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Punjabi University Patiala

Department of Commerce
Seminar on
Modern Accounting Theory:
Accounting for price-level changes

Abdi Dufera
Oct , 2016 G.C.
By the end of the seminar , you would
be able to:
describe the problems of historical
cost accounting (HCA);
explain the approach taken in each of
the inflation adjusting models;
prepare financial statements applying
each model (HCA, CPP, CCA,
critically comment on each model
1 Introduction
The basic objective of accounting is the
preparation of financial statements in a way
that the I/s report should disclose the true
financial condition and position of
organization in particular period.
Financial statements are prepared in
monetary units like birr, rupee, dollar
F/S can serve very well the basic objective if
the value of such monetary units remains
This is possible only when there is a stability
in the price levels. However, over a period of
time, the prices have not remained stable.
There have been inflationary as well as
deflationary tendencies
Financial statements which are
prepared according to the conventional
or historical cost accounting system,
therefore, do not reflect current
economic realities.
Thus, neither the balance sheet nor
the income statement shows the
correct operating and financial position
of the business.
2 Review of the problems
of historical cost
accounting (HCA)
1. Fall to disclose current worth of the
enterprise: They do show the true current
worth of the enterprise
2. Contains non-comparable Items :The
financial statements contain items which
non comparable since they are usually a
composite of historical and current costs.
Eg. Building
3. Mixes holding and operating gains: In
conventional accounting, gains on account
of holding the inventories may be mixed up
with the operating gains.
A business purchased 100 units of a product at Rs 6
per unit in 1990. It could sell only 50 of such units in
that year. In 1991, it purchases another 100 units at Rs
8 per unit and sells all 150 units at Rs 10 per unit. In
such a case the profit in 1991 as per historical
accounting will be as follows:
Sales (150 units x Rs 10) 1,500
Less: Cost of sales (50 x 6 + 100 x 8) 1,100
Thus, Rs100 is the holding profit while Rs 300 is the
operating profit.
The historical accounting system, as seen above, does
not make this distinction.
Note: In order to combat these serious defects, price
level accounting became the subject of research and
debate as to the most appropriate method to use for
financial reporting
Price level accounting
is technique of accounting by which the
financial statements are restated to
reflect changes in the general price
Such changes, as stated earlier, may
be either inflationary or deflationary.
Since, inflation has come to stay and
frequently occurred and, therefore,
price level accounting is more
concerned with inflationary tendencies.
Methods of Accounting for
Changing Prices
The following are the generally
accepted methods of accounting for
price level changes:
a. Current Purchasing Power Method or
General Purchasing Power Method (CPP or
GPP Method).
b. Current Cost Accounting Method (CCA
c. Hybrid Method, i.e., a mixture of CPP and
CCA methods.
Current Purchasing Power
Method CPP Method
The introduction of CPP method is one of the
greatest revolutions in the field of accounting.
It involves the restatement of all of the items
in the historical financial statement for
changes in the general price level
Under this method, any established and
approved general price index is used to
convert the values of various items in the
B/Sheet and I/Statement
This method helps to present financial
statement in terms of units of equal
purchasing power.
An asset purchased for a sum of Rs 200 in 1970
would be valued in 1990 according to CPP
Method at the amount which would be needed
to buy the asset as per change in the general
price index in 1990 as compared to 1970.
Presuming that general price index was 150 in
1970 and 300 in 1990,
the asset would be valued at Rs 400 (i.e., 200 x
300/150) as per CPP Method.
This is because the current purchasing power of
a sum of Rs 200 spent in 1970 is equivalent to
Rs 400 in 1990.
Note: It should be noted that under the CPP
Method, only the changes in general purchasing
power of money are taken into account. It does
not consider the changes in the value of
individual assets
Characteristics Of CPP
1. Method
A supplementary statement is prepared and
annexed to historical financial statement. The
supplementary statement includes re-statement of
income statement and re-stated balance sheet.
2. Any statement prepared under CPP method is
based on the historical statement.
3. Consumer price index or wholesale price index is
used as conversion factor for re-stated of historical
4. All the items in financial statement are classified
into monetary and non-monetary items. Non-
monetary items are adjusted, there is no need of
any adjustment for the monetary items.
5. Net gain or loss account of monetary items is to be
accounted in the profit and loss account.
Preparation of the financial
statements according to CPP
Under CPP method, financial statements prepared
under historical cost accounting are re-stated by
using an approved price index.
The following steps are taken in preparing the
financial statements.
1.Calculation Of Conversion factor: CPP
Method requires the restatement of historical
figures as disclosed in the financial statement at
current purchasing prices
Conversion factor =Price Index at the date of conversion
Price Index at the date the item arose
Conversion factor at the beginning = Price Index at the
end/Price Index at the beginning
Conversion factor at an average = Price Index at the
end/Average Price Index
Conversion factor at the end = Price Index at the end/Price Index at
the end
CPP Value = Historical value X Conversion factor
For the items taken from the beginning period
(e.g assets, liabilities, taken from the
operating balance sheet), beginning
conversion factor is used
For the items which occur throughout the
year like sales, purchases, operating expenses
etc., average conversion factor is used
For the items which occur at the end of the
year like tax, dividend etc. ending conversion
is used.
A company purchased a machinery on 1990 for
a sum of Rs 90,000. The retail price index on
that date stood at 150. You are required to
restate the value of the machinery according to
CPP Method on 31 December, 1995 when the
price index stood at 200.
Conversion factor =Price Index at the date the item
Price Index at the date of conversion
200/150 =4/3

