Accounting For Price Level Changes

Accounting for Price Level Changes (Inflation Accounting)
Introduction
Financial statements are prepared with a view of presenting the financial position of
the business on a particular date and displaying the results achieved during an
accounting period These statements according to existing accounting practices, are
prepared on historical cost (i.e. original or acquisition cost) on the assumption that the
purchasing power of the money remains the same. But the assumption is not valid as
the purchasing power of the shillings, the basic measuring unit of accounting in India,
goes on changing from time to time on account of changes upwards or downwards in
price level.
Limitations of Historical Accounting

Now there is a near unanimity among the accountants that historical cost accounts
suffer for many serious limitations during the period of rapidly changing prices. The
following are the ma limitations of historical accounts:
1. Utility of accounting records seriously impaired. Financial statements or
reports based on historical cost fail to reflect the effect of such changes in
purchasing power on the financial position and profitability of the firm.
Financial statements may be incorrectly interpreted unless adjustments are
made to place the data on the current price level. In this way, the utility of the
accounting records not taking care of price level changes is seriously impaired
and make a demand on the accounts for adjusting financial accounting for
inflation to know the real financial position and profitability of a concern.
2. Unrealistic profits. Under the historical accounting system, depreciation
calculated on the basis of historical cost of old assets is usually lower than that
of those calculated at current value or replacement value. This results in more
profits on paper which, if distributed in full, will lead various consequences of
over statement of profits as more taxes, more bonus will be demanded by the
employees, more dividend to shareholders etc. Thus, there will be reduction of
capita and ultimately the company may go into liquidation.
3. Insufficient provision of depreciation. Under the historical accounting system,
depreciation is calculated on the original cost of fixed assets with the result that
only an amount equivalent to the original cost of the fixed assets is available for
its replacement when its life is over. But the replacement cost of the asset will
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be more than the original cost on account of Ration so that the replacement
provision made by way of depreciation charge on the original cost will be
insufficient for the purpose.
According to the "Economic Survey: 1975-76", "there is now considerable
evidence that the •p increase in cost of machinery and equipment in recent years
is affecting not only new investment but also modernization and replacement of
existing equipment. In a period of rapidly prices depreciation formulae based on
historical cost cease to provide adequate resources for replacement of the
existing worn out equipment. Moreover, in industries under price control, so
long as the calculations of permissible rates of return continue to be based on
historic cost of capital in use, there is a built in disincentive to new investment."
Most of the industrial sickness in India is due to the insufficient funds available
for replacement and renovation on account of charging depreciation on
historical cost.
4. Fixed assets values are unrealistic. In times of rising prices, the conventional
system of its based on historical cost does not give a true and fair view of the
business enterprise as is under the Companies Act, 1956 as fixed assets are
shown at their historical cost and not at current values.
5. Different basis. In conventional system of accounting fixed assets are shown at
the historical costs whereas operating expenses and incomes are taken at
current prices. Thus different adopted are not desirable for having correct and
reliable information about the business.
6. Return on capital employed misleading. Under historical cost accounting
system the profits are overstated and fixed assets are understated specially
when there is increase in the price of old fixed assets. Return on capital
employed which is very useful for the valuation of the business by its owners,
Creditors and management will not be correct and may lead to misleading
decisions. This will be more clear from the following example:
Kshs.
Fixed Assets at cost 2,000,000
Less: Accumulated Depreciation 1,200,000
800,000
Add: Current Assets 1,000,000
Total Assets 1,800,000
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Less: Current Liabilities 400,000
Capital Employed 1,400,000
Net profit after tax @ 50% and 10% depreciation on original cost is Kshs. 280,000.
Replacement the fixed assets is Kshs. 4,000,000.
In the above example, under the historical accounting system return on capital
employed (after taxes is 20%, i.e.
Net Profit x 100 = Kshs. 280,000 x 100
Capital Employed Kshs. 1,400,000
But if we calculate depreciation on replacement cost of the fixed assets, return on
capital employed will not be 20% as is shown below:
Kshs.
Net Profit as given 280,000
Add: 10% depreciation on Kshs. 2,000,000 fixed assets written back 200,000
Add: Tax written back (50% of profit before tax, i.e., 50% of Kshs. 560,000) 280,000
Profit before depreciation and tax 760,000
Less: 10% Depreciation on replacement cost of Kshs. 4,000,000 400,000
360,000
Less: 50% Tax 180,000
Profit on the basis of price level accounting 180,000
Capital employed on the basis of replacement cost:
Fixed assets at replacement cost 4,000,000
Less: Accumulated depreciation (60% as in historical accounting system) 2,400,000
1,600,000
Add: Current assets 1,000,000
Less: current liabilities 400,000
Capital employed 2,600,000
2,200,000
Return on capital employed = Kshs. 180,000 x 100 = 8.2%

