Chapter One: Inflation Accounting
1.1 Nature of Inflation
Chapter 1
Inflation Accounting
1 the general price level.
 Experience shows that the prices have not
remained stable of period of time. Prices
have been changing.
 The changes may be inflationary (increase
price) or deflationary (decrease price). In
recent years inflationary tendencies have
been dominating economics of all countries
in the world.
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 Inflation is persistent rise in general price level. A
one-time level of prices is not inflation.
 Only sustained increase in general price level is
considered to be inflation.
 Inflation is important to consider when discussing
the stability of a country economy usually
countries that experience highly-variable rates of
inflation are not considered to have a stable
economy. In contrast deflation is continuous fall in
2
 Accounting for price level changes may deal
with inflationary or deflationary situation.
Since in increase in price level is dominating
the world, this unit is concerned with inflation
accounting.
 inflation accounting is system maintaining accounts
just like historical accounting the difference between
the processes of matching cost against revenue in an
inflation accounting.
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 Chapter One: Inflation Accounting

 In historical accounting represents historical  Inflation accounting a range of accounting

cost whereas in inflation accounting it system designed to correct the problems
represents the cost prevailing at the arising from the historical cost accounts in
reporting date or time. the presence of inflation is solution to this
problem.
 This type of accounting is used in countries
experiencing high inflation or hyperinflation.

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1.2 Historical Cost Accounting

 The distinct features of inflation accounting  This section focuses on the theory of
are: historical cost as it relates to the convention
• the recording procedure is automatic and practices that have been adopted by
accounting over several years.
• the unit measurement is not assumed
 Therefore, financial statement which are
to be stable. prepared according to the conventional
(Historical Cost) accounting do not reflect
current economic realities.
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 Chapter One: Inflation Accounting
 In historical cost accounting accounts are
prepared without considering changes in the
price levels.
 The assets are shown at the values they
were purchased less any depreciation are
recorded at the prices at which they were
purchased
9 • Mixes holding and operating gains
1.4 Effects of Inflation of
Financial Statement
 During the period of rising prices, a net
monetary asset position result in loss in
purchasing power and conversely a net
monetary liability position result in an
increase in purchasing power.
 As price have recently increased financial
institutions experienced a decline in the
purchased power of their net assets.
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1.3 Limitations of Historical
Cost Accounting
 Accounting to conventional or historical
cost accounting, the income statement and
balance sheet are subject to criticism by
accountants, investors, financial analysts,
etc. the following reasons were indicated:
• Financial statement fail to disclose current
worth of the enterprise.
• Creates problems at the time of replacement
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 In most countries primary financial
statement are prepared on the historical cost
basis of accounting without regard either to
changes in the general level of prices.
 A General Price level changed financial
reporting creates distortions in financial
statement such as,
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 Chapter One: Inflation Accounting
 many of historical numbers appearing on
financial statement are not economically
relevant.
 Reported profits may exceed the earning that
could be distributed to shareholder comparing
the company’s ongoing operations.
 The asset values for inventory, equipment and
plant do not reflect their economic value to
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the business
1.5 Methods of Accounting for
Changing Prices
 The previous section explained the nature of
inflation accounting and limitation of
historical financial statement. This section
is concerned with current purchased power
methods of inflation accounting
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 Future earning are not easily projected from
historical earnings
 The impact of the price changes on the monetary
assets and liability is not clear.
 Future capital needs are difficult for forecast any
may lead to increase leverage which increases the
risk is the business when real economic
performance is distorted these distortion lead to
social political consequences that damage business
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1.5.1. Current Purchasing Power
(CPP) Method
 According to current purchasing power method all
items in the financial statement are to be restated for
changes in the general price level.
 For this purchase the price index is used to convert the
various items of balance sheet and income statement.
 Under the CPP method, only the changes in general
purchased power money is taken into account. It does
not consider the changes in the value of individual
asset. A particular asset may have become cheaper over
the last few years, whereas the general price index may
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have risen.
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 Chapter One: Inflation Accounting
1.5.1. Current Purchasing
Power (CPP) Method
 Example an asset purchased with $ 10,000 in
2000 when general price index was 200. what
will be the current purchase power in 2005 if
the current price index is 280?
Solution
$ 10,000x 280
200
=$10,000x1.4
=$14,000
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Steps in the preparation of financial
statement under CPP method
The following steps can be used
I. Determine the Conversion Factor:
CPP method requires the restatement of
historical figures as disclosed in the
financial statement at current purchased
prices. This requires the determination of
convertion factor,
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 Under the CPP method, only the changes in
general purchased power money is taken
into account.
 It does not consider the changes in the value
of individual asset.
 A particular asset may have become
cheaper over the last few years, whereas the
general price index may have risen.
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 Under CPP method the retail price index is
considered to be appropriate price index
 To illustrate assume that the firm purchased
equipment on January 1, 2000 for $. 40,000
when the price was 120. Assume that you
are on December 31, 2005 when the retail
price index stood at 180. Conversion factor
is computer as follows
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 Chapter One: Inflation Accounting

