rajneesh karloopia 11010940

8/3/2019 Rajneesh Karloopia 11010940

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Inflation Accounting

By : Rajneesh Karloopia

11010940

Q4001


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Inflation

INFLATION is the erosion or reduction inthe value of money. Simply stated whatone can buy for Rs.100 cannot buy the

same thing for Rs.100 after some time.

For e.g a pao was Rs.5/- some timebackbut the same pao is around Rs.10/-

today


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Concept of Inflation Accounting:

Inflation normally refers to the increasing trend ingeneral price level. In other words, it is a state inwhich the purchasing power of money goes down.

Inflation Accounting is a system of accountingwhich shows the effect of changing costs andprices on affairs of a business unit during anaccounting year.

While the cost in the traditional accounting refers tothe historical cost, in inflation accounting itrepresents the cost that prevails at the time of

reporting.


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Why Inflation Accounting? In the traditional accounting, assets are shown at

historical cost, year after year.

During the inflationary period, historical cost baseddepreciation would be highly insufficient to replacethe existing assets at current cost. Moreover currentrevenues for the period are not properly matchedwith the current cost of operation.

Thus, the problems created by price changes in thehistorical cost based accounts necessitated somemethod to take care of inflation into the accounting

system.


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Objectives of Inflation Accounting

The user or the decision maker gets an information which shows thePerformance

To facilitate the comparison of the performance of two different periodsit is necessary that the figures are adjusted for inflation.

The monetary items and income and expenses do not show the correctPurchasing power of money. Therefore their values should be adjusted

for inflation.

To ascertain the current value of assets.


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Methods of Inflation Accounting:

Some of the generally accepted methods of Inflationaccounting are as follows

(a) Current Purchasing Power Method (CPP Method)

(b) Current Cost Accounting Method (CCA Method)


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Current Purchasing Power Method ORConstant Rupee Method (CPP Method)

Under CPP method, all items in the financialstatements are restated in terms of units ofequal purchasing power.

The CPP method basically attempts toremove the distortions in financial statements,

which arise due to change in the value ofrupee.

CPP method distinguishes between

monetary and non-monetary items.


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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


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Illustration:

A company purchased a plant on 1/1/2005 for a sum ofRs. 45,000. The consumer price index on that date was125 and it was 250 at the end of the year. Restate thevalue of the plant as per CPP method as on 31st

December 2005.


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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


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Monetary Vs Non Monetary Items: Monetary Items (both assets and liabilities) are

those items whose amounts are fixed by contractsor otherwise they remain constant in terms ofmonetary units. Example debtors, creditors,debentures, Preference share capital etc.

During the period of inflation the holder of monetaryassets lose general purchasing power since theirclaims against the firm remain fixed irrespective of

any changes in the general price levels.Conversely, the holder of monetary liabilities gainssince he is to pay the same amount due in rupeesof lower purchasing power.


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Monetary Vs Non Monetary contd.

Non monetary items are those items that cannot

be stated in fixed monetary amounts. Theyinclude tangible assets such as building, plant &machinery, stock etc.

Under CPP method all such items are to berestated to represent the current purchasingpower. For example a machinery costing Rs25,000 in 1996 may sell for Rs 35,000 todaythough it has been used. This may be due to

change in the general price level.

Note : Equity capital is a non monetary item sincethe equity shareholders have a residual claim on

the companys net assets.


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Computation of Monetary gain or loss:

The changes in purchasing power affects both

monetary and non monetary items of the financialstatements. In case of monetary assets andmonetary 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 purchasingpower.

Such monetary gain or loss should be computedseparately and shown as a separate item in therestated income statement in order to find out theoverall profit or loss under CPP method.


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Illustration:

From the following data calculate net monetary gain /loss as per CPP method

Item 1/1/2008 31/12/2008Cash Rs. 5000 Rs 10000

Debtors Rs. 20000 Rs 25000Creditors Rs. 15000 Rs 20000Public Deposits Rs. 20000 Rs 20000

Consumer Price index numbers areOn 1//12008 -- 100On 31/12/2008 -- 150Average for the year -- 120


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Solution :

Impact on Assets:

Assets as on 31/12/2008 = 35000 out of which 25000are opening and rest 10000 are additions during the

year.

Value of assets as per CPP =25000 x 150 / 100 = 37500

+ 10000 x 150 / 120 = 12500

50000Less: Value of assets as per closing B/S - 35000Resultant monetary Loss 15000


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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 = 625058750

Less: Value of liabilities as per closing B/S - 40000

Resultant monetary gain 18750


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Solution contd.

Net monetary Gain =

Monetary gain from liabilities 18750

Less: Monetary loss from assets 15000Net Monetary gain = 3750


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Adjustment for cost of sales and Inventories:

The restatement of the Cost of Sales and

inventories under the CPP method, depends uponthe method used for accounting for inventories(FIFO or LIFO).

