ACCOUNTING FOR PRICE LEVEL CHANGES – part 1

2.1 NEED FOR INFLATION ACCOUNTING

• The major reason why inflation accounting or accounting for price level changes has been a hot topic in the academic
literature is because of the deficiencies of the historical cost accounting (HCA) approach.
• HCA is a well established method of accounting all over the world because it is able to meet the legal requirements of
financial reporting i.e fulfilling the stewardship function assigned to financial reports. HCA has been able to provide
information about the financial position, performance and changes in financial position of an enterprise to a wide range
of users especially during periods of stable prices.
• However, most economics in the world are characterized with environments of non-stable prices —inflation. Under such
circumstances, it is unlikely that HCA can be able to satisfy the informational demands of users whose academic needs
are dependent on estimates of future cashflows. HCA is likely to fail because:

(a) The balance sheet figures for assets, based on cost at time of acquisition are unlikely to reflect present day values since
they lack additivity. The balance sheet includes a conglomerate of costs incurred on different dates which will not enable
users to "realistically predict future cashflows" related to those assets.
(b) If profit (income) is dependent on measure of capital at different dates, then profit measurement can be considered to be
the result of comparing two fairly meaningless totals. In addition the profit that results is usually considered to be
overstated and any ratio, including return on capital employed, will also be overstated.
(c) Historic cost profit give a misleading impression of the ability of a company to continue to operate at the same level of
operation and/or maintain capital in `real terms' - problem of capital maintenance.
(d) A series of historic cost accounts can give a misleading impression of the financial trends of a company.

2.2 CAPITAL MAINTENANCE

There is a relationship between profit and capital. Conventionally, profit is calculated by setting expenses against revenues in
a formal statement known as a profit and loss account. An alternative view of profit is to see it, in the absence of fresh capital
inputs or drawings, as the increase in the net worth of a business.

Thus the relationship between profit (income) and capital can best be expressed by the following equation:

I = D + (K2 - K1)

Where I = Income for the period

D = Dividends or distribution
K2 = Capital at the end of the period
K1 = Capital at the beginning of the period
If K2 = K1, I = D, i.e. all the income has been distributed
K2 > K1, I > D, i.e. retained profits which form part of the capital at the beginning of next year
K2 < K1, I < D i.e. dividends have been paid out of capital or reserves brought forward
As can be seen from the above equations, income is only recognised after the capital at the beginning of the year is maintained
at the end of the year. Thus, capital maintenance is thus a minimum concept. Capital represents the absolute minimium
funding that must be retained to provide security for creditors, and to keep the business at least at the level of activity that was
originally determined by the owner(s).
In order to keep track of essential capital, accountants have traditionally made a clear distinction between capital and revenue
funds.

The value of income will also depend on the manner in which the capital is measured. A number of models are available to
measure income. These can be broadly categorised into two:
(a) Economic income model
(b) Accounting models
Economic Income Model

It can be measured using the following equation

I = C + (K2 - K1)

Where I = Income for the period

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 C = Realised cashflow in the period
K2 = Capital at the year-end measured in terms of present value of future cashflows.
K1 = Capital at the beginning of the year measured in terms of present value of future cashflows.

This equation is based on Hick's model of ideal income and he defines the income as being "the amount a man can spend and
still be as well off at the end of the period as he was at the beginning.

This approach to measurement of income sidesteps all the problems associated with year end adjustment to profit. The
estimations of accurals and prepayments, the assumptions about fixed assets lives etc that are embodied in the traditional
profit and loss account are entirely avoided.

However, the main disadvantage is probably that the calculation of well-offness, or capital, is similarly subject to estimates and
professional judgements. Remember the value of capital at the beginning and the end of the period is defined as the
discounted present value of the future income stream. This income is measured from changes in capital, by contract to the
accrual concept where capital is the residual after measuring income.

Future cash flows are discounted at the entity's cost of capital and the maximum one can spend to maintain the "welloffness"
is I and not C. An essential feature of the model is that the definition of income takes account of consumption and saving
and dis-saving. The sums saved should be reinvested and should earn interest, which will ensure capital maintenance and a
constant income.