Kshs. 2,200,000
7. Matching principle violated. Financial accounting based on historical cost
shows closing stock at cost or market price, whichever is lower. Sales are
shown at current purchasing power of the shillings while stocks are shown at
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cost or market price, whichever is lower. Thus, profit disclosed by financial
accounting based on historical cost during inflation does not represent increase '
wealth of the business in terms of current purchasing power because closing
stocks are not shown at their current value. Similarly, during inflation balance
sheet also does not exhibit a true and fair view of the financial position of the
firm because closing stock is shown at its original cost which is lower than its
current value.
8. Incorrect ascertainment of operating capacity. In historical cost accounting,
cost of goods sold is understated because replacement cost of inventory
consumed or used is not matched against revenue giving rise to higher figure of
profit. It, thus, does not give true and fair view of the operating capability of
the enterprise.
9. Difficulty in comparison of profitability of two plants. In case of price level
changes comparison of profitability of two plants set up at different dates
becomes difficult. Suppose a plant costing Kshs. 1,000,000 was set up by one
firm 9 years ago and the plant of the same capacity costing Kshs. 2,000,000
(price increased due to inflation) is set up by another firm in 2003. It is the
practice of the firm to charge 10% depreciation on plant. The old firm will
charge Kshs. 100,000 as depreciation (i.e., 10% on Kshs. 1,000,000) and the
new firm will charge Kshs. 200,000 as depreciation (i.e., 10% on Kshs.
2,000,000). Consequently, profit of the old firm will be overstated by Kshs.
1,00,000 because of less depreciation as compared to the new firm even though
the efficiency of the both the plants may be the same. Hence comparison of the
two plants set up at different dates is not possible.
10. Violation of the law of additivity. During inflation accounting data may not
be additive It is argued that data may be added or subtracted if the purchasing
power of the currency remains the same. Since the value of the shillings does
not remain the same on account of price level changes, the addition and
subtraction of accounting data does not give meaningful results and violates the
law of additivity.
11. Mixing up of holding gains and operating gains. Historical cost accounting
mixes up the holding gains and operating gains and does not help to take proper
decision.
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12. Misleading interperiod and interfirm comparison. For the purpose of
interperiod and interfirm comparison, ratios are to be calculated. Financial
ratios calculated based on historical costs will not give correct view. No
meaningful information will be available for correct decisions.
From the above discussion, it is clear that conventional accounting based on historical
cost has outlived "its utility when prices are changing frequently. To overcome the
drawbacks of conventional accounting, the adoption of accounting for changing
prices is advocated.
Meaning of Accounting for Changing Prices

Accounting for changing prices is also known as inflation accounting because
changes in prices are usually on the upward side.
Accounting for changing prices (or inflation accounting) is a system of accounting
which regularly records all items in financial statements at their current values. A
system recognizes the fact that the purchasing power of money is decreasing day-by-
day during inflation and finds out profit or loss or states the financial position of
business on the basis of the current prices prevailing in the economy.
Approaches to Price Level Accounting (or Inflation Accounting)

At present there are four approaches to price level accounting:
(1) Current Purchasing Power Accounting (CPPA)
(2) Current Cost Accounting (CCA)
(3) Specific and General Price Level Accounting (SGPLA)
(4) Periodic revaluation of fixed assets along with the adoption of LIFO method of
inventory.
1. Current Purchasing Power Accounting (CPPA)

