Current Purchasing Power Accounting (CPPA)

In this article we will discuss about Current Purchasing Power Accounting (CPPA):- 1. Subject Matter of CPPA 2. Methodology of CPPA 3. Balance Sheet 4. Evaluation.

Subject Matter of CPPA:

Current Purchasing Power Accounting (CPPA) is known by different names such as Constant Purchasing Power Accounting (CPPA), General Price Level Accounting (GPLA), Constant Dollar Accounting (in USA), General Purchasing Power Accounting, this method adjusts historical costs for changes in the general level of prices as measured by a general price-level index.

Changes in the general level of prices represent changes in the general purchasing power of the monetary unit. Increases in the general level of prices (inflation) reduce the general purchasing power to purchase goods and services in general; decreases in the general level of prices (deflation) increase the general purchasing power to purchase goods and services in general.

Under CPPA, by restating historical cost financial statements for changes in the general purchasing power, the adjusted financial statements would reflect the original amounts in terms of current purchasing power, which, if spent today, would command the same general purchasing power as the original reported amounts.

Since historical financial statements consist of transactions at various times, such statements contain measurements that represent purchasing powers at various points in time.

CPPA transforms the various historical measures into current purchasing power which represents purchasing power at the same point in time. Thus, CPPA makes all the accounting numbers comparable in terms of general purchasing power by removing the mixed purchasing power element from historical financial statements.

Methodology of CPPA:

To convert the historical cost financial statements, an acceptable general price level index representing the changes in the general purchasing power of the monetary unit (rupee) is needed.

Generally the most broad based consumer goods price index is used. The historical cost figures are multiplied by a conversion factor which is the ratio of the price-level index at the date of conversion and price level index at the transaction date.

A price level index is the ratio of the aver-age price of a group of goods or services at a given date and the average price of a similar group of goods or services at another date, known as the base year, when the price level index is equal to 100. For example, assume that a plant has been purchased on January 1, 2001 for Rs. 60,00,000 when the general price index was 150.

The general price index on January 1, 2006 was 200. The cost of the plant in terms of rupees on January 1, 2006 would be Rs. 80,00,000 (60,00,000 x 200/ 150). Since it is practically difficult to convert each figure in terms of the price-level index of the date of transaction, it is assumed that all transactions take place evenly throughout the year.

Balance Sheet under CPPA:

Monetary and Non-Monetary Items:

The working of CPPA requires that, first of all, balance sheet items should be classified into Monetary Items, and Non-Monetary Items.

I. Monetary Items:

Monetary items are those items which are fixed by contract or otherwise remain fixed irrespective of any change in the general level of price. Monetary items may be monetary assets as well as monetary liabilities. Examples of monetary assets are cash, debtors, bills receivable, etc.

Similarly debentures, creditors etc., are monetary liabilities. Financial Accounting Standards Board of USA designate certain balance sheet items as monetary and the remainder as non-monetary. FASB’s classification of such items is presented in Fig. 12.1: 

It is obvious that in a period of inflation, the holders of cash or other monetary assets lose purchasing power because the cash they have or expect to receive represents amounts of less purchasing power. On the other hand, holders of monetary assets gain purchasing power during a period of deflation.

These relationships are reversed for monetary liabilities. Holders of monetary liabilities gain general purchasing power during a period of inflation because they can repay the amounts due in rupees of lower purchasing power.

However, holders of monetary liabilities lose purchasing power during a period of deflation. For example, suppose a firm has creditors of Rs. 20,000 on January 1, 2008, which are payable on December 31, 2008. It may be argued that the firm’s liability of Rs. 20,000 represents less general purchasing power as on December 31, 2008, as compared to original liability (January 1, 2008) which possesses higher general purchasing power.

Therefore, purchasing power gain arises from holding monetary liabilities during inflationary periods. Conversely, the holders of monetary assets lose in a period of inflation because of loss in general purchasing power, i.e., because a given amount of money could buy fewer goods and services.

For instance, suppose a firm has Rs. 40,000 as cash on hand on January 1, 2008 which remained intact until December 2008. Assume that 10 per cent inflation occurred during the year. This situation implies that the firm would need Rs. 44,000 on December 31, 2008.

