Inflation Accounting for Debt

According to Irving Fisher, nominal interest rates are comprised of two components: (1) the real interest rate and (2) the anticipated rate of inflation. When inflation is perfectly anticipated, the decline in the purchasing power of a lender’s claim is offset by the difference between the real and nominal interest rates. Only when the actual rate of inflation differs from the anticipated rate will there be an economic gain or loss on such a claim.

The FASB requires that inflation gains be measured by taking the product of the observed rate of inflation and the book value of outstanding debt. They call the result the purchasing power gain on debt. The FASB’s purchasing power gain will correspond to the real economic gain only in the unlikely event that experienced inflation is a total surprise to borrowers and lenders.

In contrast, current cost accounting for debt monitors changes in its market price, terming these changes holding gains (or losses). Whether holding gains constitute income depends on the concept of capital maintenance selected. Under the physical capital maintenance concept, a firm’s income consists of the portion of net operating flows it can distribute in dividends without reducing the level of its physical operations. This view is consistent with the so-called entity theory of ownership equity, which views both creditors and equityholders as essentially similar providers of capital. Because unanticipated inflation mainly represents a wealth transfer from bondholders to shareholders, gains or losses leave the position of the entity as a whole unchanged, hence are not reflected in income.

Under the financial capital maintenance concept, income consists of the flow that can be distributed without eroding the beginning-of-period market value of net assets. Holding gains on assets are treated as distributable income. Because a decrease in the market value of debt constitutes a net increase in owners’ equity, it too must be treated as distributable income if this concept is to be internally consistent.