INFLATION ACCOUNTING

INTRODUCTION
 Prices do not remain constant over a period of time.
 They tend to change due to various economic, social or political factors.
 Changes in the price levels cause 2 types of economic condition, inflation and deflation.
 When there is rise in general price level, the purchasing power of money decreases and vice-versa.
 Rise in general price level is called Inflation and fall in general price level is called deflation.
 Financial statements prepared at historical cost fail to depict time and fair view of financial position
and correct profit due to changes in the value of money.
MEANING & DEFINITION OF INFLATION
ACCOUNTING
 A method of accounting that includes inflation. In inflation
accounting, one records price changes that affect the
purchasing power of current assets and the value of the
company's long-term assets and liabilities. This can provide
a more accurate picture of a company's value. It is used to
supplement a company's ordinary financial statements. It is
also commonly called general price level accounting.
ADVANTAGES OF INFLATION
ACCOUNTING
1. It gives accurate picture of profitability.
2. It keeps the capital of the enterprise intact. (dividend and taxes)
3. It depicts the true and fair view of financial positions.
4. It makes possible the profitability comparative study of the enterprises set
up at different periods.
5. It helps the enterprise to replace the assets.
6. It helps the company to have realistic price.
DISADVANTAGES OF INFLATION
ACCOUNTING
 It is complicated, confusing & time consuming process.
 An ordinary person fails to understand, analyze and interpret the adjusted
financial statements.
 This is not suitable for income tax purpose.
 It involves constant adjustments.
TECHNIQUES OF INFLATION ACCOUNTING

1. Current Purchasing Power Method

2. Current Cost Accounting Method

CURRENT PURCHASING POWER METHOD

 Under this method the values of various items of profit and loss account and
the balance sheet are changed in tune with the changes in price level.
 This is done with the help of approved general price index number.
 Almost in each country, the government prepares and publishes the general
price index numbers.
 In India, index numbers published by reserve bank of India are considered to
be more suitable.
 Business concerns should prepare the balance sheet and profit and loss
account on the basis of historical costs.
 In addition to final accounts, the concerns should also prepare supplementary
statements in which revise values of accounting items according to changes in
price level should be shown.
 A reasonable index number should be selected for changing the figures.
 A separate note explaining the base of price changes should be presented to
the board of directors.
MECHANISMS OF PREPARING FINANCIAL
STATEMENT UNDER CPP METHOD
1. Conversion Factor
2. Mid Period Conversion
3. Monetary Items
4. Non Monetary Items
5. Cost Of Sales & Inventories
6. Ascertainment Of Profit
 CONVERSION FACTOR
 CPP method requires the restatement of historical figures as disclosed in the financial statements at
current purchasing prices.
 This is done by multiplying the historical figures by the conversion factor calculated as follows:
Conversion factor = price index at the date of conversion
Price index at the date the item arose
The retail price index is considered to be the appropriate price index under CPP method.
 A company purchased machinery on 1-1-2005 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 st
December 2010 when the price index stood at 200
 Converted value of machinery,
= Existing value x price index at the date of conversion
Price index at the date when the item arose
= 90,000 x 200 = Rs 1,20,000
150
MID PERIOD CONVERSION

 In case of transactions occurring throughout a period, it will be advisable to

convert them according to the average index of the period.
 Such transactions generally include revenue items such as sales and purchases
of goods, payment of expenses, etc.
 In case the information regarding average index is not available, it may be
calculated by taking the average of the index numbers at the beginning and
at the end of the period.
 In the case of inflation, there would be losses on monetary assets and gains
on monetary liabilities, because the purchasing power of amount receivable
from monetary asset is declined and the amount used to pay off monetary
liabilities remains the same but with its lower purchasing power.
 The procedure for calculating such gains / losses is as under:
i. Change the monetary assets at the beginning of the current year on the basis of the opening index number
and the increase during the year on the basis on average index. If average index is not known of
information not given, then the absolute amount of increase is taken into account. Out of the total of such
changed values, the values of monetary assets at the end of the current year are deducted and the balance
is known as monetary loss.
ii. The value of monetary liabilities are also changed on the above lines and out of the total changed values,
values at the end of the current year are deducted and the balance is known as monetary gains.
iii. The difference between ii and i above shall be net monetary gain or net monetary loss which will be
adjusted in profit and loss account.
Particulars 1-1-2010 31-12-2010

Cash 7,000 10,000

Debtors 20,000 25,000

Creditors 15,000 20,000

Bills Payable 20,000 20,000

Price index number are:

January 1 2010 200

December 31 2010 300

Average for 2010 240

Particulars
Monetary loss
Cash 7000 X 300 10,500
200
Additions 3000 X 300 3,750
240
Debtors 20,000 X 300 30,000
200
Additions 5000 X 300 6,250
240
50,500
Less: Monetary Assets 31-12-2010 35,000
Monetary Loss (15,500)
Creditors 15,000 X 300 22,500
200
Additions 5000 X 300 6,250
240
Bills Payable 20,000 X 300 30,000
200
58,750
Less Monetary Liabilities 31-12-2010 40,000
Monetary Gains 18,750
Net Monetary Gains 3,250
Cost of sales & Inventories

 The cost of sales and value of inventories depends upon the cost flow
assumptions, i.e., FIFO or LIFO. According to the FIFO method, inventories
first purchased are taken to be first issued to production or sold to customers;
while according to LIFO Method inventory purchased in the last are taken to
have been first issued to production or sold to customers. While we stating
the figure under CPP method, it would be appreciated to keep in mind the
cost flow assumptions, since they affect both cost of sales and closing
inventory as shown below:
 FIFO Method
i. Cost of sales: it comprises entire opening stock and current purchases less closing stock.
ii. Closing inventory: : it comprises entirely current purchases. However, in case total sales are
even less than the opening inventory, a part of the opening inventory may also become a part of
the closing inventory.
 LIFO Method
i. Cost of sales: it comprises current purchase only. However, if the current
purchases are less than cost of sales, a part of the opening inventory may
also become a part of the cost of sale.
ii. Closing Stock: : it comprise purchases made in the previous year or years.
 The following indices are used under CPP Method for restating the historical
figures:
i. For current purchases: average index of the year.
ii. For opening stock: index at the beginning at the year
iii. For purchases of previous year: average indices of the relevant year.
 Yee Ltd follows LIFO method. From the particulars given below, ascertain cost of sales and closing
inventory under CPP Method:

Particulars Rs

closing stock 31-12-2009 20,000

Purchases during the year 2010 1,12,000

closing stock 31-12-2010 25,000

Price index number are:

2009 end 150

2010 end 240

Average for 2010 160

 Cost of sales under historical cost & CPP

Particulars Historical Cost Conversion factor CPP

Opening Stock 20,000 240/150 32,000
Add: Purchases 1,12,000 240/160 1,68,000
1,32,000 2,00,000
Less Closing Stock 25,000 39,500
1,07,000 1,60,500

Particulars Rs Rs
Closing stock as given at LIFO 25,000
20,000 from opening stock = 20,000 X 240 32,000
150

5,000 from purchases 5,000 X 240 7,500

160
39,500
 Ascertainment of profit
 There are 2 ways to ascertain the profit.
1. Net Change method: This method is based on the normal accounting principle that profit is the change
in equity during an accounting period. In order to determine this change the following steps are taken:
i. opening balance sheet prepared under historical cost accounting method is converted into CPP terms
as at the end of the year. These is done by application of proper conversion factors to both monetary
as well as non monetary items. Equity share capital is also converted. The difference in the balance
sheet is taken as reserves. Alternatively, the equity share capital may not be converted and the
difference in balance sheet be taken as equity.
ii. Closing balance sheet prepared under historical cost accounting method is also converted. Of course
monetary items are not restated as explained earlier. The difference between the 2 sides of the
balance sheet is put as reserves after converting equity capital. Alternatively, the equity share capital
may not be converted in CPP terms and the balance be taken as equity.
iii. Profit is equivalent to net change in reserves or net change in equity.
 The balance sheet of swikriti ltd as on 31-12-2011 and its profit & Loss a/c for the year 31st December 2011 are
given below:

Balance sheet
Liabilities Rs Assets Rs

Shareholders Equity 40,000 Machinery 60,000

Depreciation Fund 24,000 Stock 9,600

Creditors 14,400 Debtors 4,800

Cash 4,000

Additional Information:
a) Debtors & Creditors and cash remain constant throughout the year.
b) Shareholder’s equity on 1st Jan 2011 on CPP comes to Rs 50,000
c) Following indices are given: January 1, 2011 = 200, average for 2011 = 240 and December 31, 2011 300
Calculate the profit for the year 2011, based on CPP, by net change method.
 Balance Sheet

Liabilities Rs Assets Rs
Shareholders Equity 60,400 Machinery 90,000
Depreciation Fund 36,000 Stock 12,000
Creditors 14,400 Debtors 4,800
Cash 4,000
1,10,800 1,10,800

Net profit as per net change method:

Shareholder’s equity on 31-12-2011 60,400
Less: Shareholder’s equity on 1-1-2011 Working Note 50,000
Profit based on CPP method for the year 2011 10,400

stock 9,600 X 300/240 = 12,000

Machinery 60,000 X 300/200 = 90,000
Depreciation Fund 24,000 X 300/200 = 36,000
2. Conversion of income statement method: The income statement prepared on historical cost basis is
converted in CPP terms on the following basis;
a. Sales and operating expenses are converted at the average rate applicable for the year.
b. Cost of sales is converted as per cost flow assumptions (FIFO or LIFO)
c. Fixed assets are converted on the basis of the indices prevailing on the dates they were purchased. The
same applies to depreciation.
d. Taxes & dividends paid are converted on the basis of the indices that were prevalent on the dates they
were paid.
e. Gain or loss on account of the monetary items should be calculated and stated separately in restated
income statement to arrive at the overall figure of profit or loss.
 The income statement of XYZ Ltd for the year ending 31st December 2010 prepare under conventional accounting
is as under:

Particulars Rs Rs

Sales 12,00,000

Expenses
Opening stock
1,20,000
Add: purchases
8,28,000 8,40,000
Less: Closing stock
1,08,000
Cost of sales
Salaries & Wages 1,50,000

Other Expenses 60,000

Depreciation on Building 12,000

Interest 6,000 10,68,000

Net Income 1,32,000
 Additional Information:
i. General price Index numbers are:
1st January 2010 100
31st December 2010 200
Average 150
ii. Interest and dividends are paid on 31st December.
iii. Building was purchased in 2009 when the general price index was 50.
Prepare income statement under CPP
 Two conversion factors are to be applied:
i. On the basis of opening index no = 200/100 = 2
ii. On the basis of average index no = 200/150 = 1.33

Sales and other revenue items are to be converted at average index.

Depreciation on building will be converted at the index no applicable to the
purchase of building i.e. 200/50 = 4, closing stock is out of purchase which means
the company is using FIFO method.
 The income statement under CPP method
Particulars Rs Rs

Sales 12,00,000 X 4/3 16,00,000

Less: Cost of sales:

Opening stock 1,20,000 X 2 2,40,000
Add: purchases 8,28,000 X 4/3 11,04,000
Less: Closing stock 1,08,000 X 4/3 1,44,000 12,00,000
Gross Margin 4,00,000
Less: Expenses
Salaries & Wages 1,50,000 X 4/3 2,00,000
Other Expenses 60,000 X 4/3 80,000

Depreciation on Building 12,000 X 4 48,000

Interest 6,000 3,34,000

Net profit 66,000
Less Dividends 1,00,000
Erosion in Retained earnings 34,000
CURRENT COST ACCOUNTING METHOD

 The current cost accounting technique has been preferred to the current
purchasing power technique of inflation accounting as it is a complete system
of inflation accounting.
 The financial statements prepared under this technique provide more realistic
information and makes a distinction between; profits earned from business
operations and the gains a rising from changes in price levels.
 As depreciation under CCA is provided on current cost, the method prevents
overstatement of profits and keeps the capital intact.
 The effect of holding monetary items in terms of gains and losses having
impact on the finance of the business is also highlighted.
 The salient features of the CCA method are:
Fixed assets are shown not at their depreciated original cost but at their net replacement value
Stocks are shown at their net replacement value
Depreciation is calculated at the current value of assets
Gains/losses due to the changes in the price level are shown in a separate statement
• Inventory consumed is valued at the price at the date of consumption
 Under the CCA method, assets and expenses are shown in financial statements at the
current cost to replace those specific resources.
 Thus, profit is measured by comparing revenues with the current replacement cost of the
assets consumed in the earning process.
 Current cost accounting has the following important features:
 (a) Fixed assets are to be shown in the balance sheet at their value to the business
and not at their depreciated original cost.
 (b) Stocks are to be shown in the balance sheet at their value to the business and
not at the lower of their original cost and realisable value.
 Suppose an asset is acquired on 1st April, 2008 at a cost of Rs 10 lakh with an
expected life of 10 years ignoring the scrap value. By 1st April, 2011 the price
index for the asset rose by 60% and by 75% by the end of March, 2012.
 The asset will be valued on historical cost (HC) basis and on CCA
basis as shown below:
 The CCA balance sheet will show the asset on 31st March, 2012 at Rs 10,50,000.
The increase of Rs 4,50,000, from Rs 6,00,000 (HC basis) to Rs 10,50,000 (CCA
basis), will be credited to a (capital) reserve styled as “Current Cost Accounting
Reserve”.