Professional Documents
Culture Documents
Department of Commerce
Seminar on
Modern Accounting Theory:
Accounting for price-level changes
By
Abdi Dufera
Oct , 2016 G.C.
Objectives
By the end of the seminar , you would
be able to:
describe the problems of historical
cost accounting (HCA);
explain the approach taken in each of
the inflation adjusting models;
prepare financial statements applying
each model (HCA, CPP, CCA,
critically comment on each model
(HCA, CPP, CCA,
1 Introduction
The basic objective of accounting is the
preparation of financial statements in a way
that the I/s report should disclose the true
financial condition and position of
organization in particular period.
Financial statements are prepared in
monetary units like birr, rupee, dollar
F/S can serve very well the basic objective if
the value of such monetary units remains
stable.
This is possible only when there is a stability
in the price levels. However, over a period of
time, the prices have not remained stable.
There have been inflationary as well as
deflationary tendencies
Cont..
Financial statements which are
prepared according to the conventional
or historical cost accounting system,
therefore, do not reflect current
economic realities.
Thus, neither the balance sheet nor
the income statement shows the
correct operating and financial position
of the business.
2 Review of the problems
of historical cost
accounting (HCA)
1. Fall to disclose current worth of the
enterprise: They do show the true current
worth of the enterprise
2. Contains non-comparable Items :The
financial statements contain items which
non comparable since they are usually a
composite of historical and current costs.
Eg. Building
3. Mixes holding and operating gains: In
conventional accounting, gains on account
of holding the inventories may be mixed up
with the operating gains.
Example
A business purchased 100 units of a product at Rs 6
per unit in 1990. It could sell only 50 of such units in
that year. In 1991, it purchases another 100 units at Rs
8 per unit and sells all 150 units at Rs 10 per unit. In
such a case the profit in 1991 as per historical
accounting will be as follows:
Rs.
Sales (150 units x Rs 10) 1,500
Less: Cost of sales (50 x 6 + 100 x 8) 1,100
400
Thus, Rs100 is the holding profit while Rs 300 is the
operating profit.
The historical accounting system, as seen above, does
not make this distinction.
Note: In order to combat these serious defects, price
level accounting became the subject of research and
debate as to the most appropriate method to use for
financial reporting
Price level accounting
is technique of accounting by which the
financial statements are restated to
reflect changes in the general price
level.
Such changes, as stated earlier, may
be either inflationary or deflationary.
Since, inflation has come to stay and
frequently occurred and, therefore,
price level accounting is more
concerned with inflationary tendencies.
Methods of Accounting for
Changing Prices
The following are the generally
accepted methods of accounting for
price level changes:
a. Current Purchasing Power Method or
General Purchasing Power Method (CPP or
GPP Method).
b. Current Cost Accounting Method (CCA
Method).
c. Hybrid Method, i.e., a mixture of CPP and
CCA methods.
Current Purchasing Power
Method CPP Method
The introduction of CPP method is one of the
greatest revolutions in the field of accounting.
It involves the restatement of all of the items
in the historical financial statement for
changes in the general price level
Under this method, any established and
approved general price index is used to
convert the values of various items in the
B/Sheet and I/Statement
This method helps to present financial
statement in terms of units of equal
purchasing power.
Example
An asset purchased for a sum of Rs 200 in 1970
would be valued in 1990 according to CPP
Method at the amount which would be needed
to buy the asset as per change in the general
price index in 1990 as compared to 1970.
Presuming that general price index was 150 in
1970 and 300 in 1990,
the asset would be valued at Rs 400 (i.e., 200 x
300/150) as per CPP Method.
This is because the current purchasing power of
a sum of Rs 200 spent in 1970 is equivalent to
Rs 400 in 1990.
Note: It should be noted that under the CPP
Method, only the changes in general purchasing
power of money are taken into account. It does
not consider the changes in the value of
individual assets
Characteristics Of CPP
1. Method
A supplementary statement is prepared and
annexed to historical financial statement. The
supplementary statement includes re-statement of
income statement and re-stated balance sheet.
2. Any statement prepared under CPP method is
based on the historical statement.
3. Consumer price index or wholesale price index is
used as conversion factor for re-stated of historical
items.
4. All the items in financial statement are classified
into monetary and non-monetary items. Non-
monetary items are adjusted, there is no need of
any adjustment for the monetary items.
5. Net gain or loss account of monetary items is to be
accounted in the profit and loss account.
Preparation of the financial
statements according to CPP
Method
Under CPP method, financial statements prepared
under historical cost accounting are re-stated by
using an approved price index.
The following steps are taken in preparing the
financial statements.
1.Calculation Of Conversion factor: CPP
Method requires the restatement of historical
figures as disclosed in the financial statement at
current purchasing prices
Conversion factor =Price Index at the date of conversion
Price Index at the date the item arose
Conversion factor at the beginning = Price Index at the
end/Price Index at the beginning
Conversion factor at an average = Price Index at the
end/Average Price Index
Conversion factor at the end = Price Index at the end/Price Index at
the end
CPP Value = Historical value X Conversion factor
Cont
Notes:
For the items taken from the beginning period
(e.g assets, liabilities, taken from the
operating balance sheet), beginning
conversion factor is used
For the items which occur throughout the
year like sales, purchases, operating expenses
etc., average conversion factor is used
For the items which occur at the end of the
year like tax, dividend etc. ending conversion
is used.
Example
A company purchased a machinery on 1990 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 December, 1995 when the
price index stood at 200.
Conversion factor =Price Index at the date the item
arose
Price Index at the date of conversion
200/150 =4/3
THANK YOU