Value of machinery on 3 1st December,

1995 after conversion = Existing value x
Conversion factor
= 90,000x(4/3)=120,000
2. Monetary and non-
monetary items
While converting the figures under CPP Method, a distinction
is to be made between monetary items and non-monetary
A. Monetary items
Monetary items are assets and liabilities, the amounts of
which are receivable or payable only at current monetary
value or
Monetary items are those whose amounts are fixed by
contract in terms of monetary units (Birr, rupees, dollars,
pounds, etc.) regardless of changes in the general price level.
Monetary assets include cash, bank, bills receivables, debtors,
prepaid expenses, account receivables, investment in bond or
debentures, etc.
Monetary liabilities include creditors, account payable, bills
payable, outstanding expenses, notes payable, dividend
payable, tax payable, bonds or debentures, preference share
capital etc.
Holders of monetary assets lose general
purchasing power during a period of
inflation, since their claims against the
firm remain fixed irrespective of any
change in the general price level. The
inverse applies to those having
monetary liabilities.
Monetary items need no conversion since
they are already stated in current rupees
(dollars or birr) at the end of the period to
which the accounts relate.
B. Non-monetary items.
These are the items that cannot be stated in fixed
monetary amounts.
Such items denote assets and liabilities that do
not represent specific monetary claims
They include land, building, machinery, vehicles,
furniture, inventory, equity share capital,
irredeemable preference share capital.
For example, a building costing Rs. 15,000 in
1976 may sell for Rs. 35,000 today though it has
been used and may also be of old fashion.
This may largely be due to change in the general
price level.
Thus, non-monetary items do not carry a fixed
value like monetary items.
Hence, under CPP method, all such items are to
be restated current general purchasing power.
4. Gain or loss on
monetary items
It has already been stated above that change in the
purchasing power of money affects both monetary as
well as non-monetary items.
Of course in case of monetary items, the firm
receives or pays amount fixed as per terms of the
contract but it does gain or lose in terms of real
purchasing power.
Such gain or loss, termed as general price level
gain or loss, should be taken into account under the
CPP method but it should be shown as a separate
item in the restated income statement to arrive at
the overall profit or loss.
This is particularly important in case of gain since the
amount may not be available for distribution by way
of dividend on account of inadequate liquidity.
4. Valuation of Cost of Sales and Inventories
Cost of sales and inventory value vary
according to cost flow assumptions i.e. first-in-
first-out (FIFO) or last-in-first-out (LIFO).
Under FIFO, cost of sales comprises the entire
opening stock and current purchases less
closing stock. And closing is entirely from
current purchase.
Under LIFO method, cost of sales comprises
current purchase only. However, if the current
purchase is less than cost of sales, a part of
opening inventory may also become a part of
cost of sales. And closing stock comprises
purchases made in previous year.
5. Ascertainment of Profit
profit can be determined in two ways. They are:
a. Re-statement of Income Method
Under this method, historical income statement is re-
stated in CPP terms. Following conversion factors are
used to restate the figures of historical cost statement.
* Sales and operating expenses are converted at the
average rate application for the year.
* Cost of sales is converted as per cost flow assumption
i.e. FIFO and LIFO.
* Depreciation is converted on the basis of indices
prevailing on the dates when assets were purchased.
* Taxes and dividend paid are converted on the indices
that were prevalent on the dates when they are paid.
* Gain or loss on monetary items should be shown as
separate item to arrive at the overall profit or loss.
ii. Net Change Method
This method is based on the normal accounting
principle that profit is change in equity during an
accounting period. In order to determine profit,
following steps are taken.
i. Opening balance sheet prepared on historical cost
accounting method is converted in CPP forms at the
end of the year.
ii.Monetary and non-monetary items are re-stated by
using proper conversion factors. Equity share capital
is also converted.
iii.The difference in the balance sheet is taken as
reserve. Alternatively, the equity share capital may
not be converted and the difference in balance
sheet be taken as equity.
Closing balance sheet prepared under
historical costing is also converted.
Only non-monetary items are re-stated. The
difference in balance sheet is taken as