The fact that the firm only holds Rs. 40,000 results in a loss of general purchasing power of Rs. 4,000. The same purchasing power loss would also arise from holding accounts receivable or debtors or any claims to a fixed quantity of money since the amount of money expected to be received commands a decreasing amount of general purchasing power during periods of general price level increases.

Calculation of Purchasing Power Gain or Loss on Monetary Items:

The CPPA method suggests the computation of the purchasing power gain or loss made by an enterprise on holding net monetary items. Purchasing Power gain or loss on monetary items can be calculated in two ways. One procedure calculates the purchasing power gain or loss associated with each monetary asset and each monetary liability and then sums up the individual gains and losses to determine the gain or loss.

A second procedure calculates the gain or loss on holding all monetary items as if they were maintained in a single account. Alternatively, under the second procedure, general purchasing power gain or loss can be computed in terms of net monetary assets (monetary assets—monetary liabilities) for which the following procedures may be used.

(i) Compute the net monetary asset position at the beginning of the period. For example, if cash and accounts payable at the beginning of the period are Rs. 50,000 and Rs. 30,000 respectively, the net monetary assets will be Rs. 20,000.

(ii) Restate net monetary asset position at the beginning of the period in terms of the purchasing power at the end of the period. For example, assume the general price-level index was 120 at the beginning of the period and 180 at the end of the period. The net monetary asset position at the beginning of the period, which was Rs. 20,000 would be restated to Rs. 30,000 (Rs. 20,000 x 180/120).

(iii) Restate all the monetary receipts of the year to the year-end basis and add this to the restated net monetary position at the beginning of the period as calculated in (ii). Assume that sales of Rs. 40,000 occurred evenly during the year and the general average price index was 150, the adjusted monetary receipts would be restated to Rs. 48,000 (Rs. 40,000 x 180/150). This result is added to Rs. 30,000 as calculated in (ii) to arrive at a total restated net increase in monetary items of Rs. 78,000.

(iv) Restate all the monetary payments of the year to the year-end basis and deduct the result from the total restated net increase in monetary items as calculated in (iii). Assume that purchases and expenses of Rs. 30,000 also occurred evenly during the year. The adjusted monetary payments would be restated to Rs. 36,000 (Rs. 30,000 x 180/150). This result is deducted from Rs. 78,000 as calculated in (iii) to arrive at the adjusted computed net monetary assets at the end of the period, which is Rs. 42,000

(v) Deduct the actual net monetary assets at the end of the period from the adjusted net monetary asset at the end of the period as found in (iv) to obtain the purchasing power gain/loss. In this example, the net monetary assets at the end of the period is Rs. 30,000 (20,000 + 40,000 – 30,000) and adjusted net monetary assets as found in (iv) is Rs. 42,000. Therefore purchasing power loss on net monetary items is Rs. 12,000,

Treatment of Purchasing Power Gain and Loss:

It has been widely suggested that the purchasing power gain or loss should be included in current income.

Example:

Compute the net monetary result of X Company Ltd. as at 31st December, 2008.

The relevant data are given below:

Purchasing Power gain on monetary items Rs. 8750 – Rs. 5000 = Rs. 3750

Note: The amount of net monetary liabilities as on December 31, 2008 should be Rs. 8750 during inflation. However, such liabilities are only Rs. 5000. Therefore, the company is making purchasing power gain of Rs. 3750.

Alternative Solution:

Purchasing power gain can be computed following another method, as shown below:

Working Notes:

(i) Conversion factors:

For items as on 1st January, 2008: 300/200 = 1-5

For items arising during 2008: 300/240 = 1.25

(ii) Increase in monetary assets/liabilities during 2008:

II. Non-Monetary Items:

All assets and liabilities that lack the properties of monetary items are classified as non­monetary. Non-monetary assets include inventories, building, plant and equipment, and claims to cash in amounts dependent on future prices.

Whereas the holding of monetary items (like cash and accounts receivable) results in purchasing power gain or loss, the mere holding of non­monetary items (like inventory and equipment) does not result in purchasing power gain or loss because they do not represent a fixed amount to be received or paid and thus their prices in terms of the monetary unit may change over time.

While most liabilities are monetary, non­monetary liabilities include equity capital and retained earnings. Non-monetary liabilities do not represent fixed claims to pay cash.

