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Topic Covered

• Inflation Accounting
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 –

(a) 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 1/1/2008 31/12/2008
Cash Rs. 5000 Rs 10000
Debtors Rs. 20000 Rs 25000
Creditors Rs. 15000 Rs 20000
Public Deposits Rs. 20000 Rs 20000

Consumer Price index numbers are –


On 1//12008 -- 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 25000


are 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
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 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 = 6250
58750
Less: Value of liabilities as per closing B/S - 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.
Illustration:
• From the following particulars, ascertain the values of
cost 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
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
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


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 terms


of current value of that item and in terms of general
purchasing power of the money.

• Assets and liabilities are stated at their current value to the


business. Similarly, the profits are computed on the basis
of current values of the various items to the business. This
requires carrying out the following adjustments –
• Revaluation adjustment
• Depreciation adjustment
• Cost of Sales adjustment
• Monetary Working Capital adjustment
Revaluation Adjustment :
• Fixed Assets Are shown in the balance Sheet at
their values to the business. To the business of
an asset refers to the opportunity loss to the
business of were deprived of such assets.
• The replacement cost could be taken as gross or
et.
• Gross replacement cost of an asset is the cost to
be incurred at the time of valuation to obtain a a
similar asset for replacement. Net replacement
cost of an asset is the gross replacement cost
less depreciation.
Illustration:
• An asset purchased on 1/1/2005 for Rs
50,000 now costs Rs 80,000 on
31/12/2005 , then the gross replacement
cost of the asset is Rs 80,000.

• Assuming that the useful life the asset is 5


years, then the net replacement cost =
80,000 – 80000 x 3 / 5 = 32,000.
Depreciation Adjustment:
• The profit and loss account should be charged
for depreciation with an amount equal to the
value of fixed assets consumed during the
period.

• Depreciation charge may be computed either on


the basis of total replacement cost of the asset
or on average net current cost of assets. i.e.
Current cost at beg. + Current cost at the end / 2
Illustration:
• X ltd purchased a machine on 1/1/2002 for Rs
80,000 and its expected life was 10 years
without any scrap value. On 1/1/2005 the same
new machine would cost Rs 30,000 and on
31/12/2005 Rs 40,000.
Calculate the depreciation charge for the year
2005 as per CCA method assuming that there is
no change in the useful life of the asset.
Solution:
• Depreciation under CCA method =
Average replacement cost / useful life

= (30,000 + 40,000) / 2
10
= 3500
Alternatively 40,000 / 10 = 4000
Cost of sales Adjustment (COSA):
• COSA represents the difference between value to the
business and the historical cost of stock consumed in the
period
• COSA Adjustment =
CS – OS – Ia ( CS/Ic – OS/Io)
Where:
CS means Closing Stock
OS means Opening Stock
Ia means Average Index for the year
Ic means Closing Index for the year
Io 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 WC
O means Opening Monetary WC
Ia means Average Index for the year
Ic means Closing Index for the year
Io means Opening Index for the year
Illustration:
• From the following information carry out MWCA
under the CCA method –
Opening Closing
Balance Balance
Accounts Receivable 18,000 21,000
Accounts Payable 10,000 12,000
Price Index 175 205
Average Pirce 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
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