Inflation Accounting

Topic Covered • Inflation Accounting

Concept of Inflation Accounting: • Inflation normally refers to the increasing trend in general price level. In other words, it is a state in which the purchasing power of money goes down. • Inflation Accounting is a system of accounting which shows the effect of changing costs and prices on affairs of a business unit during an accounting year. • While the cost in the traditional accounting refers to the historical cost, in inflation accounting it represents the cost that prevails at the time of reporting.

Why Inflation Accounting? • In the traditional accounting, assets are shown at historical cost, year after year. • During the inflationary period, historical cost based depreciation would be highly insufficient to replace the existing assets at current cost. Moreover current revenues for the period are not properly matched with the current cost of operation. • Thus, the problems created by price changes in the historical cost based accounts necessitated some method to take care of inflation into the accounting system.

Methods of Inflation Accounting: • Some of the generally accepted methods of Inflation accounting are as follows – (a) Current Purchasing Power Method (CPP Method) (b) Current Cost Accounting Method (CCA Method)

Current Purchasing Power Method OR Constant Rupee Method (CPP Method) • Under CPP method, all items in the financial statements are restated in terms of units of equal purchasing power. • The CPP method basically attempts to remove the distortions in financial statements, which arise due to change in the value of rupee. • CPP method distinguishes between monetary and non-monetary items.

CPP Method

contd……

• Value of asset as per CPP = Historical Cost of Asset x Conversion Factor Conversion Factor = Price Index at the date of conversion Price at the date of transaction

Illustration: • A company purchased a plant on 1/1/2005 for a sum of Rs. 45,000. The consumer price index on that date was 125 and it was 250 at the end of the year. Restate the value of the plant as per CPP method as on 31st December 2005.

Solution: Conversion Factor = Price Index as on 31/12/2005 = 250 = 2 Price Index as on 1/1/2005 125 Value of the plant on 31/12/05 = Historical Cost x Conversion Factor Rs 45,000 x 2 = Rs 90,000

Monetary Vs Non Monetary Items: • Monetary Items (both assets and liabilities) are those items whose amounts are fixed by contracts or otherwise they remain constant in terms of monetary units. Example – debtors, creditors, debentures, Preference share capital etc. • During the period of inflation the holder of monetary assets lose general purchasing power since their claims against the firm remain fixed irrespective of any changes in the general price levels. Conversely, the holder of monetary liabilities gains since he is to pay the same amount due in rupees of lower purchasing power.

Monetary Vs Non Monetary

contd….

• Non monetary items are those items that cannot be stated in fixed monetary amounts. They include tangible assets such as building, plant & machinery, stock etc. • Under CPP method all such items are to be restated to represent the current purchasing power. For example a machinery costing Rs 25,000 in 1996 may sell for Rs 35,000 today though it has been used. This may be due to change in the general price level. • Note : Equity capital is a non monetary item since the equity shareholders have a residual claim on the company’s net assets.

Computation of Monetary gain or loss: • The changes in purchasing power affects both monetary and non monetary items of the financial statements. In case of monetary assets and monetary liabilities, the firm receives or pays the amounts fixed as per the terms of the contract, but it gains or losses in terms of real purchasing power. • Such monetary gain or loss should be computed separately and shown as a separate item in the restated income statement in order to find out the overall profit or loss under CPP method.

Illustration: • From the following data calculate net monetary gain / loss as per CPP method – Item 1/1/2008 31/12/2008 Cash Rs. 5000 Rs 10000 Debtors Rs. 20000 Rs 25000 Creditors Rs. 15000 Rs 20000 Public Deposits Rs. 20000 Rs 20000 Consumer Price index numbers are – On 1//12008 -- 100 On 31/12/2008 -- 150 Average for the year -- 120

Solution : • Impact on Assets: • Assets as on 31/12/2008 = 35000 out of which 25000 are opening and rest 10000 are additions during the year. • Value of assets as per CPP = 25000 x 150 / 100 = + 10000 x 150 / 120 = Less: Value of assets as per closing B/S Resultant monetary Loss

37500 12500 50000 - 35000 15000

Solution

contd….

• Impact on Liabilities: • Liabilities as on 31/12/2008 = 40000 out of which 35000 are opening and rest 5000 are additions during the year. • Value of liabilities as per CPP = 35000 x 150 / 100 = 52500 + 5000 x 150 / 120 = 6250 58750 Less: Value of liabilities as per closing B/S Resultant monetary gain 18750

- 40000

Solution

contd….

• Net monetary Gain = Monetary gain from liabilities Less: Monetary loss from assets Net Monetary gain =

18750 15000 3750

Adjustment for cost of sales and Inventories: • The restatement of the Cost of Sales and inventories under the CPP method, depends upon the method used for accounting for inventories (FIFO or LIFO). • Under FIFO method, the cost of sales normally includes the entire opening stock and current purchases less closing stock. Closing stock comprises latest purchases. • Under LIFO method, the cost of sales normally includes the latest purchases and the closing comprises the earliest purchases.

