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Subject COMMERCE

Paper No and Title 4 Accounting Theory and Practice

Module No and Title 30 Inflation Accounting

Module Tag COM_P4_M30

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TABLE OF CONTENTS

1. Learning Outcomes 2. Introduction of Inflation Accounting 3.Historical Cost Accounting 3.1 Arguments in favour of Historical cost Accounting (HCA) 3.2 Limitations of Historical Cost Accounting 4. Methods of Accounting For Changing Prices 4.1 Current Purchasing Power Accounting (CPPA) 4.2 Current Cost Accounting (CCA) 5. Summary

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1. Learning Outcomes

After studying this module, you shall be able to:

 Some particular limitations of historical cost accounting in terms of its ability to cope with various issues associated with changing prices  A number of alternative methods of accounting that have been developed to address problems associated with changing prices  Some of the strengths and weaknesses of the various alternative accounting methods

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2. Inflation Accounting

2.1 Introduction

The basic objective of Accounting is the preparation of financial statements is a way that gives a true and fair view of the operating results and the financial position of the business to its various users namely, investors, government, creditors, management, trade unions, research institutions etc. These financial statements are prepared based on certain accounting concepts and conventions. The money measurement concept is a basic attribute of accounting.

The money measurement concept states that only those business transactions can be recovered in the books of accounts that are capable of being expressed in terms of money. It also assumes that the monetary unit used for recording the transaction is stable in nature. However, this is not true in practice as many countries, developed as well as developing, have been experiencing inflation of high magnitude in recent times. Inflation refers to state of continuous rise in prices. It brings downward changes in the purchasing power of the monetary unit. Thus, the financial statements prepared without taking into account the change in purchasing power of the monetary unit lose their significance.

There is a demand that business enterprise should prepare inflation adjusted financial statements. The different ways through which financial accounts can be adjusted for changing prices is studied under the subject “Inflation Accounting”. Given that price changes can also be downward, it is more appropriately called “Accounting for price level changes.

Inflation accounting is a term describing a range of accounting systems designed to correct problems arising from historical cost accounting in the presence of inflation. Inflation accounting is used in countries experiencing high inflation or hyperinflation. For example, in countries experiencing hyperinflation the International Accounting Standards Board requires corporate financial statements to be adjusted for changes in purchasing power using a price index.

2.2 History of inflation accounting

Accountants in the United Kingdom and the United States have discussed the effect of inflation on financial statements since the early 1900s, beginning with index number theory and purchasing power. Irving Fisher's 1911 book The Purchasing Power of Money was used as a source by Henry W. Sweeney in his 1936 book Stabilized Accounting, which was about Constant Purchasing Power Accounting. This model by Sweeney was used by The American Institute of Certified Public Accountants for their 1963 research study (ARS6) Reporting the Financial Effects of Price-Level Changes, and later used by the Accounting Principles Board (USA), the Financial Standards Board (USA), and the Accounting Standards Steering Committee (UK). Sweeney advocated using a price index that covers everything in the gross national product. In March 1979, the Financial Accounting Standards Board (FASB) wrote Constant Dollar Accounting, which advocated using the Consumer Price Index for All Urban Consumers (CPI-U) to adjust accounts because it is calculated every month.

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During the Great Depression, some corporations restated their financial statements to reflect inflation. At times during the past 50 years standard-setting organizations have encouraged companies to supplement cost-based financial statements with price-level adjusted statements. During a period of high inflation in the 1970s, the FASB was reviewing a draft proposal for price-level adjusted statements when the Securities and Exchange Commission (SEC) issued ASR 190, which required approximately 1,000 of the largest US corporations to provide supplemental information based on replacement cost. The FASB withdrew the draft proposal.

3. Historical Cost Accounting (HCA)

Fair value accounting (also called replacement cost accounting or current cost accounting) was widely used in the 19th and early 20th centuries, but historical cost accounting became more widespread after values overstated during the 1920s were reversed during the Great Depression of the 1930s. Most principles of historical cost accounting were developed after the Wall Street Crash of 1929, including the presumption of a stable currency.

Historical Cost Accounting (HCA), also known as conventional accounting, record transactions appearing in both the balance sheet and the profit and loss account in monetary amount which reflects their historical cost. The historical cost principal requires that accounting records be maintained at original transaction prices and that these value be retained throughout the accounting process to serve as the basis for values in the financial statements. HCA is based on the realization principle which requires the recognition of revenue when it has been realized.