II.Determine Converted Value

 According to CPP method, the value of
equipment on December 31, 2005 is
Conversion factor =180/120 determined as:
converted value = (Existing value)(conversion factor)
=1.5
 Alternatively,the converted value of
So the conversion factor is 1.50 and will be
equipment is determined as follows
used to calculate Current Value

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converted value =$40,000 X 1.50  The difference between the existing value
=$60,000 and converted value is determined as:
Alternatively Difference = Existing value X(conversion
converted value =$ 40,000 X 180 factor-1)
120 Difference =$40,000 (1.50-1)
There for converted value is $60,000 =$40,000 (0.50)
=$20,000
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 Chapter One: Inflation Accounting
1.6 Monitory and Non-monitory Items
 When historical figures are converted under
CPP method, a distinction is to be made
monitory and non-monitory items.
I. Monetary Items
 These are items whose amounts are fixed by
contract in terms of monetary units
regardless of changes in general price level.
Examples of monetary items include:
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To illustrate assume that Mr. Abebe Feyissa lends $
3000 to Mr. Bekele Deyassa on January 1, 1997
when the general price index is 120. The contract
between two stares that Mr. Bekele will reply the
loan on December 31, 1997. from the above
description, the general price level has increased
from 120 to 180. Mr. Abebe is the creditor and
Mr. Bekele is the debtor. The value of Mr. Abebi’s
money on December 31, 1997 is $ 4500 (i.e.
3000X180/120 =4500).
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• Cash
• Receivables
• Payables
• Loan capital
• Outstanding expenses etc.
 Monitory item include both monitory assets
and monitory liabilities. During period of
inflation,
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 However according to their agreement, Mr.
Bekele is to return $3000 on December 31,
1997 to Mr. Abebe. This implies that Mr.
Abebe (the lender) is the loser. His lose will
be $ 1500 (i.e. 4500-3000 =1500). On the
other hand, Mr. Bekele will gain $ 1500.
That is why it is indicated earlier that holder
of monetary liabilities gain during inflation.
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 Chapter One: Inflation Accounting
II. Non-Monetary Items
 Non-monetary items are those that cannot be
stated in fixed monetary amounts. They
include tangible items such as buildings,
machines, inventories of material or finished
goods. Under CPP method, all non-monetary
items should be restated to present current
general purchasing power. In addition to
tangible items, non-monetary items include
investments in bonds or debentures, and stock.29
 Under the CPP method, this gain or loss
should be taken into account and presented
in the income statement as a separate item
arrive at overall profit or loss.
 Note: holders of monetary liabilities gain
during inflation on the other hand holders of
monetary asset loss during inflation.
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III. Computation of Gain or
Loss on Monetary Items
 Ithas been discussed that change in the
purchasing power of money affects both
monetary and non-monetary items. In the
case of monetary item the firm receives or
pays a fixed amount as per the terms of the
contract. But involve gain or loss in of real
purchasing of the real purchasing power.
Such gain or loss is called General
purchasing power gain or loss. 30
 Example: To illustrate the following data is
extracted from the records of Abel
Company as of December 31, 2015:
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 Chapter One: Inflation Accounting
Retail price index: January 1, 2015------120
December 31, 2015-------------------------180
Average for the year------------------------150
Required:
Compute the following:
a) The amount of monetary asset on January1, 2015 and
December 31,2015
b)The amount of monetary liabilities on January 1,2015 and
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December 31,2015
The following indices are used under CPP
method for restating the historical figures:
a)Average index of the year :for current
purchase
b) Index at beginning of the year : for
beginning inventory
c) Average indices for the relevant year or
years: for purchases of the previous year(s).
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c)Change in monetary asset during 2015
d) Change in monetary liabilities during 2015
e)Conversion factor for items on January 1,2015
f)Conversion factor for item arising during 2015
g) Gain in holding monetary liabilities
h) Lose on holding monetary asset
i)Net gain/loss on monetary item
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1.7 Restating Cost of Sales and
Inventories
 The cost of sales, the value of sales, and value of
inventories depend on the cost follow assumption i.e.
FIFO or LIFO.
 Under FIFO, inventories first purchased are taken to
be first issued to production or sold to customers.
According to LIFO, inventories purchased in the last
are taken to have been first issued to production or
sold to customers. Thus, while restating figures under
CPP method, it would appropriate to keep in mind the
cost flow assumption. Let’s see how inventory cost
method affects the restatements under CPP method. 36
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 Chapter One: Inflation Accounting

