Inflation Accounting

Inflation Accounting Kamalpreetkaur Assistant professor GCCBA-42, Chandigarh

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 – 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 cash debtors creditors public deposits 01/01/2008 5000 20000 15000 20000 31/12/2008 10000 25000 20000 20000 Consumer Price index numbers are – On 1/1/2008 -- 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 25000are opening and rest 10000 are additions during the year. Value of assets as per CPP = 25000 x 150 / 100 = 37500 Add: + 10000 x 150 / 120 = 12500 50000 Less: Value of assets as per closing B/S - 35000 Resultant monetary Loss 15000

Solution contd…. Impact on Liabilities: Liabilities as on 31/12/2008 = 40000 out of which35000 are opening and rest 5000 are additions during the year. Value of liabilities as per CPP = 35000 x 150 / 100 = 52500 Add =5000 x 150 / 120 = 6250 Total = 52500+6250 =58750 Less: Value of liabilities as per closing B/S =58750- 40000 Resultant monetary gain =18750

Solution contd…. Net monetary Gain = Monetary gain from liabilities 18750 Less: Monetary loss from assets 15000 Net Monetary gain = 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

Cost of sales Adjustment (COSA): COSA represents the difference between value to thebusiness and the historical cost of stock consumed in the period COSA Adjustment = CS – OS – Ia ( CS/Ic – OS/Io)Where:CS means Closing StockOS means Opening StockIa means Average Index for the yearIc means Closing Index for the yearIo 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 WCO means Opening Monetary WCIa means Average Index for the yearIc means Closing Index for the yearIo means Opening Index for the year

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

Inflation Accounting