reserve after converting equity capital.
Alternatively, the equity capital may not be
restated in CPP terms and balance be taken
as equity.
Profit is equivalent to net change in reserve
where equity capital has also been
or net change in equity where equity capital
has not been re-stated.
6. Restated Balance Sheet
The historical balance sheet is prepared as per the
historical income statement, so it can not represent
the revised or changed value of assets and liabilities.
Under the price level change, the historical balance
sheet should be revised to reflect the true picture of
financial position of any organization.
Inside the historical balance sheet, both monetary and
non-monetary items are listed. So, the monetary and
non monetary items should be separated first of all.
It is not necessary to change the monetary item into
CPP value because such items are already utilized
while calculating the holding gain or loss.
Only the non monetary items are to be adjusted to the
CPP value by multiplying appropriate conversion
advantages of CPP method.
1. Under CPP method, historical accounts continue to
be maintained. CPP statements are prepared on
supplementary basis.
2. CPP method facilitates the calculation of gain or
loss in purchasing power due to the holding of
monetary items.
3. CPP method uses common purchasing power as
measuring unit. So, the comparative study is easy.
4. CPP method provides reliable financial information
for taking management decision to formulate
plans and policies.
Criticism of the CPP
1. CPP method considers only the changes in
general purchasing power. It does not
consider the changes in the value of
individual items.
2. CPP method is based on statistical index
number which cannot be used in an
individual firm.
3. It is very difficult to choose a suitable
price index.
4. CPP method fails to remove all the defects
of historical cost accounting system.
Current Costing Accounting
a. (CCAAccounting (CCA
Meaning Of Current Costing
CCA approach was introduced in 1975 to
overcome the difficulties of CPP method.
Actually the CPP method applies the retail price
index for finding out the conversion factors to
restate the income statement and balance sheet.
So the CPP approach was criticized by the
business world
Current costing accounting (CCA) approach
recognizes the changes in the price of individual
due to the change in general price level.
In CCA method, the assets are valued in current
cost basis. It does not consider the retail price
index. This method considers the replacement
value of the assets for its real accounting records.
Under this method, each financial statement is to
be restated in terms of the current value of such
Similarly, the profits are computed on
the basis of what the cost would have
been at the date of sale rather than the
actual amount paid.
Example, if goods purchased for Rs 8
are worth Rs 10 on the date of sale are
sold for Rs 12, profit will be taken as Rs 2
(and not Rs 4) based on their current
Objectives Of Current Cost
Accounting(CCA) Approach
i. To provide correct and reliable financial
information based on the current replacement
ii. To protect the business in the event of normal
inflationary situation.
iii. To keep level of capital in very balance position
by making valuation of assets in proper value
based on replacement value.
iv. To provide realistic information to the
management, investors, creditors, government
and to other interested parties.
v. To prepare the financial statement at the end
of the year on the basis of current value of
such items.
Features Of Current Cost
1. The fixed assets are recorded at Net
current replacement value and not at their
depreciated original cost in the balance
This refers to the money now required to buy a
new asset of the same type as an existing one
less an amount of depreciation that recognizes;

The difference between the value of fixed assets

under Current Cost Accounting System and
Historical Cost Accounting System is transferred
to a capital reserve styled as Current Cost
Accounting Reserve.
A firm purchased a machinery for a sum of
Rs 10 lakhs on January 1,1987 and an
expected life of 10 years without any scrap
value. The price indices for the asset were as
follows :
January 1, 1987 100
January 1, 1990 160
December 31, 1990 175
You are required to value the machinery on
January 1, 1990 and December 31, 1990,
both according to Historical Cost Accounting
System and Current Cost Accounting System,
charging depreciation on .straight line basis.
2. Inventories are shown at market
value rather than (LCM) market or
cost price whichever less as in the
historical system is.
3. Depreciation of fixed assets is to be
calculated at replacement value.
4. Liabilities are recorded in their
original value because there is no any
change in monetary unit.
The End