METHODS OF INFLATION ACCOUNTING

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2 METHODS OF INFLATION ACCOUNTING No doubt in theoretically the philosophy of measuring all the economic events and details of financial statements with adjustment of price level changes is good but the important thing i.e. problem is how we evaluate the events according to day to day changes in price level. So in this regard methods used by some companies and which are till today only found popular are as below - 1. Current purchasing power method or general purchasing power method (CPP or GPP method). 2. Current cost accounting method (CCA method) 3. Hybrid method, i.e., a mixture of CPP and CCA method. Current Purchasing Power Method The method of current purchasing power was evolved by the institute of chartered accountant in England and Wales by issue of the provisional statement of standard accounting practice No. 7 (SSAP-7) entitled, "Accounting for changes in the purchasing power of money" in May According to this method all items in the financial statement are to be restated for changes in the general price level. For this purpose approved price index is used to convert the various items of the balance sheet and the profit and loss account.1 In other word - current purchasing power accounting is based on historical measurement of transaction but it replaces traditional monetary

3 Methods of Inflation Accounting unit of measurement with "purchasing power unit" of measurement. It advocates that money unit fluctuates with changes in price level and, thus should be replaced with a unit of measurement with remains constant over a period of time. Thus, to provide a common unit of measurement, it uses purchasing power unit which is nothing but the money unit adjusted for changes in the price level. To convert conventional financial statements based on historical cost into current purchasing power (i.e. purchasing power on accounting date of finalisation of accounts) adjusted financial statements, general price indices are used. All items of income statement and balance sheet are restated on the basis of price index at the end of the year. For restatement of figures, figure is multiplied by the year end index and divided by the index on the date of the transaction the steps involved are as under : 1. Calculation of monetary gain/loss. 2. Restatement of historical statements especially cost of goods sold, depreciation etc. 3. Restatement of historical balance sheet. 4. Verification of capital in the beginning of the period. 1. Computation of monetary gain/ loss : Monetary (or purchasing power) gain/loss is not considered under historical cost system. But under CPP accounting it is ascertained and treated as revenue item and, thus, transferred to profit and loss account, to compute gain or loss of each monetary item following : 101

4 Methods of Inflation Accounting Particulars of monetary item Historical value Adjustment Adjusted Value Opening balance - /TT i r \ YearEndlndex (H.V.) x Openinglndex = Increase (or Decrease) during the year + (-) (H.V.) x Average I ndex = + (-) Closing balance In fact, here index on the date of transaction is to be considered. However, in most of the problems, this information is missing. Therefore, it is assumed that increase (or decrease) has taken place evenly throughout the period and, thus, adjusted on the basis of average index during the year. If the problem is silent about the average index during the year, it is ascertained as follow : Average Index = (Opening Index + Closing Index) x la For example: We can calculate the net monetary gain or loss from the following information which is related to year Cash Debtors Creditors General Price Index Assuming the average price index during the year is Rs

5 Methods of Inf Cation Recounting Although net monetary gain (or loss) can be computed by taking together the three monetary items given above, but it is advisable to calculate it separately for each item and then, ascertain net gain or loss. This will provided the necessary information for conversion of financial statements. Computation of monetary gain / loss Particulars Historical Value Adjustment Adjusted Value CASH Opening Balance 3000 x 180/100 = 5400 Add Increase during the year 3000 x 180/ Closing balance DEBTORS Opening balance 2000 x 180/ Less Decrease during the year (1500) x 180/150 -(1800) Closing balance CREDITORS Opening balance 500 x 180/ Less Decrease during the year (300) x 180/150 (360)

