Inflation Accounting

Accounting for price level changes

Limitations of historical Accounting

        

 

Utility of accounting records seriously impaired Unrealistic profits Insufficient provision for depreciation Fixes assets values are unrealistic Different basis Return on capital employed misleading Matching principle violated Incorrect ascertainment of operating capacity Difficulty in comparison of profitability of two plants Mixing up holding gains and operating gains Misleading inter-period and inter-firm comparison interinter-

Inflation accounting


Accounting for changing prices is also known as inflation accounting because changes in prices are usually on the upward side Accounting for changing prices (Inflation accounting) is a system of accounting which regularly records all items in financial statements at their current values. The system recognises the fact that the purchasing power of money is decreasing day-by-day during inflation and finds day-byout profit or loss or states the financial position of business on the basis of the current prices prevailing in the economy.

Approaches to inflation Accounting



 

Current purchasing power accounting (CPPA) Current cost accounting (CCA) Specific and general price level accounting (SGPLA) Periodic revaluation of fixed assets along with the adoption of LIFO method of inventory

Current purchasing power accounting (CPPA)



In CPP Accounting the historic cost accounting data are adjusted on the basis of any established and approved general price index at a given date. In India wholesale price index of Reserve Bank of India can be taken which shows the change in the value of the rupee in the past years. This method take into consideration the changes in the value of the items as a result of the general price level, but it does not account for changes in the value of individual items. The formula for the conversion of the historic cost to the general price level is as follows:follows:Conversion factor= Index to which it is converted Index from which it is converted

A Company had the following monetary items on Jan 1: Rs. Rs. Debtors 41000 Bills receivable 10000 Cash 20000 71000 Less:Less:Bills payable 10000 Creditors 25000 35000 Net monetary assets 36000 The transactions affecting monetary items during the year were: 1. Sales of Rs.140000 made evenly through out the year 2. Purchases of goods of Rs.105000 made evenly during the year 3. Operating expenses of Rs.35000 were incurred evenly throughout the year 4. One machine was sold for Rs.18000 on July 1 5. One machine was purchased for Rs.25000 0n December 31. The general price index was as follows: On January 1 300 Average for the year 350 On July 1 360 On December 31 400 You are required to compute the general purchasing power, gain or loss, for the year stated in terms of the current year end rupee.


Ascertain net monetary result as at 31st December,2002 from the data given below: 1st Jan 31stDec Cash at Bank 15000 21000 Accounts receivable 45000 54000 Accounts payable 75000 50000 General price index number: 1st January 2002 100 31st December 2002 125 2002 average 120


Current Cost Accounting (CCA)



In this method , historic values of items are not taken into account; rather current values of individual items are taken as the basis for preparing profit and loss Account and Balance sheet. The CPP method takes care of changes in the value of money but it does not account for changes in the value of individual items. The value of an item may be increased on the basis of general price index whereas the actual value of that item might have decreased. To remove this drawback, the U.K. Government set up a committee known as the Inflation Accounting Committee under the chairmanship of Mr. Francis Sandilands to consider the problem of price level accounting. They recommended the adoption of CCA method for dealing with the problem of inflation.

Characteristics of CCA
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Fixed assets shown at their current values Stocks are shown in the balance sheet at the value prevailing on the date For profit computation, depreciation is computed on current values The difference between current values and the depreciated original cost of fixed assets is transferred to revaluation reserve account The cost of stock consumed during the year is taken at current value of the stock at the date of consumption and not at the purchase price of the stock consumed Monetary assets and liabilities are not adjusted under this method because they are always recorded at the value to the business Under CCA approach accounting profit is divided into three parts for properly ascertaining the operating results. They are a) current operating profit b) Realised holding gain and c) unrealised holding gain

Realised holding gain:- Excess of gain:replacement cost over its historical cost of a non-monetary asset on the date of its nonsale Unrealised holding gain:- Excess of gain:replacement cost over its historical cost of a non-monetary asset on the closing date nonCurrent operating profit:- Excess of sale profit:proceeds of goods and services sold during a particular accounting period over the replacement costs of the goods or services sold on the dates the sales were effected.

Adjustments to be made in CCA method

   

Depreciation adjustment Cost of sales adjustment (COSA) Monetary working capital adjustment Gearing adjustment

Depreciation adjustment


The current depreciation charge under CCA method is obtained by apportioning the average net replacement cost over the expected remaining useful life of the fixed asset at the beginning of the period. When fixed assets are revalued every year, there will be shortfall of depreciation known as backlog depreciation representing the effect of price rise during the period. The current year difference should be adjusted in this years depreciation and backlog of previous years should be adjusted in current cost reserve or revaluation surplus

