Accounting for Price Level Changes | Accounting

The following are the generally accepted methods of accounting for price level changes:-  1. Current Purchasing Power Method (or) General Purchasing Power Method (CPP or GPP Method) 2. Current Cost Accounting Method (CCA Method).

Method # 1 Current Purchasing Power Method (CPP):

Institute of Chartered Accountants in England and Wales recommended that changes in the price level should be reflected in the financial statements through the current purchasing power method (CPP). For measuring changes in the price level and incorporating the changes in the financial statements we use index numbers, which may be considered to be a barometer meant for the purpose.

Under this method any established and approved general price index is used to convert the values of various items in the Balance Sheet and Profit and Loss Account. This method takes into consideration the changes in the value of items as a result of the general price level, but it does not account for changes in the value of individual items.

For example, a particular machine may have become cheaper over the last few years, whereas the general price level may have risen; the value of the machine will also be raised in accordance with general price index. Thus general price level adjustment restates financial data by bringing past rupee amounts in line to current rupee purchasing power by general index multiplier.

The preparation of the financial statements according to CPP method, needs understanding of the following steps:

(i) Conversion Factor

CPP method involves the restatement of historical figures at current purchasing power.

For this purpose, historical figures must be multiplied by conversion factors and the formula for the calculation of conversion factor is:

 

Illustration 1:

A Company purchased a machine on 1.1.2004 for Rs. 60,000. The retail price index on that date stood at 150. You are required to restate the value of the machine according to CPP method on 31.12.2004 when the price index stood at 200.

(ii) Mid-Period Conversion:

In case of transactions occurring throughout a period, it will be advisable to convert them according to the average index of the period. Such transactions generally include revenue items such as sales and purchases of goods, payment of expenses etc. In case the information regarding average index is not available, it may be calculated by taking the average of the index numbers at the beginning and at the end of the period.

(iii) Monetary and Non-Monetary Items:

Monetary items are those assets and liabilities the amount of which are fixed by contract or otherwise, and expressed in units of money, regardless of changes in general price level. These cover cash, bank, bills receivable, bills payable, debtors, creditors, outstanding expenses, pre-paid expenses etc., represent specific monetary claim which is receivable or payable in specified number of rupees regardless of price level changes.

For example, a person lends to a company a sum of Rs. 10,000 on 1st Jan. 2004 and payable on 31st Dec. 2004. The price index on 1st Jan. 2004 was 100 while it is 150 on 31st Dec. 2004. If the creditor is to be compensated for loss in purchasing power on account of increase in the price level, he should be paid Rs 15,000 Rs. 10,000 x 150/100). However, he will be paid as per contract only a sum of Rs. 10,000.

Similarly the company is gaining Rs. 5,000 while the lender is losing Rs. 5,000. Monetary items need no conversion since they are already stated in current rupees at the end of the period to which the accounts relate.

Contrary to monetary items, non-monetary items denote such assets and liabilities that do not represent specific monetary claims and include land, buildings, machinery, investments, stocks, etc. For example, a land costing Rs. 50,000 in 1998 may sell for Rs. 1, 00,000 in 2000. This is due to change in the general price level. The non-monetary items do not carry a fixed value like monetary items. Therefore, under CPP method, all such items are to be restated to represent current general purchasing power.

Monetary assets lose their value during a period of inflation since they are expressed in fixed monetary value: similarly, there is a gain in holding monetary liabilities. Accordingly, the loss by holding monetary assets is offset to a little extent by the gain on monetary liabilities. The difference between the loss and gain indicates the extent to which the concern is exposed to inflation.

Illustration 2:

Compute the net monetary result of X Company Ltd. as at 31st December 2004.

The relevant data are given below:

 

(iv) Cost of Sales and Inventories:

Cost of sales and inventory value vary according to cost flow assumptions, i.e., FIFO or LIFO. Under FIFO method cost of sales comprise the entire opening stock and current purchases less closing stock. And closing stock is entirely from current purchases.

Under LIFO method cost of sale comprise current purchases only. However, if the current purchases are less than cost of sales, a part of the opening inventory may also become a part of cost of sales. And closing stock comprises purchases made in the previous year.