Under FIFO method, the cost of sales normallyincludes the entire opening stock and currentpurchases less closing stock. Closing stockcomprises latest purchases.

Under LIFO method, the cost of sales normallyincludes the latest purchases and the closingcomprises the earliest purchases.


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Illustration:

From the following particulars, ascertain the values ofcost of sales and closing stock as per CPP method

Stock on 1/1/08 Rs 20000

Purchases during 2008 Rs 60000

Stock on 31/12/08 Rs 24000

Price Index on 1/1/2008 150

Price Index on 31/12/2008 240

Average Price Index for 2008 180


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Solution: Under FIFO Method

H.C. Conver. Factor CPP Method

Opening Stock 20000 240 / 150 32000

Add: Purchases 60000 240 / 180 80000

80000 112000

Less: Closing Stock 24000 240 / 180 32000

Cost of Goods sold 56000 80000


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Solution: Under LIFO Method

H.C. Conver. Factor CPP Method

Opening Stock 20000 240 / 150 32000

Add: Purchases 60000 240 / 180 80000

80000 112000

Less: Closing Stock

from Opening Stock 20000 240 / 150 32000

from Closing stock 4000 240 / 180 5333

Cost of Goods Sold 56000 74667


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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 termsof current value of that item and in terms of generalpurchasing power of the money.

Assets and liabilities are stated at their current value to thebusiness. Similarly, the profits are computed on the basisof current values of the various items to the business. Thisrequires carrying out the following adjustments

Revaluation adjustment Depreciation adjustment Cost of Sales adjustment Monetary Working Capital adjustment


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Revaluation Adjustment :

Fixed Assets Are shown in the balance Sheet attheir values to the business. To the business ofan asset refers to the opportunity loss to thebusiness of were deprived of such assets.

The replacement cost could be taken as gross oret.

Gross replacement cost of an asset is the cost to

be incurred at the time of valuation to obtain a asimilar asset for replacement. Net replacementcost of an asset is the gross replacement costless depreciation.


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Illustration:

An asset purchased on 1/1/2005 for Rs50,000 now costs Rs 80,000 on31/12/2005 , then the gross replacement

cost of the asset is Rs 80,000.

Assuming that the useful life the asset is 5years, then the net replacement cost =80,000 80000 x 3 / 5 = 32,000.


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Depreciation Adjustment:

The profit and loss account should be chargedfor depreciation with an amount equal to thevalue of fixed assets consumed during the

period.

Depreciation charge may be computed either onthe basis of total replacement cost of the assetor on average net current cost of assets. i.e.

Current cost at beg. + Current cost at the end / 2


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Illustration:

X ltd purchased a machine on 1/1/2002 for Rs80,000 and its expected life was 10 yearswithout any scrap value. On 1/1/2005 the same

new machine would cost Rs 30,000 and on31/12/2005 Rs 40,000.

Calculate the depreciation charge for the year2005 as per CCA method assuming that there is

no change in the useful life of the asset.


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Solution:

Depreciation under CCA method =

Average replacement cost / useful life

= (30,000 + 40,000) / 2

10

= 3500Alternatively 40,000 / 10 = 4000


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Cost of sales Adjustment (COSA):

COSA represents the difference between value to thebusiness and the historical cost of stock consumed in theperiod

COSA Adjustment =

CS OS Ia ( CS/Ic OS/Io)Where:

CS means Closing Stock

OS means Opening Stock

Ia means Average Index for the yearIc means Closing Index for the year

Io means Opening Index for the year


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Illustration:

Determine the value of COSA Adjustment fromthe 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


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Solution:

COSA = CS OS Ia ( CS/Ic OS/Io)

= (16000 12000) 190 ( 16000/200 12000/160)

= 4000 -190 (180 75)

= Rs. 3050


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Monetary Working Capital Adjustment (MWCA):

MWCA refers to the excess of accounts receivable andunexpired expenses over accounts payable and accruals.

CCA ensures that the impact of changing prices on workingcapital is taken care of through MWCA. This adjustment isrequired only for price level changes and not for any increasein volume of the business.

MWCA = C O Ia ( C/Ic O/Io)Where:

C means Closing Monetary WCO means Opening Monetary WCIa means Average Index for the yearIc means Closing Index for the yearIo means Opening Index for the year


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Illustration:

From the following information carry out MWCAunder the CCA method

Opening Closing

Balance BalanceAccounts Receivable 18,000 21,000

Accounts Payable 10,000 12,000

Price Index 175 205Average Pirce Index 190


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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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Thank You

&

Have a nice Day

rajneesh karloopia 11010940

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