The monetary assets and liabilities at the end of the year will appear at the same amounts, whereas non-monetary items are reported at their adjusted amounts in the CPPA adjusted balance sheet. The restatement of non-monetary items is done by applying the following conversion factor.

For example, assume that a plant was purchased for Rs. 2,00,000 on January 1, 2004 when the general price index was 100. The estimated useful life of the asset was 10 years.

If the general price level index on December 31, 2008 is 150, the adjustments of the plant amount would be as follows:

The adjustment of the owner’s equity, with the exception of retained earnings, is similar to the non-monetary items.

The original invested capital is multiplied by the following conversion factor:

Retained earnings, which cannot be adjusted by a single conversion factor represent net income after dividends accumulated since the business firm was created.

Retained earnings may be restated as follows:

(i) The first time when historical cost financial statements are restated in terms of current general purchasing power, retained earnings may be determined simply as a residual after all other items in the balance sheet have been restated.

(ii) In the following periods, the adjusted end-of-period retained earnings may be determined by (a) net income as reported in the general price-level income statement (including general price-level gains and losses on monetary items), and (b) adjustments resulting from general price-level gains or losses on monetary shareholders equity items.

Profit and Loss Account under CPPA:

In CPPA profit and loss account, adjustments are needed about the following items:

(a) Opening inventory,

(b) Transactions during the year,

(c) Depreciation written off for the year and,

(d) Closing inventory.

The method to be followed for restating historical cost-income statement under CPPA is basically the same as suggested for adjusting other historical amounts in terms of current purchasing power, usually applying the following conversion factor:

For example, for restating opening inventories, opening price level-index is relevant whereas average price index for the year can be used for adjusting transactions occurring evenly throughout the year. Purchases are adjusted using price-level index when the purchases were made.

Alternatively, average price index is used if specific price index relating to the purchases are not available. In order to calculate depreciation under CPPA, first of all, assets are restated in terms of CPPA, and then the depreciation rate is applied on the restated values of assets. Closing inventory is restated using a price level index depending on the cost flow assumption (FIFO, LIFO or average costing) used by a business firm.

Example:

From the following information, find out (i) cost of sales, (ii) closing inventory, under the CPP method assuming the firm is following FIFO method:

Example:

From the following data, calculate cost of the sales and closing inventory under CPP method assuming that the firm is following LIFO method for inventory valuation:

Example:

The following is the balance sheet of ABC Company for the year ending December 31, 2008 and December 31, 2009.

The following additional information is available:

(i) On December 31, 2008 the price-level index was 100. The price-level index as on December 31, 2009 was 180 and the average price index for 2009 had been 120.

(ii) The inventory purchases were made at a date when the price-level index was 150.

(iii) All revenues and costs were incurred evenly throughout the year, with the exception of the cost of goods sold and the depreciation expense.

(iv) LIFO has been assumed.

(v) Depreciation for plant and equipment was accumulated by the straight line method on a five-year life.

Evaluation of CPPA:

CPPA restates historical costs in terms of current purchasing power. This accounting model attempts to stabilise the measuring unit a constant value that prevails on the latest balance sheet date.

CPP does not create a new basis of valuation or profit determination; it merely restates the actual costs that were incurred in currency units of different values into currency units of a constant value, thus making them properly comparable and additive. It, however, has depressive effect on profits. In the long run, total profits shown by CPPA accounts will be smaller than those shown by HCA.

Arguments In Favour of CPPA:

A number of arguments have been advanced in favour of CPPA which are as follows:

(i) Inflation is concerned with changes in the general level of prices, therefore, only CPPA can be regarded as a true form of inflation accounting. Those who consider inflation as an increase in general price-levels and a decline in the purchasing power of the money, favour CPPA as the best approach to inflation accounting.

(ii) As CPPA uses uniform purchasing power as the measuring unit, it possesses the qualities of objectivity and comparability. It has the further advantage of being based on historical costs used in conventional accounting system presently in use. Therefore, it retains all the characteristics of historical cost accounting except for the change in unit of measurement. Also it does not involve the sometimes subjective measurements required by the current value and current cost methods.

(iii) Several authors, e.g., Mathews, Ijiri, Agrawal and Hallbaur, have demonstrated that the adoption of CPPA helps maintain the capital of the entity in terms of its general purchasing power. The accompanying retention of additional resources is accomplished by expensing the inflation-adjusted costs of non-monetary assets and recognising a loss on holding net monetary assets in the computation of distributable income.

(iv) CPPA provides useful information about the comparable impact of inflation across firms. Inflation affects firms differently, depending on the age and composition of their assets and equities. Highly capital intensive firms are likely to report significantly larger depreciation expense under CPPA method than nominal depreciation expense. Highly leveraged firms will report a larger purchasing power gain during periods of increasing prices than firms that use relatively little debt. CPPA reports these differing effects of inflation across firms.

(v) CPPA improves the relevance and measurement of net income as it provides a better matching of revenues and expenses because of a constant and common measuring unit. On the contrary, conventional historical accounting does not measure income properly as a result of the matching of rupees of different size (purchasing power) on the income statement.

Also, a gain or loss under CPPA is explicitly recognised for the changes in the general purchasing power of monetary assets and liabilities held. Income before the purchasing power gain or loss must exceed any loss of purchasing power of monetary assets and equities if the purchasing power of the monetary or financial, capital of the firm is to be maintained.

(vi) CPPA provides relevant information for management evaluation and use. Purchasing power gain and loss resulting from holding monetary items reflect management’s response to inflation. The restated non-monetary items indicate the approximate purchasing power needed to replace the assets.

(vii) CPPA presents to users, in general, the impact of general inflation on profit and provides more realistic return on investment. Financial data adjusted for price-level changes provide a basis for a more intelligent, better informed allocation of resources, whether those resources are in the hands of individuals, business entities or government. Baran, Lakouishok and Offer examined the extent to which GPL data contain information not available in historic cost data.

Information content was defined as the degree of association between the market systematic risk and the accounting data. They found the associations between market betas and GPL adjusted betas were significantly higher than those observed between market and historic cost betas and concluded that “the results obtained in this study appear to support the hypothesis that price-level data contains information which is not included in the financial reports currently provided”.

Arguments against CPPA:

The following arguments have been advanced against CPPA:

(i) CPPA accounts only for changes in the general price-level and does not account for changes in the specific price-level. Since specific price movements are not necessarily synchronized with movements of the general price level index, the restatement in terms of general purchasing power does not reflect the current value of the resources of the firm.

If the general price index has increased, many specific price changes will be running at a lower level than the general index, whilst many others will be running at a higher level. Furthermore, the discrepancies between specific price and general price changes are likely to be even more pronounced when the general price index is based on consumer goods, and the specific price index relates to producer goods, such as those represented by the assets of a typical business enterprise.

Thus, a general price index will not be relevant to any business entity which needs to make adjustments to asset valuations in order to maintain the value of capital in the long run. Gynther finds that there is no such thing as generalized purchasing power.

In fact, the purchasing power of money should be related to those items on which money is intended to be spent. A unit of measurement which relies for its validity on the purchasing power of money assessed by reference to a set of goods and services will not be equally useful to all individuals and entities.

Hendriksen also observes:

“The restatement (to constant dollars) is not intended to represent current values, but merely the historical cost restated for changes in genera] purchasing power. However, interpretation remains difficult because historical cost represents the number of dollars paid for a specific item, but the restated amount does not represent the amount that would have been paid for the item if the current price-level and the current price structure were then known. And since it is not intended to be a surrogate or current value, there is a difficulty in attaching any current market or utility valuation interpretation to it.”

It is apparent, therefore, that this method is not designed to convey current values although users may believe that the restated values correspond to current values.

(ii) Furthermore, there is a problem of choice of an appropriate general price-level index. A general price-level index that is applied must necessarily be a broad measure of purchasing power for a comprehensive market basket of goods. Unfortunately, broad indices arc generally not well suited to specific industries, e.g., individual companies and investors do not buy market baskets but rather have specific spending and investment needs.

Each of these needs is affected differently by inflation and changes in other economic conditions. The application of general indices may be most useful from a standpoint of overall economic evaluation, broad strategic planning and policy making, management, and employee and investor education. But its usefulness is limited for budgeting, investment, and operating decision-making.