6 Methods of Inflation Accounting Monetary loss on holding of cash ( ) Monetary loss on holding of debtors ( ) Less : Monetary gain on holding of creditors ( ) Net monetary loss This can be verified by ascertaining it on the basis of net monetary assets as under: Net monetary assets opening Historical Adjustment Adjusted Value ( ) Add : Increase during the year (b.f.) Closing ( ) 4500 x 180/100 = x 180/150 = ,260 Net monetary loss = 10, = Rs Restatement of Income Statement: To convert conventional historical income statement into CPF adjusted statement, all items are to be restated. Items like sales, expenses etc. arc unless otherwise given, are assumed to be evenly spread over the period involved and converted on the basis of average index. Depreciation is converted on the basis of index on the date of acquisition of assets. Items, about which specific information is given are converted on that basis. 104

7 i!metfiocfs of Inf Cation Accounting For Example From the following information, compute historical and CPP adjusted cost of goods sold - Opening stock = Rs. 50,000 (Price Index 100) Purchases -1 = Rs. 50,000 (Price Index 125) 11 = Rs. 60,000 (Price Index 150) Closing stock = Rs. 70,000 (Price Index 200) (FIFO) Calculation of cost of goods sold Particulars Historical Adjustment Adjusted! j i Opening stock 50,000 x 200/ ,000 Add : Purchases I 50,000 x 200/125 80,000 Add : Purchases II 60,000 x 200/150 80,000 Total 1,60,000 2,60,000 ; Less : Closing stock ' 60,000 " x 200/150 " 80,000" + > _ < ( + ) [ ^ 10,000 _ x 200/125 16,000 5 J l Cost of goods sold 90,000 1,64,000 Calculation of CPP adjusted net profit : After restating all debit and credit items appearing in historical income statement calculation of the net balance is made then, adjustment the amount of net monetary gain (or loss) ascertained earlier to arrive at the figure of CPP adjusted net profit (or loss). 105

8 Methods of Inflation Recounting 3. Restatement of closing balance sheet: As monetary assets and liabilities representing fixed money value are already in terms of year end index, their restatement is not required. Non-monetary assets except inventory are restated keeping in mind, the index on the date of acquisition of those assets. Restatement of closing inventory is as per discussion on calculation of cost of goods sold in restatement of income statement. After restatement of assets and liabilities, the balancing figure represents owners funds, comprising of capital contribution and reserves. Treatment of owner s funds : There are three ways of dealing with it as given below : 1. Owners funds taken as balancing figure. 2. Keeping in mind the restated profit and information about additional capital and drawings. Reserves and surplus is taken as balancing figures. 3. Even reserve can be adjusted, then, balancing figure represent accumulated monetary gain (or loss). For Example: From the following data, prepare conventional and general purchasing power (CPP) adjusted financial statement. 106

9 Methods of InfCation Jlccountinfj Balance sheet as at 1 July, 2001 Liabilities Amount Assets Amount Capital 75,000 Cash in hand 30,000 Current liabilities 15,000 Building 60,000 Rs. 90,000 Rs. 90,000 During the year , the net cash in-flow of Rs was accounted by the cash sales revenue of Rs. 57,500 and cost of sales of Rs. 40,000 and decrease in current liabilities of Rs. 10,000 depreciation on building was Rs Assume closing stock in nil. Price index were as under : At the time of purchase of Building

10 Methods of Inflation Recounting Computation of purchasing power gain/loss Actual amount Adjustment Adjusted amount Monetary assets Cash in the beginning 30,000 x 200/150 (opening rate) 40,000 Add Increase during the year 7500 x 200/175 (average rate) ,500 48,571 Less 37,500 Actual purchasing power loss (-) 11,071 Monetary liabilities Current liabilities 15,000 x 200/150 (opening rate) Decrease during the year (10,000) x 200/175 (Average rate) 20,000 (1,429) Less Actual liabilities purchasing power gain Purchasing Power Gain 3571 Net purchasing power loss (-) (+3571) = Rs. - (7500) 108