3.1 Arguments in favour of Historical Cost Accounting (HCA)

Arguments which are advanced in favour of HCA are listed as follows:

1. Accounting data under HCA are generally considered free from bias, independently verifiable, and hence more reliable by the investing public, and other external users.

2. Historical accounting reduces to a minimum the extent to which the accounts may be affected by the personal judgments of those who prepare them.

3. It has been generally found that users, internal and external, have preference for HCA and financial statements prepared under it.

4. Historical accounting is also defended on the ground that it is only the legally recognized accounting system accepted as a basis for taxation, dividend declaration, defining legal capital, etc.

5. Historical cost valuation is, among all valuation methods currently proposed, the method that is least costly to society considering the social costs of recording, reporting, auditing and settling disputes.

3.2 Limitations of Historical cost Accounting

The drawbacks of HCA are listed as follows: COMMERCE 4 Accounting Theory and Practice 30 Inflation Accounting

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1. In times of inflation, the value of money declines and, therefore, the monetary unit (e.g. , rupee in India) which is used as a standard of measurement does not have a constant value and shrinks in value as the prices rise. The HCA ignores this decline in the value of rupee and keeps adding transactions acquired at different dates with rupee of varying purchasing power. The HCA is based on the assumption of stable monetary unit which assumes that (i) there is no inflation, or (ii) the rate of inflation can be ignored. This assumption does not prove true during inflation because of the change in general purchasing power of the monetary unit.

2. Secondly, HCA does not match current revenues with the current costs of operations. Revenues are measured in inflated (current) rupees whereas production costs are a mix of current and historical costs. Some costs are measured in very old rupees (e.g. depreciation), other trend to be in more recent rupees (e.g. inventories), while still others reflect current rupees (e.g. wages, salary, selling expenses and similar current operating expenses). In general, whenever there is a time lag between acquisition and utilisation, historical cost may well differ significantly from current cost.

3. The ‘inflated’ profits resulting under HCA are not the real profits but exaggerated and illusory. This causes the depreciation allowance to become inadequate to replace fixed assets and finance growth and expansion.

4. Inflation causes many other problems and dislocations, such as the following, which are not considered in HCA. The result is that Historical cost figures become of less and less significant and the value of accounts for decision-making is severely restricted.

5. HCA is defended on the ground of its objectivity. Objectivity is claimed because historical cost numbers are derived from actual transactions that have been entered into by the enterprise itself rather than (sometimes) from transactions that are being entered into by others in the market-place. The objectivity that is claimed is largely unfounded because of the existence of alternative, generally accepted methods for computing depreciation, inventory valuation and other such items. As a result, there is a serious credibility gap in financial reporting.

6. Although historical cost generally represents ‘current market value’ at the time of transactions, however, as time passes, the cost (value) of non-monetary items in the balance sheet tends to move further and further from their current value due solely to changes in the value of money (inflation).

7. Since historical accounting is based on realisation principles, profit can easily be manipulated. By accelerating or retarding the timing of the realization of gains, profits can be increased or decreased.

To conclude, the HCA has several drawbacks, which emerge mainly from two of the underlying principles: stable monetary units and realisation principle.

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Nature of Price Changes

Price changes can be the following times:

(1) General Price Changes

A general price change is the result of a change in the value of the monetary unit during period of inflation or deflation. General purchasing power means the ability to buy all types of goods and services available in the economy, and it is measured by changes in the general price level.

(2) Specific Price Changes

A change in the price of a specific commodity represents a change in its exchange value. Changes in prices of an input market result in increase or decrease in costs or expenses of the firm, and changes of prices in the output market result in a shift in revenues (assuming that the price change does not affect the quantity sold).

(3) Relative Price Changes

Most often, prices of goods and services move at different rates, and some even in different directions. The extent to which specific prices move at different rate or in a different direction from general price is known as relative price changes.

