That sinking feeling

For the past 60 years any discussion about the impact of general price changes on management accounting has been synonymous with a discussion on inflation. This is so because between 1940 and the late 1990s price inflation was an endemic feature of most western economies. The UK experienced rates of inflation exceeding 10 per cent a year for protracted periods during the 1940s, 1970s and 1980s. But in the 1920s and 1930s the issue was price deflation. This was associated with the restoration of the gold standard and the subsequent depression. Factors that contribute to deflation include the development of the global economy and advances in technology. Many manufactured goods, particularly in the electronics industry, and raw materials have been falling steadily in price for at least the past decade. Japan is one country that has experienced an extended period of deflation, associated with falling prices and low or nil interest rates. Deflation affects various aspects of management accounting. In a situation of price deflation, the purchasing power of money rises over time: 5 per cent annual deflation may be taken to indicate that £1 at year zero and £0.95 at year one have the same purchasing power. This implies that “real” interest rates are higher than the “nominal” or “money” rates quoted by banks. Take the following simple investment appraisal as an example. Consider a project that involves a £100 initial investment and which generates annual cash inflows of £40 (year one), £40 (year two) and £30 (year three) at year-zero price levels. The current cost of money is 1 per cent and the annual deflation rate is 5 per cent. Using a 1 per cent interest rate to discount the cash inflows, this gives the project a positive net present of £7.93, which suggests that the project is viable. But the approach is wrong because it ignores deflation. To appraise the project properly, you have the option of using either a “real” interest rate with cash flow figures projected at current (year zero) price levels (see figure 1), or a “money” interest rate with cash flow figures projected at future price levels (see figure 2). Deflation is not only a mathematical phenomenon. The recent experience in Japan suggests that it affects the behaviour of investors, managers, employees and consumers. Much of that impact is in essence psychological in origin. Deflation may affect business decisionmaking in several ways. l Investing in projects that have long payback periods (or even no payback periods) at projected future price levels may require some courage. l Borrowing to finance the purchase of assets that are going to shrink in money value over time may also require some courage. Money interest rates may be low, but real interest rates are higher and people will eventually realise this. l It may be difficult to reduce some costs – eg, wages – in line with deflation. This may make many projects less attractive than would otherwise be the case. l Consumers may start to defer purchasing decisions if prices are falling. This may be irrational, but it will make the general climate for investment less attractive. John Keynes stated in The General Theory of Employment, Interest and Money that “nothing is more injurious to the volume of trade and investment than steadily sagging price levels”. He was writing about deflation in the 1930s, but his comments could apply equally to modern conditions. In recent years Japan has seen the Nikkei index fall from a peak of 38,000 to its current level of around 10,000. Residential property prices have fallen by as much as 60 per cent in many Japanese cities. Deflation may be set off by a decline in real prices for many manufactured Figure 1 Real interest rate and current price levels