretically benefit from inflation
if monetary liabilities exceed assets.
There are
five general principles for planning and managing for inflation
- There is no single rate of inflation.
• Each
business or product/market segment is affected differently by
inflation.
• There
are active management strategies that can be followed for either
adapting to or resisting inflation.
• Strategies
for financing a corporation are of in-creasing importance in an
inflationary environment.
• Management
systems must be adjusted for inflation.
Setting
Strategic Direction:
Technological
investments should be considered because they often provide a
substitute for labor, are often not capital-intensive, and offer
growth rates that exceed the CPI.
Low labor and energy content investments are attractive
because of the apparent burgeoning costs of pensions and other
fringes as well as the apparent impact of inflation on labor and
energy costs.
Limited
asset-replacement requirement opportunities are more apt to be found
in embryonic and growth industries than in mature industries and
inflationary environment. it is often wise to invest in businesses
that provide distributable funds rather than use cash.
Product
Pricing Product pricing is ordinarily
market-driven rather than cost-driven. Market demand and competition
call the tune
Growth
Objectives :With a shortage of capital, many
companies can no longer set targets and assume that capital will be
available to support whatever objective is established. Growth
objectives today must be supported by the distributable cash flow
that is available and the capacity of the corporation to borrow
without impairing liquidity.
Capital
Expenditures :capital expenditures. How much
do we invest, where, when, and for what return? Most companies,
including the oil companies, are constrained as to the amount of
money that is available
Working
Capital:With inflationary increases in the
investment in working capital and with a high prime rate, many
companies are paying a great deal of attention to minimizing the
investment in working capita
Capital
Structure: Many companies are financing
growth with debt to the extent feasible, providing that liquidity is
not impaired and the cost of debt after taxes is lower than the
inflation rate plus the real cost of debt.
Internal Application
of Constant Dollar/Current Cost Constant dollar and current cost
methodologies
Budgeting:
Brazil, where inflation is galloping along at a rate of more than 100
percent a year, Villiers is maintaining multi cost systems,
including a fiscal cost system for external reporting, a standard
cost system for control, and a replacement cost system for pricing
new products. Standards and operating budgets are revised quarterly.
funds
Management :Some 76 percent of the respondents to the questionnaire
said that they are placing more emphasis on funds management as a
result of inflation, and 88 percent said that they include a funds
statement with their budgets should be used in the strategic planning
process at the business-unit level to determine which in-vestments
offer the most attractive real rates of return.
• Constant
dollar/current cost progress should be tracked against the plan.
Forecasting
Methods
- Forecasting in nominal dollars;
• Forecasting
in constant dollars; and
• Forecasting
in both ways.
For
long-range planning purposes, the respondents to the questionnaire
indicated that their prac-tices were as follows:
• Nominal
dollars—45 percent;
• Constant
dollars—24 percent; and
• Both
ways—25 percent
Conclusion
The study
bore out what GE has identified in its Effectively Coping With
Inflation course as the six Ps of management in an inflationary
environment: Possibility inflation combatting strategies do exist;
,Positioning—is the key to success; Price-change accounting—is
necessary for real measurement; Productivity—is a major
controllable element for management; Prices of goods coming in as
well as those going out are key factors to profitability; and
Payments—cash management is increasingl.
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