11 IMetfiods of Inflation Accounting Income statement for the year ending Based on historical cost Adjustment CPP Adjusted Sales 57,500 x 200/175 65,714 Less - Purchases (40,000) x 200/175 (45,714) Gross Profit 17,500 20,000 Less Depreciation on building (5000) x 200/100 (10,000) Net profit 12,500 10,000 Less net monetary loss (7500) Net profit 2500 Balance sheet (based on historical cost) as at Liabilities Amount Assets Amount Capital 75,000 Cash 37,500 Add - Net profit ,500 Building 60,000 Current liabilities 5000 Less 55,000 Depreciation 5000 Total 92,500 Total 92,

12 Methods of Inflation Accounting Cash Account Particulars Amount Particulars Amount To, Balance bid 30,000 By current liabilities (creditors) 50,000 1! i To, Sales a/c 57,500 By balance c/d 37,500 Total 87,500 Total 87,500 Balance sheet (in terms of purchasing power on ) as at Liabilities Amount Assets Amount i Opening capital Cash 37,500 (B.F) 1,40,000 Add Building Net profit ,000x220/100 1,10,000 (adjusted) 1,42,500 Current liabilities 5000 Total 1,47,500 Total 1,47,500 Rs. 1,40,000 figure of opening capital can be verified by restating opening balance sheet as under : 110

13 Methods of Inflation Recounting Balance sheet (in terms of purchasing power on ) as at Liabilities Amount Assets Amount j Current liabilities 20,000 Cash 40,000! (15000x200/150) 30000x200/150 Capital (B.F.) 1,40,000 Building 60000x200/100 1,20,000 Total 1,60,000 Total 1,60,000 For Example We can calculate the net monetary gain or loss form the following information which is related to year The balance sheet of Himachal LTD as on 1st January 2001 and profit and loss statement for the year ending 31st December 2001 are given below : Balance sheet as on 31st Dec i I Liabilities Amount Assets Amount Share capital 4,00,000 Plant & Machinery 3,00,000 13% debentures 1,00,000 Furniture and Fixture 40,000 Current liabilities 50,000 Inventory 60,000 Debtors 50,000 Cash 1,00,000 Total 5,50,000 Total 5,50,

14 Metfiods of Inflation Accounting Profit and Loss Statement for the year ending 31st Dec., 2001 Particulars Amount Amount Sales 10,00,000 Less - Cost of goods sold- Opening inventory 60,000 Add - purchases 7,10,000 7,70,000 Less - closing inventory 70,000 7,00,000 Gross Profit 3,00,000 Less - opening expenses 1,51,000 Interest on debentures 13,000 Depreciation on machinery 45,000 Depreciation of Furnitures 4,000 2,13,000 Net Profit 87,000 Debtors and current liabilities balances remained constant throughout the year interest on debentures was paid on The general price index was as follows : On January 1, Average for the year 320 On December 31, We are required to prepare the financial statement for the year 2001 after adjusting for price level changes under current purchasing power method : 112

15 ^Methods of Inflation Accounting Profit and loss statement as per CPP method for the year ending 31st December 2001 Particulars Historical amount Adjusted factor Price level adjusted amount Sales 10,00, /320 11,25,000 Opening inventory 60, /300 72,000 Purchases 7,10, /320 7,98,750 7,70,000 8,70,750 Less- Closing inventory 70, / Cost goods sold 7,00,000 7,92,000 Gross profit (sales- cost of goods sold) 3,00,000 3,33,000 Opening expenses 1,51, /320 1,69,875 Depreciation on machinery 45, /300 54,000 Depreciation on furniture / Interest on debentures 13, /360 13,000 Total Expenses 2,13,000 2,41,675 Net profit (gross profit - expenses) Loss On monetary assets as calculated in a separate statement shown below retained earnings 87,000 91,325 17,375 73,950 Note : FIFO method has been followed for the cost of goods sold and closing inventory in the absence of information. 113