Some doubt may be expressed about the accuracy of index numbers prepared by government agencies. It may show a downward bias because there is a desire to report as low a degree of inflation as possible. Therefore, the ability of index numbers to measure what they intend to is doubted.

(iii) CPPA requires the identification and classification of assets and liabilities as monetary or non-monetary. The treatment of monetary items has been a source of criticism under CPPA. Not only is there conceptual disagreement, but there is strong objection to the idea of ‘rewarding’ highly leveraged (indebted) firms with a reported increase in profits based solely on indebtedness.

Many companies feel that CPPA ‘gain on borrowing’ which is added to profit, would lead to the overstatement of their profits in a period of inflation, since the gain to shareholders is a loss to lenders. Also, while there is general agreement on how most items should be classified, some items are subject to different interpretations. Examples are deferred income taxes, preference shares, foreign currency items, and convertible debt.

(iv) The capital maintenance concept of CPPA is a proprietary one, i.e., maintenance of financial capital in real terms in contrast to entity approach to capital maintenance. CPPA does not solve the problem of gradual depletion of operating capital of an enterprise in periods of inflation. The balance sheet prepared on the basis of CPPA does not reflect the current worth of an enterprise.

Users of financial statements are interested in a firm’s ability to maintain its operating capability, in terms of goods and services that it normally purchases. If the general price-level index does not reflect the specific price-level changes of particular goods and services sold by the firm, the restated income statement provides a measure of income that is difficult to interpret, even though it may serve to reduce the ‘paper profit’ resulting in historical cost model in a period of general inflation.

Because of the dubious assumptions underlying the computation of purchasing power gains and losses on holding monetary items, the inclusion of such gains and losses would only produce a more confusing and potentially misleading measure of performance.

(v) Most empirical studies have concluded that general price-level information is not relevant and useful, and there are better ways to disclose the effect of inflation on a specific company, its assets, operations, and its future.

The Sandilands Committee (UK) summarizes its view of CPPA as follows:

“It (CPPA) fails to show the company’s ‘operating profit’, it is potentially misleading in including net gains on monetary items which exist only in terms of current purchasing power units and not in terms of monetary units, and it shows how far the ‘purchasing power’ of a shareholder’s investment has been maintained in a sense which is not useful to him for any practical purpose. If CPPA does not provide useful information for shareholders, from whose point of view it is conceived, it is unlikely to provide useful information for other users of account.”

Solomons comments:

“…Because CPPA retains historical cost as the attribute to be measured, it measures very imperfectly the amount by which an enterprise or its owners are better or worse off at the end of a period compared with the beginning, so that an appearance of maintaining real financial capital may be no more than that appearance.”

Truly speaking, CPPA is pure inflation accounting. It is a logical method of dealing with the effects of inflation when all prices have changed in the same proportion, so that there is no problem of reporting relative or specific price changes. Also, CPPA has been generally favoured when inflation has been at a high rate, so that the rise in the general level of prices has been seen to be large. CPPA offers a relatively simple and objective solution to the problem of accounting for inflation which would appeal to the professional auditors, but which might not satisfy users of accounts in period of significant relative (specific) price changes.

Example:

Sylvia Haywood purchased a tract of land at a cost of Rs. 1,20,000 when the price index was at 90. She anticipated that the land, along a feeder route to an inter-state highway, could be sold later at a profit. Seven years later with the price index at 150, she was offered Rs. 2,35,000 for the tract.

Required:

(i) Adjust the cost of the land to a current price basis by index numbers. Does this amount agree with the current value of the land?

(ii) How much of the gain or loss is a real gain or loss? How much of the difference is attributable to a price level change?

Solution:

(i) Adjusted cost of land = Rs. 1,20,000 x 150/90 = Rs. 2,00,000

Does this adjusted cost agree with the current value of land………….. No.

(ii) Total gain = Rs. 2,35,000 – Rs. 1,20,000 = Rs. 1,15,000

Real gain = Rs. 2,35,000 – Rs. 2,00,000 = Rs. 35,000

Purchasing power gain = Rs. 1,15,000 – Rs. 35,000 = Rs. 80,000 or, Rs. 2,00,000 – Rs. 1,20,000 = Rs. 80,000