Illustration: • From the following particulars, ascertain the values of cost of sales and closing stock as per CPP method – • Stock on 1/1/08 • Purchases during 2008 • Stock on 31/12/08 • Price Index on 1/1/2008 • Price Index on 31/12/2008 • Average Price Index for 2008

Rs 20000 Rs 60000 Rs 24000 150 240 180

Solution: Under FIFO Method • • • • • •

Opening Stock Add: Purchases Less: Closing Stock Cost of Goods sold

H.C. 20000 60000 80000 24000 56000

Conver. Factor 240 / 150 240 / 180 240 / 180

CPP Method 32000 80000 112000 32000 80000

Solution: Under LIFO Method • • • • •

Opening Stock Add: Purchases Less: Closing Stock from Opening Stock from Closing stock

Cost of Goods Sold

H.C. 20000 60000 80000

Conver. Factor 240 / 150 240 / 180

20000 4000

240 / 150 240 / 180

56000

CPP Method 32000 80000 112000 32000 5333 74667

Current Cost Accounting Method: • Under the CCA method money remains to be the unit of measurement. • The items of the financial statements are restated in terms of current value of that item and in terms of general purchasing power of the money. • Assets and liabilities are stated at their current value to the business. Similarly, the profits are computed on the basis of current values of the various items to the business. This requires carrying out the following adjustments – • Revaluation adjustment • Depreciation adjustment • Cost of Sales adjustment • Monetary Working Capital adjustment

Revaluation Adjustment : • Fixed Assets Are shown in the balance Sheet at their values to the business. To the business of an asset refers to the opportunity loss to the business of were deprived of such assets. • The replacement cost could be taken as gross or et. • Gross replacement cost of an asset is the cost to be incurred at the time of valuation to obtain a a similar asset for replacement. Net replacement cost of an asset is the gross replacement cost less depreciation.

Illustration: • An asset purchased on 1/1/2005 for Rs 50,000 now costs Rs 80,000 on 31/12/2005 , then the gross replacement cost of the asset is Rs 80,000. • Assuming that the useful life the asset is 5 years, then the net replacement cost = 80,000 – 80000 x 3 / 5 = 32,000.

Depreciation Adjustment: • The profit and loss account should be charged for depreciation with an amount equal to the value of fixed assets consumed during the period. • Depreciation charge may be computed either on the basis of total replacement cost of the asset or on average net current cost of assets. i.e. Current cost at beg. + Current cost at the end / 2

Illustration: • X ltd purchased a machine on 1/1/2002 for Rs 80,000 and its expected life was 10 years without any scrap value. On 1/1/2005 the same new machine would cost Rs 30,000 and on 31/12/2005 Rs 40,000. Calculate the depreciation charge for the year 2005 as per CCA method assuming that there is no change in the useful life of the asset.

Solution: • Depreciation under CCA method = Average replacement cost / useful life = (30,000 + 40,000) / 2 10 = 3500 Alternatively 40,000 / 10 = 4000

Cost of sales Adjustment (COSA): • COSA represents the difference between value to the business and the historical cost of stock consumed in the period • COSA Adjustment = CS – OS – Ia ( CS/Ic – OS/Io) Where: CS means Closing Stock OS means Opening Stock Ia means Average Index for the year Ic means Closing Index for the year Io means Opening Index for the year

Illustration: • Determine the value of COSA Adjustment from the data given below – • Stock on 1/1/2005 Rs 12,000 • Stock on 31/12/2005 Rs 16,000 • Index number on 1/1/2005 160 • Index number on 31/1/2005 200 • Average Index number for the year 190

Solution: • COSA = CS – OS – Ia ( CS/Ic – OS/Io) = (16000 – 12000) – 190 ( 16000/200 – 12000/160) = 4000 -190 (180 – 75) = Rs. 3050

Monetary Working Capital Adjustment (MWCA): • MWCA refers to the excess of accounts receivable and unexpired expenses over accounts payable and accruals. • CCA ensures that the impact of changing prices on working capital is taken care of through MWCA. This adjustment is required only for price level changes and not for any increase in volume of the business. • MWCA = C – O – Ia ( C/Ic – O/Io) Where: C means Closing Monetary WC O means Opening Monetary WC Ia means Average Index for the year Ic means Closing Index for the year Io means Opening Index for the year

Illustration: • From the following information carry out MWCA under the CCA method – Opening Closing Balance Balance Accounts Receivable 18,000 21,000 Accounts Payable 10,000 12,000 Price Index 175 205 Average Pirce Index 190

Solution: • MWCA = C – O – Ia ( C/Ic – O/Io)

• Opening MWC = 18000 – 10000 = 8000 • Closing MWC = 21000 – 12000 = 9000 • MWCA = (9000 - 8000) – 190(9000/205 – 8000/175) = 1000 – 190 ( 43.90 – 45.70) = 1342

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