16 Methods of Inflation Accounting Statement of gains or loss on monetary items Historical amount Adjusted factor Price adjusted amount Purchasing power gain or loss Monetary assets on Debtors /300 60,000 Cash 1,00, /300 1,20,000 Increase in cash (I) / ,375 Monetary assets on ,89,000 3,36,375 Purchasing power loss (335, ,000) Monetary liabilities on Debentures 1,00, /300 1,20,000 Current liabilities 50, /300 60,000 Monetary liabilities 1,50,000 1,80,000 Purchasing power gain (180, ,000) 30,000 Loss on monetary items 17,

17 Methods of Inflation Jlccounling Balance Sheet as on 31st December 2003 Liabilities Amount Assets Amount Share capital (400,000x 360/300) 4,80,000 Plant & Machinery (300,000x 360/300) = 3,60,000 Retained earning 73,950 Less- 15% 54, % debentures 1,00,000 Furniture & Fixtures (40,000x 360/300) = Current liabilities 50,000 Depreciation@l 0% ,200 Inventory (70,000x 360/320) 78,750 Debtor 50,000 Cash - (2) 226,000 Total 7,03,950 Total 7,03,950 Working Notes : 1. Increase in cash has been calculated as follows : Sales proceeds 10,00,000 Less- Amount paid on account of purchases 7,10,000 \Amount paid on account of operating expenses 1,51,000 8,61,000 Increase in cash 1,39,

18 5Methods of Inflation Jlccounling Note : Cash paid on account of interest on debentures has not been considered because it was paid on It will not have any effect on gain or loss on monetary assets. 2. Cash in hand on is calculated as follows : 3 Cash in hand on ,00,000 Add- increase in cash as calculated above 1,39,000 2,39,000 I.ess- Interest on debentures paid on ,000 Cash in hand on ,26,000 CURRENT COST ACCOUNTING METHOD : The U.K. Government appointed a committee under the chairmanship of "Sir Francis Sandilands", the report of the committee was published in September, 1975 and SSAP-7 was withdrawn. In its report, the committee recommended the adoption of current cost accounting system as a method for correcting the deficiencies of the historical cost accounting which fails to provide sufficient information as required by the users of accounts. The current cost accounting system has been extensively studied and debated. It has now been finalised by the issue of statement of standard accounting practice - 16 (SSAP-16) in March 1980, by the accounting committee of U.K.4 Main Fcatures/Step: The main features of the CCA method are as follows : 116

19 Methods of Inflation Jlccounting Meaning: '['he method requires each item of financial statement to be restated in terms of the current value of the item. No cognizance is taken of changes in the general purchasing power of money. Assets are shown in terms of what such assets would currently cost. Similarly, the profits are computed on the basis of what the cost would have been at the date of sale rather than the actual amount paid. For example : If goods purchased for R. 16 are worth Rs. 20 on the date of sale are sold Rs. 24, profit will be taken as Rs. 4 (and not Rs. 8) based on their current cost. Objectives: The method seeks to ensure that adequate, provision/ adjustments are made for the maintenance and replacement of the operating assets of the company, at least at the minimum physical level at which the enterprise can operate efficiently and not only for the year under the review but also for the future.5 Adjustments / provisions : In order to achieve the objectives stated above, the following adjustments/provisions are usually made. 1. Depreciation adjustment (for current year and backlog depreciation) 2. Cost of sales (or goods sold) adjustment (COSA) 3. Monetary working capital adjustment (MWCA) 117

20 Methods of Inflation Accounting 4. Capital gearing adjustment (CGA)6 1. Depreciation Adjustment: It requires recording of assets at their current replacement cost i.e. current value to the business. Depreciation for the current year is determined on the basis of current cost of asset. The depreciation adjustment is made for the excess of current cost depreciation over historical cost depreciation. Backlog depreciation : Taking current cost of an assets as base not only affect current year. Depreciation but also the accumulated depreciation on that asset. It is difference of current cost of accumulated. Depreciation and historical cost of accumulated depreciated. Thus adjustment for backlog depreciation bring historical cost of accumulated depreciation to current cost level. Cost of Sales Adjustment (COSA) : COSA is made to bring value of goods consumed during the year to its average cost level during the year. For this purpose, closing and opening stock are restated on average basis. 118