The following indices are used Under CPP method for restating the historical figures:

(i) For current purchases: Average index of the year.

(ii) For opening stock: Index at the beginning of the year.

(iii) For purchases of the previous year: Average indices for the year.

Illustration 3:

From the following data calculate (a) cost of sales and cost of inventory under CPP method presuming that the firm is following LIFO method for inventory valuation:

Determination of Profit:

Under Current Purchasing Power Method, the profit can be determined in two ways:

(i) Net Change Method:

This method is based on the normal accounting principle that profit is the change in equity during an accounting period.

In order to determine this change the following steps are taken:

(a) Opening Balance Sheet prepared under historical cost accounting method is converted into CPP terms as at the end of the year. This is done by application of proper conversion factors to both monetary as well as non-monetary items. Equity share capital is also converted. The difference in the balance sheet is taken as reserves. Alternatively, the equity share capital may not be converted and the difference in balance sheet be taken as equity.

(b) Closing Balance Sheet prepared under historical cost accounting is also converted. The difference between the two sides of the balance sheet is put as reserves after converting the equity capital. Alternatively, the equity capital may not be restated in CPP terms and the balance be taken as equity.

(c) Profit is equivalent to net change in reserves (where equity capital has also been converted) or net change in equity (where equity capital has not been restated).

(ii) Conversion or Restatement of Income Statement Method:

In case of this method, the income statement prepared on historical cost basis is restated in CPP terms, generally on the basis:

(a) Sales and operating expenses are converted at the average rate applicable for the year.

(b) Cost of sales is converted as per cost flow assumption (FIFO or LIFO) as explained in the preceding pages.

(c) Fixed assets are converted on the basis of the indices prevailing on the dates they were purchased. The same applies to depreciation.

(d) Taxes and dividends paid are converted on the basis of indices that were prevalent on the dates they were paid.

(e) Gain or loss on account of monetary items should be calculated and stated separately in Restated Income Statement to arrive at the overall figure of profit or loss.

Illustration 4:

Following is the comparative Balance Sheet of a Company as on 31st December 2003 and 2004:

Method # 2 Current Cost Accounting Method:

The current cost accounting method is an alternative to the current purchasing power method. Price changes may be general or specific. Changes in the general level of prices which occur as a result of a change in the value of the monetary unit are measured by index numbers. Specific price changes occur if prices of a particular asset held change without any general price movements.

Under this method, assets are valued at current cost. Current cost is the cost at which the assets can be replaced as on a date. While the current purchasing power method is known as the general price level approach, the current cost accounting method is known as the specific price level approach or replacement cost accounting.

This method has been suggested by the Sandilands Committee of U.K. The Sandilands Committee published its report in September 1975 recommending the adoption of current cost accounting for dealing with the problem of inflation accounting. 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. Thus items are not adjusted as a result of the change in the general price level as they are adjusted in the CPP method.

 

Features of CCA System:

The following are the important features of the CCA Method:

(a) Fixed Assets are to be shown in the Balance Sheet at their value to the business and not at historical cost as reduced by depreciation. That is assets are shown in terms of what such assets would currently cost.

(b) Similarly, inventories are shown in the Balance Sheet at their value prevailing on the date of the Balance Sheet. These are not shown at cost or market price whichever is lower, as in case of historical accounting.

(c) Depreciation is to be computed on the current value of fixed assets.

(d) The cost of goods sold during the year has to be ascertained on the basis of prices prevailing at the date of consumption and not at the date of purchase.

(e) The difference between the current values and the depreciated original cost of fixed assets and of stocks, the increased requirements for monetary working capital and the under provision of depreciation in the past years may be adjusted through Revaluation Reserve Account.

(f) The fixed assets are shown at their “value to the business”. The “value to the business” can be defined in one of the following three ways:

(i) Replacement cost is the estimated cost of acquiring new asset of the same productive capacity at current prices adjusted for estimated depreciation since acquisition.

(ii) Net Realisable value is the estimated selling price in the ordinary course of business less reasonably predictable costs of completion and disposal.