2.3 ACCOUNTING MODELS

This includes:

(a) Classical school - Historical cost accounting the capital is maintained by money terms. If the entity has a historical
cost of Shs 1,000 at the beginning of the year and Shs 1,000 at the end of the year (assuming no distributions and no
injections or withdrawal of capital):

Income = Sh 1,500 - Sh 1,000 = Shs 500

This is the traditional approach to profit measurement.

(b) Neo-classical
This includes the Historical cost accounting adjusted for changes in general purchasing power. This model makes
sure that the purchasing power of the capital is maintained.

(c) Modern School - Current Value Accounting

This model tries to maintain the operating capability of the entity. The operating capability of the business entity is
its ability to replace assets as they are consumed or worn out or its ability to produce the same volume or value of
goods i.e. the next year as in the current year.

2.4 APPROACHES TO INFLATION ACCOUNTING

- HCA does not reflect the impact of changing prices on the net assets and earnings of a company, but to date no
agreement has been reached on a system that will do that and provide users with the information they require to make
decisions in an environment of moving price levels.
- However, there are two main approaches to inflation accounting. These are:

(a) Current purchasing power accounting system and

(b) Current value systems

2.5 CURRENT PURCHASING POWER (CPP) ACCOUNTING

- It is also referred to as the General Price Level Approach.
- It requires that historical cost based amounts be translated to the current purchasing power equivalent using the
general price level index.

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- The CPP accounts attempts to maintain the shareholders' capital in terms of the general or consumer purchasing
power. This is known as the proprietorship concept of capital maintenance.
- According to the CPP, all items in the profit and loss account are expressed in terms of current (year-end) purchasing
power, while the same will be true in the balance sheet. Thus all items in the balance sheet will have to be converted
in terms of year-end purchasing power except the so called monetary items (assets and liabilities) which are
automatically expressed in such terms.

Example 1 - CPP Accounts

Nyumba Ltd engages in real estate business owning only one property. The company's main income is rental income.

The balance sheet of the company as at the end of the year 1 and year 2 is as follows:

Year 1 Year 2
KShs KShs
Assets
Building (net) 150,000 105,000
Cash 45,000 90,000
95,000 195,000

The comparative income statements for both year 1 and year 2 are given below:

Year 1 Year 2
Kshs Kshs
Revenue 82,500 90,755
Expense
Depreciation (45,000) (45,000)
Net Income 37,500 45,755

Additional Information
 The company was formed on January 1st, Year 1 through a cash investment of KSh 195,000.
 The building was acquired on January 1st Year 1 at a cost of 195,000. Expected useful life is 4 1/3 years.
 All revenue is received at the end of the year.
 There are no operating expenses except depreciation.
 All net income is paid out as a dividend. The balance of cash is banked at no interest return.
 The price indexes for Year 1 and Year 2 are as follows:

1st Jan year 1 100

31st Dec Year 1 105
31st Dec Year 2 110

Required:
Prepare the balance sheet and income statements for Nyumba Ltd for the two years using the current purchasing power
approach.

Solution:
NYUMBA LTD
Income Statement for Period ending
Year 1 Year 2
KShs KShs
Revenue 82,500 90,755
Depreciation (W1) (47,250) (49,500)
35,250 41,255
Purchasing power
Loss (W2) _____ (2,250)
Net Income 35,250 39,005

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Balance Sheet as at end of
Year 1 Year 2
Assets Kshs Kshs

Buildings (net) (W3) 157,500 117,750

Cash (W4) 47,250 96,750
204,750 214,500

Capital (W5) 204,750 214,500

Workings
W1 - Depreciation Expense

Year 1  105 x 195,000 = KShs 47,250

100 4 1/3

Year 2  110 x 195,000 = KShs 49,500

100 4 1/3
W2 - Purchasing Power Loss

Year 1 - No loss/gain as there was no monetary item at the beginning of the year.

Year 2 - Monetary assets-cash = 47,250 at beginning of Year 2.

Thus the PP loss

= 47,250 x 110 - 47,250

105
= KSh. 2,250

W3 - Buildings

Year 1 - Adjusted cost (105 x 195,000) = 204,750

100
Less Acc. Depreciation ( 47,250)
157,500

Year 2 - Adjusted cost (110 x 19,500) = KSh 214,500

100
Acc. Depreciation (47,250 + 49,500) 96,750
117,750

W4 - Cash

Year 1 - Amount of depreciation retained = KShs 47,250

Year 2 - Amount of depreciation retained
to date (47,250 + 49,500) = KShs 96,750

W5 - Capital

Year 1 - 195,000 x 105 = KShs 204,250

100

Year 2 - 195,000 x 110 = KShs 214,500

100

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Purchasing Power Gain and Losses
- Purchasing power gains and losses arise as a result of holding non monetary assets or liabilities during a period when
the price level changes.
- Purchasing power gains and losses arise because monetary items, which are fixed in terms of the number of shillings to
be received or paid, gain or lose purchasing power as the price level changes.
- Monetary assets - assets receivable at fixed amounts either currently or in the future include cash, accounts receivable,
notes receivable.
- Monetary liabilities - liabilities payable in fixed number of shillings either currently or in the future include both short
term liabilities like LTD, notes payable etc.
- He potential for gains and losses is summarised in the table below where "net monetary assets" refers to total monetary
assets exceeding monetary liabilities and the converse is true for "net monetary liabilities".

PURCHASING POWER GAINS AND LOSSES

State of the Economy
State of the Enterprise Inflation Deflation
Net monetary assets position Purchasing power loss Purchasing power gain
Net monetary liabilities position Purchasing power gain Purchasing power loss

Advantages of CPP
 Current Purchasing Power accounts provide a monetary unit of valuing all items in the financial statements for proper
comparisons.
 Since CPP accounts are based on historical cost accounts the raw data is easily verified and can be edited
 The restatement of results enhances entities comparability.
 Profit is measured in real terms – as a result more accurate forecasts can be made of future profits.
 CPP accounts avoid the subjective valuations of CCA.

Problems and criticisms of CPP

Although the CPP restores the additivity of the figures, it has its own problems.

(a) Balance sheet treatment of non-monetary assets.

It is normally regarded as an extension of the historical cost approach. The resultant figures bear little resemblance to
current values of such assets.
(b) The nature of CPP profit
The CPP profit consists of trading profits and losses, and monetary gains and losses. Some critics were concerned that a
highly geared and illiquid company, with substantial liabilities, could show a trading loss and yet a substantial monetary
gain. CPP profit could give a misleading impression of its ability to pay a dividend.
(c) Difficulty of understanding the purchasing power unit concept.
It has been argued that users of CPP statements may find the current purchasing power concept difficult to understand
and explain. Items in the balance sheet and profit and loss account may appear rather abstract to non-accountants
compared with the basic principles of, say, current value accounting.

2.6 CURRENT VALUE ACCOUNTING

 There is no such thing as a current value accounting system, but rather several systems which can be regarded as members
of the current value family.
 Three possibilities include:

(a) The economic value method

(b) The net realisable (or exit value) method
(c) The current replacement cost (or entry value) method

The Economic Value Method

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Under this method, the current value of an individual asset is based on the present value of the future cashflows that are
expected to arise as a result of owning the asset. This method requires information concerning the following:

i. the amount of future benefits in cash terms;

ii. The timing of those benefits (for discounting purposes);
iii. A suitable discount factor - the cost of capital over the future lifetime of the asset.

The method is soundly based from a theoretical viewpoint but can nevertheless be criticised on several grounds of a practical
nature.

The criticisms include:

 It is difficult to see how cash flow information and estimated discount rates will be capable of verification by auditors, so
that users of accounts may be unwilling to place reliance on the resulting financial statements.
 The method is highly subjective and the figures required to operate this method could be extremely difficult to produce
e.g estimating cashflows that can be attributed to individual assets.
 Under this method it would be impossible to provide a detailed analysis of the year's profit figure. Profit for the year
would be based on the difference between opening and closing net asset valuation figures (aggregated) adjusted for capital
introduced and dividends.

The Net Realisable Method (NRV)

- Under the NRV method, asset values in the balance sheet would be based on the net price that could be obtained in the
open market if assets (stock and fixed assets) were sold in an orderly way at the balance sheet date. This method is
sometimes referred to as the "exit value" approach.

Advantages of NRV include:

- Accounts prepared on this basis show the firm's total position in terms of its net liquidity. This information will be useful
to users of financial statements such as management, shareholders, creditors, bankers etc. For example, it may assist
bankers in making lending decisions and managers in deciding the best use to which particular assets should be put.
- It also restores the additivity of balance sheet figures.
Disadvantages of NRV include:
 The method places a great emphasis on liquidation. This is inconsistent with the going- concern assumption.
 The method would be costly and time consuming, involving individual assessment of individual assets.
 It is also possible that some company assets may lack realisable/market values.
 It may also produce very unrealistic fixed assets values, for example, specialised plant could have a high value to a particular
business, but still have a very low NRV in the market place. In the absence of liquidation, such a NRV would be
meaningless.
 In the case of stocks, for example, profit is taken before goods are sold thus infringing the realisation concept.

The Replacement Cost Method

 The method is also referred to as the "Entry Value" approach.
 The method requires that the value of items be adjusted to reflect the cost at which it could have been replaced in the
normal course of business either at the date of sale goods or at the balance sheet date.
 The method seems to represent the value of the firm.

Example
The net realisable value method and the replacement cost method are illustrated below:

Assume the example in section 4.2.1 - Nyumba Ltd

Additional Information:

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i. Replacement cost for a new building of the same type is KShs 180,000 at the end of Year 1 and KShs 210,000 at the
end of Year 2.
ii. Net realisable value for the building is KSh 135,000 and KSh 120,000 a the end of Year 1 and Year 2 respectively.

Required:
Prepare the accounts for Nyumba Ltd using

(a) The Replacement Cost approach

(b) The Net Realisable Value approach

Replacement Cost Approach

Nyumba Ltd - Income Statement for Period ending

Year 1 Year 2
KShs KShs

Revenue 82,500 90,755

Depreciation Expense (W1) (41,538) (48,462)
40,962 42,293

Balance Sheet as at end of

Year 1 Year 2
Assets Kshs Kshs

Buildings (net) (W2) 138,462 113,076

Cash 41,538 90,000
180,000 203,076

Capital 180,000 203,076

Workings:
(W1) - Depreciation Expense Year 1 - 180,000 = KSh 41,538
4 1/3

Year 2 - 210,000 = KSh 48,462

4 1/3

(W2) - Buildings (net) Year 1 - (180,000 - 41,538) = KSh 138,462

Year 2 - (210,000 - 2(48,462) = KSh 113,076

Net Realisable Value (NRV) Method

Nyumba Ltd- Income Statement For Year Ending

Year 1 Year 2
KShs KShs
Revenue 82,500 90,755
Depreciation Expense (W1) (60,000) (15,000)
22,500 75,755

Balance Sheet as at End of

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 Year 1 Year 2
KShs KShs
Buildings (net) (W2) 135,000 120,000
Cash (W3) 60,000 75,000
195,000 195,000

Capital 195,000 195,000

Workings:
W1 - Depreciation Expense Year 1 - (195,000 - 135,000) = KSh 60,000
Year 2 - (135,000 - 120,000) = KSh 15,000

W2 - Buildings (net) Year 1 - 135,000 as given

Year 2 - 120,000

W3 - Cash - Year 1 - Amount of acc. depreciation = KShs 60,000

Year 2 - Amount of acc. depreciation = KSh (60,000 + 15,000)
to date = KSh 75,000