21 Methods of Inf Cation Accounting For example - Particulars Historical cost Index Adjustment Adjusted! figure Opening stock 2,00, x 120/100 2,40,000 Purchases 5,00, (average) x 120/120 5,00,000 7,00,000 7,40,000 Closing stock 3,00, x 120/150 2,40,000 Cost of goods sold 4,00,000 5,00,000 Cost of sales Adjustment = current cost of goods - historical cost of goods sold Cost of sales Adjustment = 5,00,000-4,00,000 = Rs. 1,00,000 Monetary working capital adjustment (MWCA) Depreciation adjustment is made to change current cost of using fixed assets to income statement. Similarly, COSA is made to match current cost of goods sold with revenue of the period. Now MWCA is to be made to ensure that additional MWC required to operate at the same level of business activity, is retained out of funds generated by sales revenue. The adjustment for monetary working capital is done by restating figures on average basis6. 119

22 Methods of Inflation Accounting For example: We can calcualte the monetary working capital adjustment (MWCA) from the following information which is related to I-ICA method during Particulars Jan 1,2001 Dec Accounts receivable 20,000 36,000 Accounts payable 1,000 18,400 Monetary working capital Price index for materials Price index for finished goods Solution : In order to determine MWCA, it will be necessary first to find out the amount of increase in monetary working capital on account of increase in volume of business. This should be done by eliminating the effects of change in price levels in the amounts of receivable and payable. The amount of receivable and payable have been compared for this purpose by adjusting their figure on the basis of average price indices as shown below : (a)- (b) (c) Accounts receivable 20,000 x 165/150 Jan 1, 2001 Dec 31, ,000 36,000 x 165/180 33,000 Accounts payable 1, x215/ x215/200 Monetary working capital (a-b) 120

23 Methods of Inflation Recounting The increase in monetary working capital on account of increase in volume of business is Rs (i.e. Rs ). Mowever, the actual increase in monetary working capital as shown by MCA method comes to Rs. = 8600 (i.e. Rs ) The excess of Rs (i.e. Rs ) Representing excess working capital required is "monetary working capital adjustment" the amount would be charged to profit and loss account and credited to "Current cost accounting Reserve"7. Gearing Adjustment: Historical profit adjusted for depreciation, cost of sales and net monetary working capital given current cost operating profit and ensure maintenance of over all operating capability of the business. Gearing adjustment considers the financing of operating capacity by parties other than equity shareholders. To the extent operating asset are not financed by equity shareholders. Total burden of adjustment for current cost should not falls on equity shareholders. Hence gearing adjustment is made to ensure that DA, COSA and MWCA are reduced proportionately on the basis shareholders share in current cost profit. It is made as follows: Total of depreciation cost of sales and monetary working capital adjustments Net borrowings x Net borrowings + Equity shareholders funds 121

24 Methods of Inflation Recounting For Example : C. Ltd. owns plant and machinery with an expected useful life of 8 years. The plant was purchased on You are provided with the following index numbers. Plant Cost Index Retail Price Index 1 January January Average December The plant cost Rs when purchased you are required to show the fixed asset note for the year ended 31 December 2001 using the following. (a) (b) (c) (d) Historical cost accounting Current purchasing power accounting Current cost accounting charging depreciation based upon the closing value to the business. Current cost accounting charging depreciation based upon the average value to the business. 122

25 Methods oflnffation Accounting Value of Fixed Asset (a) (b) (c) (d) Cost/ valuation at Revaluation at ,000 1,76,000 1,86,666 1,86,666 _ - 1,06,667 1,06,667 80,000 1,76,00 2,93,333 2,93,333 Accumulated depreciation at Depreciation for ,000 88,000 93,333 93,333 10,000 22,000 36,666 30,000 Revaluation ,334 60,000 50,000 1,10,000 1,83,333 1,83,333 Net book value on ,000 66,000 1,10,000 1,10,000 On ,000 88,000 93,333 93,

