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Essays on inflation accounting and valuation

Elizabeth Ann Gordon, 1998
Faculty Advisor: Trevor S. Harris
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Abstract

This thesis analyzes the issue of accounting for inflation. The issue is examined from three different but related approaches using both theoretical and empirical methods.

The first chapter develops a valuation model which explicitly incorporates changes in the general price level. It relies on the discounted dividend model, clean surplus accounting, a definition of abnormal earnings, and a linear information model to express firm value as a function of current accounting measures. In addition, the analysis exploits Fisher's definition of the risk-free interest rate to highlight key characteristics imbedded in price level accounting. The analysis shows that price level accounting retains similar measures of profitability and abnormal earnings as historical cost accounting when inflation is zero.

The empirical tests in Chapters 3 and 4 use a sample of publicly-traded firms in Mexico. Chapter 2 discusses reasons for the selection of a sample of companies from Mexico, provides an overview of accounting under Mexican generally accepted accounting principles and describes the securities market in Mexico.

The analyses in the third chapter examine the value-relevance of adjustments between historical cost balance sheet and income statement measures and measures under price level and replacement cost accounting. The analyses support the conclusion that differences between book values and earnings measured under historical cost and those measured using price level and replacement cost accounting principles are value-relevant. Consistent results over an 8-year period in which inflation ranged between seven percent and fifty-two percent imply that the adjustments are significant regardless of the inflation rate.

The fourth chapter explores valuation in a setting which conceptually differs from historical cost accounting. Two key aspects of valuation are analyzed: (1) the relationship between current and future profitability and (2) the association between current accounting measures and market value. The results reveal that the combined price level and replacement accounting performs generally as anticipated. The expected relationships between current and future profitability hold for price level and replacement cost accounting measures regardless of the rate of inflation. However, the market does not always value the accounting measures as predicted. The results relating specifically to the valuation of replacement cost accounting measures, such as the change in the revaluation and depreciation expense imply that the market may have difficulty interpreting the change in the value of non-monetary assets.

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