Cost of Sales Adjustment

This adjustment is made for determining current cost operating profit and represents a difference between value to the business and historical cost of stock consumed in the period. It is determined as given below:  COSA=(C-O)-Ia [C - O] COSA=(C-O)- [C Ic Io Where O=Historical cost of opening stock C=Historical cost of closing stock Ia=Average index number for the period Io=Index number appropriate to opening stock Ic=Index number appropriate to closing stock


Monetary working capital adjustment (MWCA)

Monetary working capital is usually represented by difference between trade debtors and creditors and this adjustment shows the effect of changes in prices arising from volume. For ascertaining current cost operating profit it is necessary to know the effect of changing prices on working capital. Monetary working capital adjustment is calculated by using the following formula:  COSA=(C-O)-Ia [C - O] COSA=(C-O)- [C Ic Io Where O=Opening monetary working capital C= Closing monetary working capital Ia=Average index number for the period Io=Index number appropriate to opening MWC Ic=Index number appropriate to closing MWC


Gearing adjustment


Gearing is the ratio of borrowed capital and shareholders funds. Fixed assets and working capital are partly financed by borrowed capital and partly by shareholders funds. But the amount of borrowed capital to be repaid will not change on account of changing prices because it is fixed by agreement. During inflation the value of assets to business exceeds the amount of borrowings that has financed them. Thus shareholders enjoy an advantage in the period of rising prices because the benefit of increases in prices is fully given to shareholders. Reverse effect is experienced when prices decline. As a result the profit attributable to shareholders would be understated/overstated if the whole of additional depreciation, cost of sales adjustment and monetary working capital adjustment were charged in the profit and loss account. The total of these adjustments is abated by another adjustment known as gearing adjustment.

After gearing adjustment, current cost operating profit will be abated and this abated profit will be attributable to shareholders which will reflect the result of adjustment to the historical cost trading profit. Gearing adjustment is calculated by applying the following formula:  Gearing adjustment=L/(L+S) x A L=Average net borrowing S=Average shareholders funds A=Total of current cost adjustments


Advantages of CCA
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It maintains intact the operative capacity of the enterprise as this method seeks to closely approximate the impact of inflation on enterprise The theory underlying this approach is quite logical and useful for users of accounting information The break up of the assets and liabilities under CCA approach is more accurate and real financial picture of an enterprise will be available as compared to historical cost accounting as CCA figures are with reference to the current prices.

Limitations of CCA
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The valuation of assets and liabilities influenced by discretion and subjective judgement Figures of operating profit and capital employed are not comparable as purchasing powers differ every year Operating profit do not reflect real earnings of the firm and profit may be distributed out of capital Cash flow prediction is difficult as cash flow statement is not subject to CCA approach Accounts will have to be adjusted because of specific price level changes even if there is no changes in the overall price levels The method of valuation is ill defined. No comprehensive body of procedures and integrated approach It is not easily understood Tax authorities may not recognise CCA reforms

Specific and general price level accounting (SGPLA)

 

It combines two approaches-CCA and CPP approachesIt considers both specific and general price levels Values shown in financial statements are based on current costs and are measured in units of purchasing power It is not popular as it is not proposed by any professional or institutional bodies

Periodic revaluation of fixed assets along with the adoption of LIFO method of inventory


In 1938, LIFO method of inventory valuation was permitted for limited class of taxpayers in USA and in 1939 the LIFO privilege was generalised for taxpayers because of price inflation. As a result of this LIFO method of inventory valuation got the world wide general acceptance and is made use of during inflation. The advocates of this method are of the view that periodic revaluation of fixed assets along with the adoption of LIFO method can considerably reduce the effect of increasing prices. The purpose of periodic revaluation of fixed assets is to charge depreciation on current cost of replacement and the objective of following the LIFO method is to charge current cost of goods consumed to Profit and Loss Account.

According to Hendriksen, From an interpretational point of view, the current cost concept appears to be more relevant than the general purchasing power concept. That is, cost restated by the use of specific indices or replaced by current cost measurements are probably closer to current values than are historical cost adjusted for general purchasing power changes.

Advantages of accounting for price level changes

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Accounting adjusted to price level changes correct the malady of providing lesser depreciation Depreciation charged on fixed assets give sufficient fund for replacement of asset True and fair view of financial position is available since assets are shown at current values Matching the cost and revenue at current values give correct picture of profitability Comparison of profitability of two plants can be done correctly as it is done at replacement cost Ratios based on current values provide more meaningful data Return on capital employed calculated to the current price index is more meaningful Employees, shareholders and public are not misled as historical profit may be inflated

Disadvantages of accounting for price level changes

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Charging depreciation on current values is not acceptable to income tax authorities Too many calculation make this method complicated Charging depreciation above the cost of asset is against the concept of depreciation It is a never ending process as price go on changing every day Current valuation of assets is subject to whims and prejudice Profit calculated under this method is not realistic and distribution of unrealised profit may result in erosion of capital In times of deflation lower depreciation leads to higher profits