I. FIFO Method
i. Cost of goods sold. Under FIFO method, the  Example to illustrate, assume the following
cost of goods sold comprises of the entire data for the year 2005 when the firm is
beginning inventory and current purchases, using FIFO method.
less ending inventory
ii. Ending inventory. Under FIFO method,
ending inventory consists of entirely current
purchases

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II. LIFO Method

i. Cost of goods sold under LIFO, cost of  Example: to illustrate. The statement of
goods sold consists of current purchases historical figures under CPP using LIFO
only. method, consider fallowing the following
ii. Ending inventory, under LIFO method, data,
ending inventory comprises of purchases
made in in previous year or years.
 In restating figures, the same indices
introduced earlier are applicable,
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 Chapter One: Inflation Accounting

III. Current Cost Accounting

(CCA) Method
 Current cost accounting (CCA) method is
adopted for correcting the deficiencies of
the historical cost accounting which fails to
provide sufficient information as required
by the users.
 This section is concerned with how CCA
methods is used in preparing financial
statements.
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 Under the historical cost accounting, the assets are
shown at the depreciated original cost.
 However under the current cost system, they are
shown at their current cost or value.
 Current cost system provides a more realistic
system of present value of the assets employed in
business.
 It enables in more meaning full assessment to be
made of the real profit earned on value the of
assets. 42

IV. Adjustment/ Provision CCA Methods i. Revolution Adjustment(RA)

 In order to achieve the objectives CCA  The fixed assets are shown at their :value of
methods the following adjustment are the business” are not at their depreciated
usually are made: cost” value to the business “means the
i. Revolution Adjustment(RA) amount which the company would lose if it
i. Net Current Replacement Value were deprived of the asset the fixed asset
ii. Economic / Recoverable Value value to the business can be defined in the e
any one of the following ways :
ii. Depreciation Adjustment( DA)
i. On the basis of current replacement cost of the asset
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ii. On the basis of average current cost of asset

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 Chapter One: Inflation Accounting
a) Net Current Replacement Value
 This refers the money now required in us to
buy a new asset of the same type as existing
one less accumulated depreciation on existing
fixed asset. Accumulated depreciation asset
of existing asset is deducted to recognize the
fact that true replaced true replacement cost
of asset
would not be new asset but an asset which has
the same remaining useful as existing asset. 45
b) Economic / Recoverable Value
 This refers to present value of net income
that will be earned for using existing asset
during the rest of its life.
 To illustrate assume the equipment
purchased for 10 years ago for $100,000 has
a book value of 50,000 after being using for
5years. The equipment is expected to
generate a
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 To illustrate, an equipment whose total life
is 10 years and which has already survived
for 5years.similar equipment can be
purchased for $80,000. Accumulated
depreciated on the existing equipment is
$30,000.the net replacement cost would be
computed as follows:
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 net cash inflows of $10,000 each year for
the remaining period of its life i.e. (5years).
If the desired discount rate is 10% the
economic value is determined using present
value of annuity as follows:
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 Chapter One: Inflation Accounting
 If the economic value of a fixed is less than
its replacement value, the firm should use
the economic value .e value of the
difference between the value fixed asset
under CCA methods and historical cost
accounting (HCA method) is transferred to
capital reserve titled as “current cost
accounting reserve ).
ii. Depreciation Adjustment( DA)
 The change to income statement for depreciation
should be equal to the value of the fixed assets
consumed during the period. When fixed assets
are valued on the basis of their cost current
replacement value, the change should be based on
such value. Therefore, a suitable depreciation
adjustment is required in historical cost profit to
determine the current cost profit.
 One of the following two basis can be used to
ascertain depreciation adjustment:
 Illustration assume that A done company purchased a
machine for assume of $1000, 0000 on January 1, 2011. The
machine had an expected life of 10 years without any salvage
value. It’s being depreciated on straight line basis. The price
indices for the asset are as the follows:
• January 1, 2015---------------------------$100,000
• January 1, 2015---------------------------$160,000
• December 31, 2015----------------------$175,000
Required:
The value of machine on January 1, 2015 and December 31,
2015 using historical cost accounting and current cost
49 accounting method. 50
a) On the basis of current replacement
cost of the asset under the basis
 Depreciation adjustment may be computed
as follows:
Required depreciation provision for the
accounting period as per CCA------------xxx
Less: depreciation charged for the accounting
period as per HCA-------------------------xxx
Depreciation adjustment-------------------xxx
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 Chapter One: Inflation Accounting

b) On the basis of average

 To illustrate, refer back to Adane Company,
the amount of depreciation adjustment can be
determined in 2015 (if annual depreciation is
10%) as follows:
current cost of asset
 Instead of using current cost at end of year,
it may be reasonable to use the average
current cost which is determined as follows:

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Chapter 1

The End

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