Inflation AccountingInflation Accounting

Accounting for price level Accounting for price level changeschanges

Limitations of historical AccountingLimitations of historical Accounting

Utility of accounting records seriously impairedUtility of accounting records seriously impaired Unrealistic profitsUnrealistic profits Insufficient provision for depreciationInsufficient provision for depreciation Fixes assets values are unrealisticFixes assets values are unrealistic Different basisDifferent basis Return on capital employed misleadingReturn on capital employed misleading Matching principle violatedMatching principle violated Incorrect ascertainment of operating capacityIncorrect ascertainment of operating capacity Difficulty in comparison of profitability of two Difficulty in comparison of profitability of two

plantsplants Mixing up holding gains and operating gainsMixing up holding gains and operating gains Misleading inter-period and inter-firm comparisonMisleading inter-period and inter-firm comparison

Inflation accountingInflation accounting Accounting for changing prices is also known as Accounting for changing prices is also known as

inflation accounting because changes in prices inflation accounting because changes in prices are usually on the upward sideare usually on the upward side

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

Approaches to inflation AccountingApproaches to inflation Accounting

Current purchasing power accounting Current purchasing power accounting (CPPA)(CPPA)

Current cost accounting (CCA)Current cost accounting (CCA) Specific and general price level Specific and general price level

accounting (SGPLA)accounting (SGPLA) Periodic revaluation of fixed assets Periodic revaluation of fixed assets

along with the adoption of LIFO along with the adoption of LIFO method of inventorymethod of inventory

Current purchasing power Current purchasing power accounting (CPPA)accounting (CPPA)

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

Conversion factor= Conversion factor= Index to which it is convertedIndex to which it is converted Index from which it is convertedIndex from which it is converted

A Company had the following monetary items on Jan 1:A Company had the following monetary items on Jan 1: Rs.Rs. Rs.Rs.DebtorsDebtors 4100041000Bills receivableBills receivable 1000010000Cash Cash 2000020000 7100071000Less:-Less:-Bills payableBills payable 1000010000CreditorsCreditors 2500025000

3500035000Net monetary assetsNet monetary assets 3600036000The transactions affecting monetary items during the year were:The transactions affecting monetary items during the year were:1.1. Sales of Rs.140000 made evenly through out the yearSales of Rs.140000 made evenly through out the year2.2. Purchases of goods of Rs.105000 made evenly during the yearPurchases of goods of Rs.105000 made evenly during the year3.3. Operating expenses of Rs.35000 were incurred evenly throughout Operating expenses of Rs.35000 were incurred evenly throughout

the yearthe year4.4. One machine was sold for Rs.18000 on July 1One machine was sold for Rs.18000 on July 15.5. One machine was purchased for Rs.25000 0n December 31.One machine was purchased for Rs.25000 0n December 31.The general price index was as follows:The general price index was as follows:On January 1On January 1 300300Average for the yearAverage for the year 350350On July 1On July 1 360360On December 31On December 31 400400You are required to compute the general purchasing power, gain or You are required to compute the general purchasing power, gain or

loss, for the year stated in terms of the current year end rupee.loss, for the year stated in terms of the current year end rupee.

Ascertain net monetary result as at Ascertain net monetary result as at 3131stst December,2002 from the data December,2002 from the data given below:given below:

11stst Jan Jan 3131ststDecDecCash at BankCash at Bank 1500015000 2100021000Accounts receivableAccounts receivable 4500045000 5400054000Accounts payableAccounts payable 7500075000 5000050000General price index number:General price index number:11stst January 2002 January 2002 1001003131stst December 2002 December 2002 1251252002 average2002 average 120120

Current Cost Accounting (CCA)Current Cost Accounting (CCA) In this method , historic values of items are not In this method , historic values of items are not

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

Characteristics of CCACharacteristics of CCA1.1. Fixed assets shown at their current valuesFixed assets shown at their current values2.2. Stocks are shown in the balance sheet at the value Stocks are shown in the balance sheet at the value

prevailing on the dateprevailing on the date3.3. For profit computation, depreciation is computed on For profit computation, depreciation is computed on

current valuescurrent values4.4. The difference between current values and the The difference between current values and the

depreciated original cost of fixed assets is transferred to depreciated original cost of fixed assets is transferred to revaluation reserve accountrevaluation reserve account

5.5. The cost of stock consumed during the year is taken at The cost of stock consumed during the year is taken at current value of the stock at the date of consumption current value of the stock at the date of consumption and not at the purchase price of the stock consumedand not at the purchase price of the stock consumed

6.6. Monetary assets and liabilities are not adjusted under Monetary assets and liabilities are not adjusted under this method because they are always recorded at the this method because they are always recorded at the value to the businessvalue to the business

7.7. Under CCA approach accounting profit is divided into Under CCA approach accounting profit is divided into three parts for properly ascertaining the operating three parts for properly ascertaining the operating results. They are a) current operating profit b) Realised results. They are a) current operating profit b) Realised holding gain and c) unrealised holding gainholding gain and c) unrealised holding gain

Realised holding gain:- Excess of Realised holding gain:- Excess of replacement cost over its historical cost of replacement cost over its historical cost of a non-monetary asset on the date of its a non-monetary asset on the date of its salesale

Unrealised holding gain:- Excess of Unrealised holding gain:- Excess of replacement cost over its historical cost of replacement cost over its historical cost of a non-monetary asset on the closing datea non-monetary asset on the closing date

Current operating profit:- Excess of sale Current operating profit:- Excess of sale proceeds of goods and services sold proceeds of goods and services sold during a particular accounting period over during a particular accounting period over the replacement costs of the goods or the replacement costs of the goods or services sold on the dates the sales were services sold on the dates the sales were effected. effected.

Adjustments to be made in CCA Adjustments to be made in CCA methodmethod

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

Depreciation adjustmentDepreciation adjustment The current depreciation charge under CCA The current depreciation charge under CCA

method is obtained by apportioning the average method is obtained by apportioning the average net replacement cost over the expected net replacement cost over the expected remaining useful life of the fixed asset at the remaining useful life of the fixed asset at the beginning of the period. When fixed assets are beginning of the period. When fixed assets are revalued every year, there will be shortfall of revalued every year, there will be shortfall of depreciation known as backlog depreciation depreciation known as backlog depreciation representing the effect of price rise during the representing the effect of price rise during the period.period.

The current year difference should be adjusted in The current year difference should be adjusted in this years depreciation and backlog of previous this years depreciation and backlog of previous years should be adjusted in current cost reserve years should be adjusted in current cost reserve or revaluation surplusor revaluation surplus

Cost of Sales Adjustment Cost of Sales Adjustment This adjustment is made for determining current This adjustment is made for determining current

cost operating profit and represents a difference cost operating profit and represents a difference between value to the business and historical cost between value to the business and historical cost of stock consumed in the period. It is determined of stock consumed in the period. It is determined as given below:as given below:

COSA=(C-O)-Ia [COSA=(C-O)-Ia [CC - - OO]] Ic IoIc IoWhere Where O=Historical cost of opening stockO=Historical cost of opening stockC=Historical cost of closing stockC=Historical cost of closing stockIa=Average index number for the periodIa=Average index number for the periodIo=Index number appropriate to opening stockIo=Index number appropriate to opening stockIc=Index number appropriate to closing stockIc=Index number appropriate to closing stock

Monetary working capital Monetary working capital adjustment (MWCA)adjustment (MWCA)

Monetary working capital is usually represented by Monetary working capital is usually represented by difference between trade debtors and creditors and this difference between trade debtors and creditors and this adjustment shows the effect of changes in prices arising adjustment shows the effect of changes in prices arising from volume. For ascertaining current cost operating profit from volume. For ascertaining current cost operating profit it is necessary to know the effect of changing prices on it is necessary to know the effect of changing prices on working capital. Monetary working capital adjustment is working capital. Monetary working capital adjustment is calculated by using the following formula:calculated by using the following formula:

COSA=(C-O)-Ia [COSA=(C-O)-Ia [CC - - OO]] Ic IoIc IoWhere Where O=Opening monetary working capitalO=Opening monetary working capitalC= Closing monetary working capitalC= Closing monetary working capitalIa=Average index number for the periodIa=Average index number for the periodIo=Index number appropriate to opening MWCIo=Index number appropriate to opening MWCIc=Index number appropriate to closing MWCIc=Index number appropriate to closing MWC

Gearing adjustmentGearing adjustment Gearing is the ratio of borrowed capital and Gearing is the ratio of borrowed capital and

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

After gearing adjustment, current cost After gearing adjustment, current cost operating profit will be abated and operating profit will be abated and this abated profit will be attributable this abated profit will be attributable to shareholders which will reflect the to shareholders which will reflect the result of adjustment to the historical result of adjustment to the historical cost trading profit. Gearing cost trading profit. Gearing adjustment is calculated by applying adjustment is calculated by applying the following formula:the following formula:

Gearing adjustment=L/(L+S) x AGearing adjustment=L/(L+S) x A

L=Average net borrowingL=Average net borrowing

S=Average shareholder’s fundsS=Average shareholder’s funds

A=Total of current cost adjustmentsA=Total of current cost adjustments

Advantages of CCAAdvantages of CCA

1.1. It maintains intact the operative capacity of the It maintains intact the operative capacity of the enterprise as this method seeks to closely enterprise as this method seeks to closely approximate the impact of inflation on approximate the impact of inflation on enterpriseenterprise

2.2. The theory underlying this approach is quite The theory underlying this approach is quite logical and useful for users of accounting logical and useful for users of accounting informationinformation

3.3. The break up of the assets and liabilities under The break up of the assets and liabilities under CCA approach is more accurate and real CCA approach is more accurate and real financial picture of an enterprise will be financial picture of an enterprise will be available as compared to historical cost available as compared to historical cost accounting as CCA figures are with reference to accounting as CCA figures are with reference to the current prices.the current prices.

Limitations of CCALimitations of CCA1.1. The valuation of assets and liabilities influenced by The valuation of assets and liabilities influenced by

discretion and subjective judgementdiscretion and subjective judgement2.2. Figures of operating profit and capital employed are not Figures of operating profit and capital employed are not

comparable as purchasing powers differ every yearcomparable as purchasing powers differ every year3.3. Operating profit do not reflect real earnings of the firm Operating profit do not reflect real earnings of the firm

and profit may be distributed out of capitaland profit may be distributed out of capital4.4. Cash flow prediction is difficult as cash flow statement is Cash flow prediction is difficult as cash flow statement is

not subject to CCA approachnot subject to CCA approach5.5. Accounts will have to be adjusted because of specific Accounts will have to be adjusted because of specific

price level changes even if there is no changes in the price level changes even if there is no changes in the overall price levels overall price levels

6.6. The method of valuation is ill defined. No comprehensive The method of valuation is ill defined. No comprehensive body of procedures and integrated approachbody of procedures and integrated approach

7.7. It is not easily understoodIt is not easily understood8.8. Tax authorities may not recognise CCA reformsTax authorities may not recognise CCA reforms

Specific and general price level Specific and general price level accounting (SGPLA)accounting (SGPLA)

It combines two approaches-CCA and CPPIt combines two approaches-CCA and CPP It considers both specific and general price It considers both specific and general price

levelslevels Values shown in financial statements are Values shown in financial statements are

based on current costs and are measured based on current costs and are measured in units of purchasing powerin units of purchasing power

It is not popular as it is not proposed by It is not popular as it is not proposed by any professional or institutional bodiesany professional or institutional bodies

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

method of inventorymethod of inventory In 1938, LIFO method of inventory valuation was In 1938, LIFO method of inventory valuation was

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

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

Advantages of accounting for price Advantages of accounting for price level changeslevel changes

1.1. Accounting adjusted to price level changes correct the Accounting adjusted to price level changes correct the malady of providing lesser depreciationmalady of providing lesser depreciation

2.2. Depreciation charged on fixed assets give sufficient fund Depreciation charged on fixed assets give sufficient fund for replacement of assetfor replacement of asset

3.3. True and fair view of financial position is available since True and fair view of financial position is available since assets are shown at current valuesassets are shown at current values

4.4. Matching the cost and revenue at current values give Matching the cost and revenue at current values give correct picture of profitabilitycorrect picture of profitability

5.5. Comparison of profitability of two plants can be done Comparison of profitability of two plants can be done correctly as it is done at replacement costcorrectly as it is done at replacement cost

6.6. Ratios based on current values provide more meaningful Ratios based on current values provide more meaningful datadata

7.7. Return on capital employed calculated to the current Return on capital employed calculated to the current price index is more meaningfulprice index is more meaningful

8.8. Employees, shareholders and public are not misled as Employees, shareholders and public are not misled as historical profit may be inflatedhistorical profit may be inflated

Disadvantages of accounting for Disadvantages of accounting for price level changesprice level changes

1.1. Charging depreciation on current values is not acceptable Charging depreciation on current values is not acceptable to income tax authoritiesto income tax authorities

2.2. Too many calculation make this method complicatedToo many calculation make this method complicated3.3. Charging depreciation above the cost of asset is against Charging depreciation above the cost of asset is against

the concept of depreciationthe concept of depreciation4.4. It is a never ending process as price go on changing It is a never ending process as price go on changing

every dayevery day5.5. Current valuation of assets is subject to whims and Current valuation of assets is subject to whims and

prejudiceprejudice6.6. Profit calculated under this method is not realistic and Profit calculated under this method is not realistic and

distribution of unrealised profit may result in erosion of distribution of unrealised profit may result in erosion of capitalcapital

7.7. In times of deflation lower depreciation leads to higher In times of deflation lower depreciation leads to higher profits profits