26 imethods of Inflation Accounting Working Notes8 1. Historical Value 4 Accumulated depreciation upto = x 80,000 = Depreciation upto = ^ x 80,000 = Rs )epreciation for the year W.D.V. = Cost - Depreciation 2. Current purchasing power Accounting Balance Sheet as at Historical Cost Adjustment C.P.P. Cost 80,000 x Depreciation 50, ,000 Balance Sheet as at (Comparative for 2001) Historical Cost Adjustment C.P.P. Cost 80,000 x ,76,000 Depreciation 40,000 x ,000 40,000 88,000 Depreciation Rs. 10,000 x Rs. 22,000 Current Cost Accounting Balance Sheet at Historical Cost Adjustment C.P.P. Cost Depreciation 80,000 x 50,000 x ,10,000 Balance Sheet as at Historical Cost Cost Depreciation x x 40,000 Adjustment C.P.P. 1,86,000 93,333 93,

27 Methods of Inf Cation Accounting Depreciation (based on closing value) 2,93,333 * 8 = 36,666 Depreciation (based on Average value) Hybrid Method : 2,93,333+1,86,666 2x8 Rs.30,000 Recently some authorities have suggested another method which is essentially a compromise formula between CPP method and CCA method. According to this method the adjustments of fixed assets and inventories are to be made with reference to specific indices in place of a general index as is the case under CPP method. Besides this, purchasing power gains and losses in respect of monetary items are also considered which are ignored under CCA method. Advocates of this method argue that by combining these two methods, the advantages of both can be obtained. The method, on the face, appears to be a satisfactory compromise formula but its acceptance may prove difficult because of theoretical objections against such a compromise. Moreover, the method is also subject to the limitation of both CCA and CCP methods. The method is still in its evolutionary stage and suggestions varying in nature and implications would continue to be made in the coming years. It will take a long time before a set of well defined procedures and guidelines is developed. The method cannot, therefore, be recommended for practical application at the present moment.9 125

28 Methods of Inflation Recounting REFERENCES : 1. Maheshwari, S.N. and Maheshwari, S.K. Book - Financial Accounting, Published by - Vikash Publishing House Pvt. Ltd., 576 Masjid Road, Jangpura, New Delhi , edition 2002, Page No Sehgal - Ashok & Deepak, Book - Advanced Accounting-1, Published by - Taxmann Allied Services (P) Ltd., 59/32, New Rohtak Road, New Delhi , Page No to Jain and Narang, S.P., Book - Advance Accountancy, Page No. Ill/142 to II1/ In U.S.A. Financial Accounting Standard Board, Issued in Oct FAS-33 for reporting price level change. 5. Maheshwari, S.N. & Maheshwari, S.K., Book- Financial Accounting, Published by - Vikash Publishing House Pvt. Ltd., 576 Masjid Road, Jangpura, New Delhi ,, edition 2002, Page No Sehgal - Ashok & Deepak, Book - Advanced Accounting - I, Published by - Taxmann Allied Services (P) Ltd. 59/32, New Rohtak Road, New Delhi , Page No to Maheshwari, S.N. and Maheshwari, S.K., Book - Financial Accounting, Published by - Vikash Publishing House Pvl. Ltd., 576 Masjid Road, Jangpura, New Delhi , edition 2002, Page No

29 Metfiods of Inf Cation Jlccounting 8. Sehgal - Ashok and Deepak, Book - Advanced Accounting-I, Published by - Taxmann Allied Services (P) Ltd., 59/32, New Rohtak Road, New Delhi , edition 2002, Page No to Maheshwari, S.N. and Maheshwari, S.K., Book - Financial Accounting, Published by - Vikash Publishing House Pvt. Ltd., 576 Masjid Road, Jangpura, New Delhi , edition 2002, Page No