Adjusted for inflation

Financial Mail 23 May 2008

Adjusted for inflation

Geoff Everingham, Cape Town

Nicolaas Smith's letter (May 9) is useful in reminding us that accounting numbers are not truly comparable over time because of the inflation element contained in them.

But the assertion that accountants "freely destroy real value in the real economy with their assumption that the rand is perfectly stable" has no substance. This confuses the reporting process with the processes which create wealth, rather like blaming the scorekeeper when the batsmen fail to score runs. Financial reporting simply reports on what took place. It is not part of the process of creating wealth, but it doesn't destroy it either, except in so far as there are costs attached to the reporting process (against which there are some benefits to users like investors).

Similarly, to suggest this alleged value destruction would be remedied if the assumption of a stable measuring unit were abandoned for reporting purposes has no substance.

A form of inflation accounting by adjusting figures using, for example, the CPI, does have conceptual appeal and was experimented with in the UK and the US in the 1970s when inflation was high. The research at the time showed that markets paid no attention to the inflation-adjusted figures.

There are two reasons for this. Firstly, players in capital markets are aware of the extent of inflation and are capable of allowing for this in determining the value of shares. Secondly, businesses are affected by the specific price changes of the products with which they are dealing, and these may bear little relationship to a general price index like the CPI.

There was thus little sense in making CPI-based adjustments (and when this was experimented with in supplementary accounts, business objected on the grounds that the adjusted numbers did not reflect the impact of specific inflation).

Eventually, with inflation abating in the UK and the US, and accountants' debates seeming increasingly technical, the use of CPI-adjusted numbers was abandoned (it is, however, required in circumstances of hyperinflation, in terms of the accounting standard IAS29 ).

I would not wish to be dismissive of Smith's concern about inflation, though. For example, where companies report a dividend history over several years, it helps shareholders if the CPI is disclosed and they can see whether there has been real growth in dividends. This is simple and understandable, but comprehensive CPI-based adjustment of the accounts themselves is not - and has nothing to do with the creation or destruction of value in the economy. It is completely mistaken to accuse accountants of this.