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1. Inflation refers to the decline in purchasing power of a monetary unit over time.
2. If the purchasing power of the monetary unit has changed substantially (high
inflation or deflation) then the financial statements may be distorted. Monetary
units of different purchasing power are aggregated as if they represent the same
purchasing power. This may result in presentation of the amounts in financial
statements that are not very meaningful.
Restating financial statements, by using general price-level indexes, means that all
the amounts in financial statements are expressed in a monetary unit with constant
purchasing power. This removes the distortion caused by aggregation of amounts
based on a monetary unit of different purchasing power.
A nonmonetary item is one that does not represent a claim to, or for, a specified
number of monetary units. Examples are inventory, equipment, land, warranty
claims payable, common stock, retained earnings, revenues, and expenses.
4. In a country that has had an extremely high rate of inflation for many years,
unadjusted historical cost basis financial statements do little to inform the user
about an entity. This is so because the financial statements reflect monetary units of
varying dimensions.
5. Multiply the nominal amount of the fixed asset with the current index divided by
the index in effect when the asset was acquired. The related depreciation and
accumulated depreciation are restated in the same manner.
6. A net monetary gain or loss, also called purchased power gain or loss, results from
the difference between the nominal net monetary position and the constant
monetary unit net monetary position.
7. A monetary gain or loss, arising from holding monetary items, appears in the
income statement adjusted for general price level changes.
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8. a. Nonmonetary
b. Monetary if held to maturity; Nonmonetary if held for resale before maturity
c. Nonmonetary
d. Nonmonetary
e. Monetary
10. A specific price index is constructed by taking the current price of a specific good or
service and dividing it by price of the same good or service at the base period.
11. The replacement cost is an input price. Net realizable value is an output price.
12. When a country has a highly inflationary economy for sustained periods of time, it
is likely to introduce inflation accounting.
13. A gearing adjustment is made to recognize that it is not necessary to make current
cost adjustments to operating assets to the extent that they are financed by
creditors. The amount of the gearing adjustment is computed by multiplying the
total current value adjustments (such as for current cost of goods sold and current
cost of depreciation) to the ratio of average borrowing to average operating assets.
14. Two major ways of accounting for inflation are either the general purchasing power
approach or current cost approach. Under IAS 15, the following adjustments
should be disclosed by large public companies:
• The amounts of the adjustment to or the adjustment amount
of depreciation of property, plant, and equipment.
• The amount of the adjustment to or the adjusted amount of
cost of sales.
• The adjustments to monetary items.
• The overall effect on income.
• If the current cost method is used, the current cost of
property, plant, equipment and inventories.
• The methods used to calculate the information above as well
as the type of indices used.
Chapter 3 31
16. IAS 29 applies to primary financial statements. The gain or loss on the net monetary
position should be included in the income statement and separately disclosed. IAS
29 requires that financial statements of a company reporting in a currency of
hyperinflationary economy be restated for general purchasing power changes at
the balance sheet date. This requirement applies regardless of whether the
primary financial statements were prepared on historical cost basis or current
value basis.
Solutions to Exercises/Problems
3-1 1. c 2. c 3. c
4. e 5. d 6. b
7. a 8. c
3.2 Using historical costs restating for the changing price level of the franc:
Depreciation:
Nominal Conversion
amount ratio
50,000 x 225/200 = 56,250 francs
Expenses:
Cost of goods sold ( 90,000) 160/140 (102,857)
Depreciation expense ( 30,000) 160/130 ( 36,923)
Salaries expense ( 40,000) 160/150 ( 42,667)
Interest expense ( 15,000) 160/150 ( 16,000)
Total expenses (175,000) (198,447)
* Rounded
Shahruz Co.
Restatement of Balance Sheet to Constant Dollars
31 December 2002
Nominal Constant
dollars Ratio dollars
Assets
Cash $ 70,000 140/140 $ 70,000
Account receivable (net) 50,000 140/140 50,000
Inventory 80,000 140/130 86,154
Land
Purchases in January 1999 250,000 140/105 333,333
Purchases in June 2000 250,000 140/120 291,667
Total land 500,000 625,000
Total assets $700,000 $831,154
Sales $350,000
Cost of goods sold ( 230,000)
Gross margin 120,000
Operating expenses ( 70,000)
Income before holding gains 50,000
Holding gains:
Inventory ($120,000 - $100,000) $20,000
Fixed assets ($275,000 - $250,000) 25,000 45,000
Net income current cost basis $ 95,000
3-10 Units
(1) Beginning inventory 20,000
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Note: Any difference between the historical cost and the current cost is accounted for
as a holding gain or loss.
(2) Rationale: It is not necessary to make a current cost adjustment for the
portion of assets that were financed from borrowings.
(2) A monetary item is cash or another asset or a liability that will be either received
or paid out in a fixed number of monetary units.
A nonmonetary item, on the other hand, does not represent an asset or a liability
that will require either receipt or payment in a specified number of monetary
units.
Income statement:
• Identify and restate each item by using the past index that was in effect
for the item.
• Compute depreciation using restated amount of the related asset.
38 Chapter 3
• Using an average index, adjust the items that occur evenly during the
period (e.g., interest expense, rent expense, etc.)
• Compute cost of goods sold using appropriate indices for beginning and
ending inventories and the restated purchases amount.
• Calculate the purchasing power gain or loss from a net monetary
position.
(4) Similarities:
• Both are historical cost basis statements.
• Both can be developed objectively, and are thus easily verifiable.
• Neither attempts to reflect current values.
Differences:
• Constant monetary unit financial statements show adjusted amounts for
the effect of change in purchasing power of the monetary unit.
• Only the constant monetary unit income statement includes purchasing
power gain or loss from holding monetary items.
(5) No. As mentioned earlier in Part (3), the 2002 supplementary statement amounts
would be rolled forward. For example, if there was 8 percent inflation in 2003, all
balances in the 2002 statements would be multiplied by 108 percent.