Accounting for Changing Prices

Accounting for Changing Prices

in accounting theory, we assume that the monetary unit is stable over time, inflation does not exist, and a dollar, a yen, or a guilder is worth the same today as it was many years ago this a assumption is important for the historical cost model of course, in reality this is not the case, especially in many developing countries in 1996, Bulgaria’s inflation rate was 400 percent while its gross domestic product declined by 11 percent

The historical cost model has been criticized for failing to take into account the economic realities critics assert that failure to consider general of specific price changes make comparability among financial statement difficult

General Versus Specific Price Indexes

General Price Index

A general price index is developed by taking the prices of a "basket" of goods and averaging them at a certain point in time. This average is then compared with the average price of those some good at some based period. We can thus estimate amount of inflation or deflation. In the united states, a widely used index is the consumer price index for all urban consumers

Specific Price Index

The price of specific good may or may not effected by changes in general price levels it may depend mostly on its supply and demand while prices of most good have risen in recent years, prices of many others products have declined due to technological advances. Price of personal computer, printers, and electronic calculators are good examples. A specific price index shows the prices changes for a specific good or service over time one way to determine the specific price of product is to ascertain the current cost of a building may require the use of a construction index. Many specific indexes are published by industry groups alternately; a specific index may be for the net realizable value of a good, that is, the net amount that would be received if an item were sold

Valuation Problem with Changing Prices

As mentioned in the introduction to this chapter, prices are assumed to be stable under the historical cost model the central flaw in this model, however, is that it combines together monetary units of different purchasing power since monetary units have different purchasing power at different point in time, when combined in financial statements, they cause distortion

Monetary Items
A monetary item is either cash or another asset or liability that will be received or paid out in a fixed number of monetary units. Examples of monetary assets in clued account receivable and notes receivable, and examples of monetary liabilities are accounts payable and salaries payable. In balance sheet that has been restated for changes in the general purchasing power of the monetary unit, monetary items are shown at their current (nominal) amounts.
During an inflationary period, a holder of monetary assets experiences a holding loss because such assets, representing a fixed number of monetary units, will have less purchasing power in the future. On the other hand, a person holding monetary liabilities will have a holding gain from paying off the liabilities in a fixed number of monetary liabilities that have lesser purchasing power. Such gains or losses (from holding monetary items) appear as monetary gains or losses in the income statement that has been adjusted for general price-level changes.

Nonmonetary Items

A nonmonetary item does not represent either a claim to or a claim for specified number of monetary units. Examples of nonmonetary items incude inventory, equipment, land, liability for warnaty, liability for future pension cost, capital stock, retained earning. In general price-level adjusted financial statement, nonmonetary items are adjusted for changes in general purchasing power.

Constant Monetary Units Restatement

Consumer monetary unit restatement is general term for restating financial statement for changes in purchasing power of the monetary unit. In United Kingdom, accountants use the term current purchasing power accounting. In the United State, accountants refer to constant dollar accounting pr general price-level accounting.
Regardless of the terminology, we should remember that restatement to a constant monetary unit does changes the basic of the financial statement. They remain historical cost basic statement, albeit restated. The rest of these section constants a brief summary of the steps involved in constant monetary unit restatement. The subsequent section provides a comprehensive example.

Balance Sheet

The starting point for restatement process is usually the balance sheet. The basic steps as follows:
 Identify assets and liabilities as either monetary or nonmonetary.
 Extend monetary items at their face (nominal) amounts.
 Adjusted for changes in purchasing power of nonmonetary assets and nonmonetary liabilities from the date of their acquisition and incurrence respectively
 Roll-forward previous year balances. If general price-level adjusted statement were prepared for the previous year, all balances to be used for compassion with the current year must be rolled forward, this is, expressed in terms of current year price levels. If there was 10 percent inflation, all balances in the previous year’s statement would be multiplied by 110 percent.

Income statement

The income statement is normally restated after the balance sheet, since cost of goods sold uses the adjusted inventory balances and depreciation is based on adjusted property, plants, and equipment amounts. The basic idea is that the amounts are adjusted from the price levels in effect at the time the events occurred to the current year’s year-end levels.
 Identify and adjust items using the price indexes in effect at the date applicable to each item when it occurred.
 Compute depreciation expense based on the adjusted historical cost of the depreciable assets.
 Adjust items that can be assumed to occur evenly throughout the year, such as sales and purchases, using a weighted average index.
 Compute cost of goods sold, using the price-level adjusted amounts for beginning and ending inventories calculated when adjusting the balance sheet, and the adjusted purchases amount from the preceding step.
 Calculate the purchasing power gain or loss from holding monetary items.

Current Value Accounting

The synonymous terms current value accounting and current cost accounting include all valuation systems designed to express specific prices. Current value financial statement show the effect of changes in prices of individual items. Cash and account receivable are generally stated at their cash or cash equivalent value. Other assets are adjusted, as necessary, to reflect their current value. In some cases, especially for property, plant, and equipment items, a specific price index to approximate the current value of the item may be employed. Alternately independent market appraisals or an assignment of current value by the board of directors may be used. Most current liabilities are shown at the face amount. Long-term debt requires a present value calculation. The excess of current value of asset over current value liabilities equals stockholders equity. Amounts in the income statement are restated to approximate their current value.

Input Price Measurement Versus Output Price Measurement

There are two different to measurement of current value: Input price measurement or output price measurement. The input price measurement assigns current value to an item on the basic of its replacement cost. Replacement cost is the total coat to acquire another item that would perform the functions identical to those performed by an exiting item. The output price measurement considers the current value of an item to be equal to its net realizable value. Net realizable value is the disposal value of an item less the related disposal cost. Exit measurement has the same meaning as the output price measurement.

Realizes and Unrealized (Holding) Gains and Losses

An unrealized, or holding, gain or loss arises from holding an asset. It is the difference between the changes in the current value of an item during, the period. Current value, as mentioned earlier, may be based on either input price measurement or output price measurement. A realized gain or loss occurs when an item is disposed at an amount different from its recorded net value on disposal date.

Gearing Adjustments

Many current value accounting models incorporate a gearing adjustment. The gearing adjustment is made in the income statement and it relates to the effect of inflation. Though different current value accounting models have their own version of the gearing adjustment, the basic idea is the same as described next.
The gearing adjustment is made to recognize that it is unnecessary to make the current cost adjustment for the operating assets that are financed by creditors. In an inflationary economy, when average borrowing is greater than average monetary assets, the stockholders are in favourable position. Expressed differently, the loss of an entity’s creditors, due to eroding purchasing power of the monetary unit, is a gain to the stockholder. Therefore, income increased by making a gearing credit. In situation where the amount of average monetary assets is greater than borrowing, a gearing charge is made to the income statement, thereby reducing the income amount. In a deflationary economy, the gearing adjustment has the opposite effect on the reported income.
The amount of gearing adjustment is computed by multiplying the ratio of average operating assets with the current value adjustments for items such as cost of goods sold and depreciation expenses.

Evaluation of Current Value Accounting

Although current value accounting can provide relevant information for coping with changing prices, critics have made several arguments against its use:
 Current cost determination is inherently subjective.
 Current costs are difficult or impossible to obtain in cases involving the products that are not commonly sold. It is especially applicable in situations where special-purpose, customized products are manufactured.
 Purchasing power gains or losses often are not recognized in current value models.
 How should the holding gains or losses be treated? Should they appear in the income statement or should they be entered directly into stockholders’ equity in the balance sheet? The treatment selected may have a significant effect on the reported earning of the company. There is no consensus on the treatment of holding gains or losses.
Many countries allow historical cost with optional current value revaluation. Very few countries require exclusive use of current cost accounting.