Example

If the market price of product X was Rs. 40 in 2013 and Rs. 60 in 2014; and further, if the market price of all the products comprising general price index was Rs. 250 in 2013 and Rs. 300 in 2014, Calculate:

(i) Specific price index for product X

(ii) General price index for all the products

(iii) Relative price index for product X

Solution

(i) Specific price index for product X, Rs. 60 - Rs. 40=Rs. 20 i.e. , 20/40x100= 50 %

(ii) General Price index for all products, Rs. 300 – Rs. 250=Rs. 50 i.e. , 50/250x100= 20%

(iii) Relative price index for product X, Assuming price index of 100 in 2013 as base, specific price index in 2014 will be 150, and General Price Index will be 120 in 2014. Therefore, Relative price index for product X is Rs. 150 – Rs. 120= Rs. 30 i.e. , 30/120x100= 25 % COMMERCE 4 Accounting Theory and Practice 30 Inflation Accounting

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4. Methods of Accounting For Changing Prices

Many alternatives have been proposed in accounting to minimize the limitations of historical cost-based financial statements and to recognize the effects of inflation on financial statements. Of the many proposals that have been put forward for inflation accounting, the following two methods need specific consideration.

(1) Current Purchasing Power Accounting (CPPA). Also known as Constant Purchasing Power Accounting, General Price Level Accounting.

(2) Current Cost Accounting (CCA)

4.1 Current Purchasing Power Accounting (CPPA)

Current Purchasing Power Accounting known by different names such as Constant Purchasing Power Accounting (CPPA), General Price Level Accounting (GPLA), Constant Dollar Accounting (in USA), General Purchasing Power Accounting, this method adjusts historical costs for changes in the general level of prices as measured by a general price-level index. Changes in the general level of prices represent changes in the general purchasing power of the monetary unit. Increase in the general level of prices (inflation) reduce the general purchasing power to purchase goods and services in general; decrease in the general level of prices (deflation) increase the purchasing power to purchase goods and services in general.

Under CPPA, by restating historical cost financial statements for changes in the general purchasing power, the adjusted financial statements would reflect the originals amounts in terms of current purchasing power, which if spent today, would command the same general purchasing power as the original reported amounts.

Methodology of CPPA

To convert the historical cost financial statements, an acceptable general price level index representing the changes in the general purchasing power of the monetary unit (rupee) is needed. Generally the most broad based consumer goods price index is used. The historical cost figures are multiplied by a conversion factor which is the ratio of the price-level index at the date of conversion and price level index at the transaction date. A price level index is the ratio of the average price of a group of goods or services at a given date and the average price of a similar group of goods or services at another date, known as base year, when the price level index is equal to 100.

E.g. assume that machinery has been purchased on Jan 1, 2010 for Rs. 50, 00,000 when the general price level was 120. The general price index on January 1, 2014 was 150. The cost of the machinery in terms of rupees on January 1, 2014 would be Rs. 62, 50, 000 (50, 00, 000 x150/120). Since it is practically difficult to convert each figure in terms of the price-level index of the date of transaction, it is assumed that all transactions take place eventually throughout the year.

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Balance Sheet under CPPA

Monetary and Non-Monetary Items

The working of CPPA requires that, first of all, balance sheet items should be classified into Monetary Items, and Non-Monetary Items.

Monetary Items

Monetary items are those items which are fixed by contract or otherwise remain fixed irrespective of any change in the general price level of price. Monetary Items may be monetary assets as well as monetary liabilities. Examples of monetary assets are cash, debtors, bills receivables, etc. similarly debentures, creditors etc, are monetary liabilities.

In the period of inflation, the holder of cash or other monetary assets lose purchasing power because the cash they have or expect to receive represents amounts of less purchasing power. On the other hand, holders of monetary assets gain purchasing power during a period of deflation. These relationships are reversed for monetary liabilities. Holders of monetary liabilities gain general purchasing power during a period of inflation because they can repay the amounts due in rupees of lower purchasing power. However, holders of monetary liabilities lose purchasing power during a period of deflation.

E.g. suppose a firm has creditors of Rs. 50, 000 on Jan 1, 2013, which are payable on 31 Dec, 2013. It may be argued that the firm’s liabilities of Rs. 50, 000 represents less purchasing power as on Dec 31, 2013 as compared to original liability (as on 1 Jan, 2013) which possesses higher general purchasing power. Therefore, purchasing power gain arises from holding monetary liabilities during inflationary periods. Conversely, the holders of monetary assets lose in a period of inflation because of a given amount money could buy fewer goods and services.

For example, suppose a firm has Rs. 50, 000 as cash on hand n 1 Jan, 2013 which remained intact until December 2013. Assume that 10 Per cent inflation occurred during that year. The situation implies that the firm would need Rs. 55, 000 on Dec 31, 2013. The fact that the firms only hold Rs. 50, 000 results in a loss of general purchasing power of Rs. 5, 000. The same purchasing power loss would also arise from holding accounts receivable or debtors or any claims to a fixed quantity of money since the amount of money expected to be received commands a decreasing amount of general purchasing power during periods of general price level increases.

Calculation of Purchasing Power Gain or Loss on Monetary Items

The CPPA method suggests the computation of the purchasing power gain or loss made by an enterprise on holing net monetary items. Purchasing Power gain or loss on monetary items can be calculated in two ways:

(i) One procedure is to calculate the purchasing power gain or loss associated with each monetary assets and each monetary liability and then sums up the individual gains and losses to determine the gain or loss.

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(ii) A second procedure calculates the gain or loss on holding all monetary items as if they maintained in a single account. Alternatively, under second procedure, general purchasing power gain or loss can be computed in terms of net monetary assets ( monetary assets- monetary liabilities) for which the following procedures may be used.

(i) Compute the net monetary asset position at the beginning of the period. For example, if cash and accounts payable at the beginning of the period are Rs. 1, 00,000 and Rs. 40,000 respectively, the net monetary assets will be Rs. 60,000.

(ii) Restate net monetary assets position at the beginning of the period in terms of the purchasing power at the end of the period. For example, assume the general price-level index was 150 at the beginning of the period and 200 at the end of the period. The net monetary asset position at the beginning of the period, which was Rs. 60,000, would be restated to Rs. 80,000 (60,000x200/150).

(iii) Restate all the monetary receipts of the year to the yearend basis and add this to the restated net monetary position at the beginning of the period as calculated in (ii). Assumes that sales of Rs. 50,000 occurred evenly during the year and the general average price index was 160. The adjusted monetary receipts would be restated to Rs.62, 500 (Rs. 50,000x200/160). This result is added to Rs. 80,000 as calculated in (ii) to arrive at a total restated net increase in monetary Items of Rs. 1, 42,500.

(iv) Restate all the monetary payments of the year to the yearend basis and deduct the result from the total restated net increase in monetary items as calculated in (iii). Assume that purchase expenses of Rs 20,000 also occurred evenly during the year. The adjusted monetary payments would be restated to Rs. 25,000 (20,000x200/160). This result is deducted from Rs. 1, 42,500 as calculated in (iii) to arrive at the adjusted computed net monetary assets at the end of the period, which is Rs.1, 17,500.

(v) Deduct the actual net monetary assets at the end of the period from the adjusted net monetary assets at the end of the period as found in (iv) to obtain the purchasing power gain/loss. In this example, the net monetary asset at the end of the period is Rs. 90,000 (60,000+50,000-20,000) and adjusted net monetary assets as found in (iv) is Rs. 1,17,500. Therefore purchasing power loss on net monetary items is Rs. 27, 500.

Treatment of Purchasing Power Gain and Loss

It has been widely suggested that the purchasing power gain or loss should be included in current income.

Non-Monetary Items

All assets and liabilities that lack the properties of monetary items are classified as non-monetary. Non-monetary assets include inventories, building, plant and equipment, and claims to cash in amounts dependent on future prices. Whereas the holding of monetary items (like cash and accounts receivable) results in purchasing power gain or loss, the mere holding of non-monetary items (like inventory and equipment) does not result in purchasing power gain or loss because they do not represent affixed amount to be received or paid and thus their prices in terms of the COMMERCE 4 Accounting Theory and Practice 30 Inflation Accounting

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monetary unit may change over time. While most liabilities are monetary, non-monetary liabilities include equity capital and retained earnings. Non-monetary liabilities do not represent fixed claims to pay cash. The monetary assets and liabilities at the end of the year will appear at the same amounts, whereas non-monetary items are reported at their adjusted amounts in the CPPA adjusted Balance sheet. The restatement of non-monetary items is done by applying the following conversion factor.

Current year index

Index when the non-monetary items were acquired

Profit and Loss Account under CPPA

In CPPA profit and loss account, adjustments are needed about the following items:

(a) Opening inventory,

(b) Transactions during the Year,

(c) Depreciation written off for the year and,

(d) Closing inventory

The method to be followed for restating historical cost-income statement under CPPA is basically the same as suggested for adjusting other historical amount in terms of current purchasing power, usually applying the following conversion factor

Current year index

Index applicable to the item at the beginning or when it was created

Evaluation of CPPA

CPPA restates historical costs in terms of current purchasing power. This accounting model attempts to stablise the measuring unit a constant value that prevails on the latest balance sheet date. CPP does not create a new basis of valuation or profit determination; it merely restates the actual costs that were incurred in currency units of different values into currency units of a constant value, thus making them properly comparable and additive. It however, has depressive effect on profits. In the long Run, total profits shown by CPPA accounts will be smaller than those shown by HCA.

Arguments in favour of CPPA

A number of arguments have been advanced in favour of CPPA which are as follows:

(i) Inflation is concerned with changes in the general level of prices, therefore, only CPPA can be regarded as a true form of inflation accounting. Those who consider inflation as an increase in

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general price level and a decline in purchasing power of the money, favour CPPA as best approach in inflation accounting.

(ii) As CPPA uses uniform purchasing power ass the measuring unit, it possesses the qualities of objectivity and comparability. It has the further advantage of being based on historical costs used in convention accounting system presently in use. Therefore, it retains all the characteristics of historical cost accounting except for the change in unit of measurement. Also, it does not involve the sometimes subjective measurements required by the current value and current cost method.

(iii) CPPA provides useful information about the comparable impact of inflation across the firms. Inflation affects firms differently, depending on the age and composition of their assets and equities. Highly capital intensive firms are likely to report significantly larger depreciation expenses under CPPA method than normal depreciation expenses. Highly leveraged firms will report a larger purchasing power gain during periods of increasing prices than firms that use relatively little debt.

(iv) CPPA improves the relevance and measurement of net income as it provides a better matching of revenues and expenses because of a constant and common measuring unit. On the contrary, conventional historical accounting does not measure income properly as a result of the matching of rupees of different size (purchasing power) on the income statement.

(v) CPPA provides relevant information for management evaluation and use. Purchasing power gain and loss resulting from holding monetary items reflects management’s response to inflation. The stated non-monetary items indicate the approximate purchasing power needed to replace the assets.

(vi) CPPA presents to users, in general, the impact of general inflation on profit and provides more realistic return on investment. Financial data adjusted for price-level changes provides a basis for a more intelligent, better informed allocation of resources, whether those resources are in the hands of the individuals, business entities or government.

Arguments against CPPA

The following arguments have been advanced against CPPA:

(i) CPPA accounts only for changes in the general price-level and does not account for changes in the specific price-level. Since specific price movements are not necessarily synchronized with movement of the general price level index, the restatement in terms of general purchasing power does not reflect the current value of the resources of the firms. If the general price index has increased, many specific price changes running at lower level than the general price index, whilst many others will be running at higher level.

(ii) Furthermore, there is a problem of choice of an appropriate general price level index. A general price level index that is applied must necessarily be a broad measure of purchasing for a comprehensive market basket of goods.

(iii) CPPA requires the identification and classification of assets and liabilities as monetary or non-monetary. The treatment of monetary items has been a source of criticism under CPPA.

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(iv) CPPA method fails to remove all the defects of historical cost accounting system.

(v) CPPA method is based on statistical index number which cannot be used in an individual firm.

4.2 Current Cost Accounting (CCA)

Current costing method is an alternative to current purchasing power (CPP) method. 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 cost accounting uses “value to the business” as the measurement basis. Value to the business is defined as (a) net current replacement cost or, if a permanent diminution to below net current replacement cost has been recognized; (b) recoverable amount. Recoverable amount is the greater of net realizable value of an asset and, where applicable, the amount recoverable from its further ruse. The ‘value to the business’ concept is illustrated in the following figures:

Value to the Business

Lower Of

Current Net Replacement Cost Recoverable Amount

Higher of

Net Realisable Economic Value (Present) Value

Figure 1

Objectives of CCA

Current Cost Accounting (CCA) aims to maintain capital of a business enterprise in terms of its operating capability. Operating capability is denoted by the net operating assets of the enterprise in terms of shareholders funds. As an equation,

Net Operating assets= Total tangible assets + Net monetary working capital (current assets – current liabilities)

A change in the input prices of goods and services used and financed by the business will affect the amount of funds required to maintain the operating capability of the business enterprise. Therefore, maintaining the operating capability is the objective which is attempted to be achieved COMMERCE 4 Accounting Theory and Practice 30 Inflation Accounting

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under CCA while preparing profit and loss account and balance sheet. CCA is based on UK accounting standard< SSAP 16 Current Cost Accounting, issued in 1980. CCA aims to prepare the following:

(A) Current Cost Profit and Loss (to determine Current Cost Operating profit)

(B) Current Cost Balance Sheet

CCA – P & L A/c Related Issues:

In determining current cost profits for an accounting period, essentially 2 stages are involved:

(i) Determination of Current cost operating profit: This is the surplus arising from the carrying on the ordinary activities of the business in the period after accounting for the impact of price changes on the funds for continuing the existing business as also to maintain its operating capability of business is the amount of goods and services a business able to supply with its existing resources in the relevant period. These resources are represented in accounting terms by the net operating assets (i.e. Fixed assets including trade investments, debtors, stocks, B/R, prepayments less creditors, accruals and B/P) at current cost.

The computation of surplus is to be done without considering the mode of financing the business. It is to be noted that the surplus figure is to be before interest on net borrowing and taxes.

(ii) Determination of current cost profit attributable to shareholders: The figure of profit is taken after taking into account the matter in which the business has been financed. To the extent the business has been financed through borrowings the full allowance of the impact of price changes on operating capability made in arriving at net profit may not be required since the rights of lenders are fixed in monetary amount Consequently the current cost profit attributable to the shareholders reflects the surplus for the period after considering the impact of price changes on the funds required to maintain the shareholders proportion of the operating capability. It is shown after considering interest, tax, gearing adjustment and extra-ordinary items. In the case of Balance sheet, the CCA method suggests that the assets where practicable be included at their value to the business based on current price levels. This provides a realistic statement of the assets employed in the business and enable a correlation of current cost profit with net assets employed.

Methodology of determining current cost operating cost:

In order to obtain c.c. operating profit from profit before interest on Historical Cost, 3 adjustments are involved. They are:

a. Depreciation adjustment: This allows for the impact of price changes when determining the charge against revenue for the part of fixed assets consumed during the period. It is equivalent to the difference between the value to the business of part and fixed assets consumed during the period and depreciation on Historical Cost basis.

b. Cost of Sales Adjustment (COSA): This accounts for the impact of price changes when determining the charge against revenue from stock consumed in the period. It is the difference between the values to the business of stock consumed on Historical Cost basis. The resulting total COMMERCE 4 Accounting Theory and Practice 30 Inflation Accounting

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changes represent the value to the business of stock consumed in earning the revenue for the period.

c. Monetary Working Capital Adjustment: This adjustment represents the amount of additional or reduced finance needed for monetary working capital as a result of the changes in input prices of goods and services used and financed by the business. Monetary working capital represents working capital component after excluding stock.

In other words it is the aggregate of

i. Trade debtors, prepaid expenses, bills receivables

ii. Stocks not subject to COSA.

Less:

iii .Trade Creditors, accruals and bills payables

In so far as they relate to day to day operating activities of the business as distinct from transactions of a special nature. Bank balance or old may fluctuate with the net of stock or the items (i), (ii) and (iii) given above. That part of bank balance and old arising from such fluctuations should be included in the monetary working capital along with any cash floats required to support day to day operations of the business of maintenance of such floats has a material effect on the current cost of operating profit. In the case of a business which holds stocks, the monetary working capital complements the COSA and together they allow for the impact of price changes on the total amount of working capital to be used in day to day operation.

Methodology of calculating current cost profit attributable to shareholders:

The net operating assets – Fixed Assets + Stock + Monetary Working Capital are usually financed partly by borrowing and partly by shareholders funds. The financing of net operating assets by borrowing needs to be reflected in c.c. profit by means of a gearing adjustment.

No gearing adjustment is required where a company is wholly financed by shareholders funds. The logic behind the gearing adjustments is that while repayment rights are proportion of net operating assets are realized either by sale or use in the business repayment and borrowing could be made so long as the proceeds are not less than the Historical Cost of these assets.

The gearing adjustment therefore discounts the operating adjustment in the gearing proportion in deriving c.c. profit attributable to shareholders. This reduction in the operating adjustment is normally achieved by adding back all 3 types of operating adjustment – Depreciation adjustment, COSA & Monetary Working Capital Adjustment in the ratio of borrowing to net operating assets. Average figures for the year are used for this purpose.

CCA – B/S Related Issues:

Fixed Assets under CCA are not shown at their original costs. They are revalued and stated at the lower of the following 2 figures: COMMERCE 4 Accounting Theory and Practice 30 Inflation Accounting

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i. Net Current Replacement Cost: In other words, the price which would have to be paid currently to purchase a similar asset of same age as the existing asset.

ii. Value of the asset based on the present value of the future earnings of such assets. After suitably discounting future earnings with present value tables. More specifically the SSAP – 16 suggests the following basis.

a. Land, Plant and Machinery and Stocks subject to COSA – To be valued at the value to the business.

b. Investment in associated companies – Directors best estimate.

c. Other Investments – Stocks exchanges quotations or director’s best estimate.

d. Intangible asset – As best estimate of value to the business.

e. Current Assets other than those subject to COSA on Historical Cost basis.

f. All liabilities – on Historical Cost basis.

g. Reserves in the current cost. Balance Sheet should include revaluation surplus/deficit and adjustment made to reflect the impact and price changes in obtaining the Current Cost profit attributable to shareholders.

Current Cost Accounting (CCA) Profit and Loss Account Rs. Historical profit before interest and tax -- Less: Current cost operating adjustments: (i) Depreciation adjustment -- (ii) Cost of sales adjustment (COSA) -- (iii) Monetary working capital adjustment (MWCA) -- -- Current cost operating profit -- Less: Interest on borrowings including debentures and dividend -- On preference shares Current cost profit after interest -- Add: Gearing adjustment -- Current cost profit before tax -- Less: Provision for tax -- Current cost profit after tax (attributable to shareholders) -- Less: Dividend proposed -- Current cost profit retained

Evaluation of Current Cost Accounting

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 The adoption of current cost or lower recoverable amount in place of historical cost as the attribute to be used for measuring assets and if relevant, liabilities also, would greatly increase the relevance of information conveyed in financial reports, and it would increase its utility and representational faithfulness.  The basic objective of current cost account is to provide more useful information than that available from historical cost accounts for the guidance of management of the business, the shareholders and others on such matters as the financial viability of the business, return on investment; pricing policy, cost control and distribution decisions; and gearing.  The current cost accounting possesses the merit of closely approximating the impact of specific price changes on the business enterprise because it makes use of specific indices. The CCA measures an individual company’s experience of inflation by reference to that company’s specific pattern of expenditure.

SSAP 16 points the limitations of CCA as follows:

 As with Historical cost accounts, CCA is not a substitute for forecasting when such matters as a change in the size or nature of the business is consideration. It assists cash flow forecasts, but does not replace them. It does not measure the effect of changes in the general value of money or translate the figures into currency of purchasing power at a specific date.  An important weakness of this model is that is seems to possess an element of subjectivity inherent in periodic revaluations, specially where specific price indices are not generated by an authoritative agency.  Largest problem is the aggregation problem. The value to the firm principle has its theoretic roots in the valuation of the individual assets, not the firm as whole.  Other important problems include the precise definition of replacement cost under conditions of economic and technological change.

5. Summary

In this chapter, constant purchasing power accounting and current cost accounting are presented as methods employed to report the effects of inflation on financial reporting.. Deficiencies of historical cost accounting are well recognized, especially during inflationary periods, and many accountants argue that the historical cost method should be replaced with a more competent accounting method which can deal with the effects of changing prices. However, some others argue that the historical cost method is based on arms-length transactions and this objectivity should not be sacrificed by using subjective methods. As a position of compromise, these methods are used to provide supplementary information within historical cost financial statements. In reality, financial statements cannot be perfectly objective, since they are prepared by the firm whose financial position is being reported. Moreover, some unavoidable uncertainties and estimates are part of all financial statements, and inflation adds to these uncertainties. The rational objective should be to reduce this uncertainty to a level which is reasonable. With this point in mind, inflation accounting methods can be utilized to increase the quality of financial data.

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