(iii) Economic Value is the sum of the discounted future cash flows expected from the use of an asset during its useful life.

Current Cost Operating Profit:

Three main adjustments to trading account, calculated on the historical cost basis before interest, are required to arrive at current cost operating profit. These are called the Depreciation Adjustment, Cost of Sales Adjustment and Monetary Working Capital Adjustments.

Depreciation Adjustment:

The depreciation adjustment allows for the impact of price changes when determining the charge against revenue for the part of fixed assets consumed in the period. It is the difference between the value to the business of part of fixed assets consumed during the accounting period and the amount of depreciation charged on historical cost basis. The resulting total depreciation charge thus represents the value to the business of the part of fixed assets consumed in earning the revenue of the period.

Illustration 5:

A plant was purchased on 1st Jan. 2000 for Rs. 2, 00,000 and is depreciated at 10% p.a. on straight line basis. By the end of 2004, the price of the same went up to Rs. 4, 00,000. Show how the plant account would appear in the Balance Sheet as at 31st Dec. 2004.

The increase in the value i.e. Rs. 2,00,000 less increased depreciation i.e. Rs. 1,00,000 Rs. 1,00,000 would be shown on the liability side of the Balance Sheet as Current Cost Reserve.

Cost of Sales Adjustment:

The important principle to be remembered is that current costs must be matched with current revenues. As far as sales are concerned, it needs no adjustment as it is a current revenue. One of the features of current cost accounting is to show inventories in the Balance Sheet on the basis of their value to the business, and not at cost or market price, whichever is lower. If there are stocks, certain adjustments are to be made to cost of sales. If there are no stocks, then cost of sales will comprise only current purchases and cost of sales adjustment is not necessary.

Illustration 6:

From the following information calculate the Cost of Sales under Historical and Current Cost Accounting System:

The increase in stock of Rs 3,000 in CCA method over Historical Cost basis will be credited to Current Cost Account Reserve. The closing stock in Balance Sheet will be shown at Rs. 9,000. The cost of Sales Adjustment amounting to Rs. 8,000 (Rs. 32,000 – Rs. 24,000) will be charged to Profit and Loss Account and credited to Current Cost Accounting Reserve.

Monetary Working Capital Adjustment:

Most businesses have other working capital besides stock involved in their day-to-day operating activities. For example, when sales are made on credit the business has funds tied up in debtors. Conversely, if the suppliers of goods and services allow a period of credit, the amount of funds needed to support working capital is reduced. This monetary working capital is an integral part of the net operating assets of the business.

Thus, the standard provides for an adjustment in respect of monetary working capital when determining current cost operating profit. This adjustment should represent the amount of additional (or reduced) finance needed for monetary working capital as a result of changes in the input prices of goods and services used and financed by the business.

In a business which holds stocks, the monetary working capital adjustment (MWCA) complements the COSA and together they allow for the impact of price changes on the total amount of working capital used by the business in its day-to-day operations.

For example, the relationship between the MWCA made in respect of trade debtors and trade creditors and the COSA is as follows:

(a) When sales are made on credit the business has to finance the changes in its input prices until the sale results in a receipt of cash. The part of the MWCA related to trade debtors, in effect, extends the COSA to allow for this; and

(b) Conversely, when materials and services are purchased from suppliers who offer trade credit, price changes are financed by the supplier during the credit period. To this extent extra funds do not have to be found by the business and this reduces the need for a COSA and in some cases for a MWCA on debtors. The part of the MWCA related to trade creditors reflects this reduction.

Gearing Adjustment:

The net operating assets shown in the Balance Sheet have usually been financed partly by borrowing and the effect of this is reflected by means of a gearing adjustment in arriving at current cost profit attributable to shareholders. No gearing adjustment arises where a company is wholly financed by shareholders’ capital.

While repayment rights on borrowing are normally fixed in monetary amount, the proportion of net operating assets so financed increases or decreases in value to the business. Thus, when these assets have been realized, either by sale or use in the business, repayment of borrowing could be made so long as the proceeds are not less than the historical cost of those assets.

Illustration 7:

From the data given below calculate the gearing adjustment required under CCA method: