Commentary on ‘Accounting for Inflation: The Dog That Didn't Bark’

Historical cost accounting presents a financial summary of a firm's activities that actually occurred in the past year and informs the user of the firm's current status through the income statement, balance sheet, and statement of cash flows. The user utilizes this information and combines with other information in drawing inferences about the management and firm's performance, the risk profile of the firm, and the firm's prospects. The collective wisdom of several users and their trading activity then determine a publicly-traded firm's valuation. A Pantheon of academics and researchers has observed that historical cost financial statements are distorted under inflationary conditions. For example, because of unaccounted inflation, historical cost financial statements understate the (replacement) cost of a firm's assets and overstate its debt obligations. They propose a general price level adjustment (GPLA) treatment, designed to attenuate the distortionary effects of inflation that are ignored in historical cost accounting. However, even after a century of passionate attempts, as Ray Ball observes, the GPLA standards remain a mirage. Ray Ball presents an incisive economic reasoning for the failure of GPLA standards becoming a reality. Revisiting the economic arguments will not add anything to the discussion. Instead, I offer conjectures for why GPLA failed to gain traction. In proposing GPLA standards, implicitly or explicitly, the proponents transitioned from summarizing a firm's financial activities to drawing inferences about the firm's financial performance and financial condition. However, this is a tall order for accountants and auditors. Thousands of financial intermediaries—analysts and investment bankers—with specialized training that goes beyond accounting engage in analyzing financial information coupled with myriad other pieces of information to formulate opinions about performance, risk, and prospects for a firm. Investors, traders, and risk arbitrageurs act on this information on technologically sophisticated trading exchanges and other venues to determine the prices of the firm's debt and equity securities. It is unreasonable to expect GPLA can be a substitute for the market participants' (e.g., analysts, investors, investment bankers, etc.) assessment of firm performance or a substitute for security prices, that is, market valuation. Even if GPLA's goals were less ambitious and limited to providing summary information that might improve historical financial information, Ray Ball's analysis exposes weaknesses in the GPLA treatment. In particular, GPLA incorporates certain economic effects of inflation, but it omits others that are best addressed by the market. Unfortunately, the omissions do not simply lead to 'noisy' financial information. The omitted phenomena are likely (negatively) correlated with the effects of inflation factored into the GPLA. So, the GPLA financial statements offer potentially an even more distorted picture. This defeats the goal of GPLA to provide financial information that is a step closer to providing a measure of firm and management performance and risk profile of a firm. I am reminded of Winston Churchill's (11 November 1947) embrace of democracy notwithstanding its weaknesses: 'Many forms of Government have been tried, and will be tried in this world of sin and woe. No one pretends that democracy is perfect or all-wise. Indeed it has been said that democracy is the worst form of Government except for all those other forms that have been tried from time to time …'. Advocates of GPLA proposed new standards because historical cost accounting suffered from certain (alleged) weaknesses, but they failed the crucial test of demonstrating that the alternative is superior. Unfortunately, history will repeat itself as fresh attempts will be made in many contexts. S. P. Kothari (email protected) is with MIT Sloan School of Management.