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Inflation
INFLATION is the erosion or reduction in the value of money. Simply stated what one can buy for Rs.100 cannot buy the same thing for Rs.100 after some time. For e.g a pao was Rs.5/- some time backbut the same pao is around Rs.10/today
While the cost in the traditional accounting refers to the historical cost, in inflation accounting it represents the cost that prevails at the time of reporting.
Thus, the problems created by price changes in the historical cost based accounts necessitated some method to take care of inflation into the accounting system.
To facilitate the comparison of the performance of two different periods it is necessary that the figures are adjusted for inflation.
The monetary items and income and expenses do not show the correct Purchasing power of money. Therefore their values should be adjusted for inflation. To ascertain the current value of assets.
Under CPP method, all items in the financial statements are restated in terms of units of equal purchasing power.
The CPP method basically attempts to remove the distortions in financial statements, which arise due to change in the value of rupee. CPP method distinguishes between monetary and non-monetary items.
CPP Method
contd
Value of asset as per CPP = Historical Cost of Asset x Conversion Factor Conversion Factor = Price Index at the date of conversion Price at the date of transaction
Illustration:
A company purchased a plant on 1/1/2005 for a sum of Rs. 45,000. The consumer price index on that date was 125 and it was 250 at the end of the year. Restate the value of the plant as per CPP method as on 31st December 2005.
Solution:
Conversion Factor =
Price Index as on 31/12/2005 = 250 = 2 Price Index as on 1/1/2005 125 Value of the plant on 31/12/05 = Historical Cost x Conversion Factor Rs 45,000 x 2 = Rs 90,000
During the period of inflation the holder of monetary assets lose general purchasing power since their claims against the firm remain fixed irrespective of any changes in the general price levels. Conversely, the holder of monetary liabilities gains since he is to pay the same amount due in rupees of lower purchasing power.
contd.
Non monetary items are those items that cannot be stated in fixed monetary amounts. They include tangible assets such as building, plant & machinery, stock etc. Under CPP method all such items are to be restated to represent the current purchasing power. For example a machinery costing Rs 25,000 in 1996 may sell for Rs 35,000 today though it has been used. This may be due to change in the general price level. Note : Equity capital is a non monetary item since the equity shareholders have a residual claim on the companys net assets.
Illustration:
From the following data calculate net monetary gain / loss as per CPP method Item 1/1/2008 31/12/2008 Cash Rs. 5000 Rs 10000 Debtors Rs. 20000 Rs 25000 Creditors Rs. 15000 Rs 20000 Public Deposits Rs. 20000 Rs 20000 Consumer Price index numbers are On 1//12008 -- 100 On 31/12/2008 -- 150 Average for the year -- 120
Solution :
Impact on Assets: Assets as on 31/12/2008 = 35000 out of which 25000 are opening and rest 10000 are additions during the year. Value of assets as per CPP = 25000 x 150 / 100 = + 10000 x 150 / 120 = Less: Value of assets as per closing B/S Resultant monetary Loss
Solution
Impact on Liabilities:
contd.
Liabilities as on 31/12/2008 = 40000 out of which 35000 are opening and rest 5000 are additions during the year. Value of liabilities as per CPP = 35000 x 150 / 100 = + 5000 x 150 / 120 = Less: Value of liabilities as per closing B/S Resultant monetary gain
Solution
contd.
18750 15000 3750
Net monetary Gain = Monetary gain from liabilities Less: Monetary loss from assets Net Monetary gain =
Illustration:
From the following particulars, ascertain the values of cost of sales and closing stock as per CPP method Stock on 1/1/08 Purchases during 2008 Stock on 31/12/08 Price Index on 1/1/2008 Price Index on 31/12/2008 Average Price Index for 2008 Rs 20000 Rs 60000 Rs 24000 150 240 180
Assets and liabilities are stated at their current value to the business. Similarly, the profits are computed on the basis of current values of the various items to the business. This requires carrying out the following adjustments Revaluation adjustment Depreciation adjustment Cost of Sales adjustment Monetary Working Capital adjustment
Revaluation Adjustment :
Fixed Assets Are shown in the balance Sheet at their values to the business. To the business of an asset refers to the opportunity loss to the business of were deprived of such assets. The replacement cost could be taken as gross or et. Gross replacement cost of an asset is the cost to be incurred at the time of valuation to obtain a a similar asset for replacement. Net replacement cost of an asset is the gross replacement cost less depreciation.
Illustration:
An asset purchased on 1/1/2005 for Rs 50,000 now costs Rs 80,000 on 31/12/2005 , then the gross replacement cost of the asset is Rs 80,000. Assuming that the useful life the asset is 5 years, then the net replacement cost = 80,000 80000 x 3 / 5 = 32,000.
Depreciation Adjustment:
The profit and loss account should be charged for depreciation with an amount equal to the value of fixed assets consumed during the period. Depreciation charge may be computed either on the basis of total replacement cost of the asset or on average net current cost of assets. i.e. Current cost at beg. + Current cost at the end / 2
Illustration:
X ltd purchased a machine on 1/1/2002 for Rs 80,000 and its expected life was 10 years without any scrap value. On 1/1/2005 the same new machine would cost Rs 30,000 and on 31/12/2005 Rs 40,000. Calculate the depreciation charge for the year 2005 as per CCA method assuming that there is no change in the useful life of the asset.
Solution:
Depreciation under CCA method = Average replacement cost / useful life
Illustration:
Determine the value of COSA Adjustment from the data given below Stock on 1/1/2005 Rs 12,000 Stock on 31/12/2005 Rs 16,000 Index number on 1/1/2005 160 Index number on 31/1/2005 200 Average Index number for the year 190
Solution:
COSA = CS OS Ia ( CS/Ic OS/Io) = (16000 12000) 190 ( 16000/200 12000/160) = 4000 -190 (180 75) = Rs. 3050
CCA ensures that the impact of changing prices on working capital is taken care of through MWCA. This adjustment is required only for price level changes and not for any increase in volume of the business.
MWCA = C O Ia ( C/Ic O/Io) Where: C means Closing Monetary WC O means Opening Monetary WC Ia means Average Index for the year Ic means Closing Index for the year Io means Opening Index for the year
Illustration:
From the following information carry out MWCA under the CCA method Opening Closing Balance Balance Accounts Receivable 18,000 21,000 Accounts Payable 10,000 12,000 Price Index 175 205 Average Pirce Index 190
Solution:
MWCA = C O Ia ( C/Ic O/Io)
Opening MWC = 18000 10000 = 8000 Closing MWC = 21000 12000 = 9000
MWCA = (9000 - 8000) 190(9000/205 8000/175) = 1000 190 ( 43.90 45.70) = 1342