In C.P.P. Accounting the historic cost accounting data are adjusted on the basis of
any established and approved general price index at a given date. In India wholesale
price index of the Reserve Bank of India can be taken which shows the change in the
value of the shillings in the past years. This method takes into consideration the
changes in the value of items as a result of the general price level, but it does not
account for changes in the value of individual items. The formula or the
conveKshs.ion of historic cost to the general price level is as follows:
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Index you are converting to
ConveKshs.ion Factor = Index you are converting from
For example, a piece of land was acquired at a price of Kshs. 50,000 in 2007 when
the general) rice index was 200. The cost of land may be restated in terms of current
value of shillings in 2008 at in index of 300 as below:
Kshs. 50,000 x 300/200 = Kshs. 75,000
The purchase price of land in 2008 which may be more or less (i.e., Kshs. 80,000 or
Kshs. 45,000) will not be considered at all in this method.
The effect of the loss or profit on monetary assets or owing liabilities is also
ascertained; Monetary items are those whose amounts are fixed by contract or
otherwise, regardless of changes in the general price level. Monetary items can be
debtors, creditor., cash, bank balance, redeemable preference share capital and loans.
The value of these items is fixed as we are not going to get more from debtors or pay
more to the creditors. regardless of general increase in the price level Examples of
non-monetary items are inventory, machinery, building, furniture etc.
Holders of monetary assets lose if there is increase in the general price index
because purchasing power of assets owned, is actually decreased. Debtors are not
going to pay more because of increase in the price level. Similarly, balance of cash in
hand is not going to increase because of inflation. Thus, the amounts of monetary
assets are fixed by contract or otherwise in terms of shillings, regardless of change in
general price level. On the other hand, decrease in the general price level is a gain
because increases the purchasing power of monetary assets owned. In case decrease
in prices, a cash balance of Kshs. 10,000 at the beginning of the year will be able to
purchase more at the end of the year because of increase in purchasing power of cash
likewise the converse applies to monetary liabilities. We are not going to pay more
or less than the amount due to creditors even though prices may have increased or
decreased. So, a company which owes monetary liabilities gains during inflation
because it pays the amount contracted even though it has a less purchasing power.
During deflation, it loses because it pays the amount contracted which has more
purchasing power.
In 1974 the English Institute of Chartered Accountants recommended that companies

should only continue to prepare financial statements on historical cost basis but
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should also prepare elementary statements showing the items of the financial
statements in terms of the values of pound as it stood at the end of the period to which
they relate. The following extracts taken the recommendations of the Institute would
indicate the basic features of the C.P.P. method.
1. Inflation, which is the decline in the purchasing power of money as the
general price of goods and services rises, affects most aspects of economic
life, including investment decisions, wage negotiation, pricing policies,
international trade and government taxation policy.
2. It is important that the management and other users of financial accounts
should be in a position to appreciate the effects of inflation on the business
with which they are concerned, for example, the effects on costs, profits
distribution policies, dividend cover, the exercise of borrowing power, returns
on funds and future cash needs. The purpose of this statement is a limited on
establishing a standard practice for demonstrating the effect of changes in the
purchasing power of money on accounts prepared on the basis of existing
conventions. It does not suggest the abandonment of the historical cost
convention, but simply that historical costs should be converted from an
aggregation of historical pounds of many different purchasing powers and that
the information should be given in a supplement to the basic accounts
prepared on the historical cost basis.
Thus, under this method, firms continue to prepare financial statements on
historical cost basis in the usual manner but should also prepare supplementary
statement showing the historical cost items in terms of the current value on the
basis of index. The price level adjustments under this method are made for all
the items of income statement and balance sheet.
ILLUSTRATION 1
A firm had Kshs. 200,000 as cash at bank on 1- 4 - 2008. The consumer price index
on that date was 200. During the year ended 31 st March, 2008 the receipts and
payment were as stated below:
Receipts Kshs. Index Payments Kshs. Index
June 1 Sales 105,000 210 Sept 15 Costs 215,000 215
Jan 15 Sales 345,000 230 Nov 20 Costs 150,000 240
Dec 1 Costs 200,000 225
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Ascertain the profit or loss on account of price changes. The year end index was 240
SOLUTION
Historical Adjustment Constant
Kshs. Kshs.
Opening Balance 200,000 240/200 240,000
Receipts
June 1 105,000 240/210 120,000
January 15 345,000 240/230 360,000
Total (A) 650,000 720,000
Payments:
September 15 215,000 240/215 240,000
November 20 150,000 240/240 150,000
December 1 200,000 240/225 213,333
Total (B) 565,000 603,333
Balance (A-B) 85,000 116,667
The balance according to Constant Shillings should have been Kshs. 116,667 whereas
the actual balance is only Kshs. 85,000. Therefore as a change in prices, there has
been a loss of Kshs. 31,667.
ILLUSTRATION 2
A company had the following monetary items on January 1:
Kshs. Kshs.
Debtors. 41,000
Bills receivable 10,000
Cash 20,000
Less: Bills payable 10,000 71,000
Creditors. 25,000
35,000
Net monetary assets 36,000
The transactions affecting monetary items during the year were:
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a. Sales of Kshs. 140,000 made evenly throughout the year.
b. Purchases of goods of Kshs. 105,000 made evenly during the year.
c. Operating expenses of Kshs. 35,000 were incurred evenly throughout the year.
d. One machine was sold for Kshs. 18,000 on July 1.
e. One machine was purchased for Kshs. 25,000 on December 31
The general price index was as follows:

On January 1 300
Average for the year 350
On July 1 360
On December 31 400
You are required to compute the general purchasing power, gain or loss, for the year
stated in terms of the current year-end shillings
SOLUTION
STATEMENT OF GENERAL PURCHASING POWER GAIN OR LOSS
Historical Adjusted Price Level Purchasing
Amount Factor Adjusted Power Gain
Amount or Loss
Kshs. Kshs. Kshs. Kshs.
ConveKshs.ion of Monetary Assets:
Net monetary assets at the beginning of 36,000 400/300 48,000
the year
Increase in net monetary assets during
the year:
Sales 140,000 400/350 160,000
Sale of machine 18,000 400,360 20,000
Total 194,000 228,000
Purchasing power loss 34,000
(Kshs. 228,000 – Kshs. 194,000)
Decrease in net monetary assets:
Purchases 105,000 400/350 120,000
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Operating expenses 35,000 400/350 40,000
Purchase of machine 25,000 400/400 25,000
Total 165,000 185,000
Purchasing power gain 20,000
(Kshs. 185,000 – Kshs. 165,000)
Net purchasing power loss 14,000
Net monetary assets at the end of the year
Price level adjusted amount of net
monetary assets
(Kshs. 228,000 – Kshs. 185,000) 43,000
Less: purchasing power loss 14,000
Net monetary assets at the end of the year 29,000
(Kshs. 194,000 – Kshs. 165,000)
ILLUSTRATION 3
Ascertain net monetary results as at 31st March, 2006 from the data given below:
1-4-2007 31-3-2008
Kshs. Kshs.
Cash at bank 15,000 21,000
Accounts receivable 45,000 54,000
Accounts payable 75,000 50,000
General price index number:
1st April, 2007 100
31st March, 2008 125
2007-08 Average 120
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SOLUTION
STATEMENT SHOWING NET MONETARY RESULT
Historical Adjusted Price Level Purchasing
Amount Factor Adjusted Power
Amount Gain or
Loss
Kshs. Kshs. Kshs.
Monetary assets at the beginning
of 2007 – 08
Cash at bank 15,000 125/100 18,750
(15,000x125/100)
Accounts Receivable 45,000 125/100 56,250
(45,000 x 125/100)
Add: increase in monetary assets
during the year
Cash at bank 6,000 125/120 6,250
(21,000-15,000) (6,000x125/100)
Accounts Receivable 9,000 125/120 9,375
(54,000-45,000) (9,000x125/100)
Total 75,000 90,625
(Kshs. 90,625 – Kshs. 75,000)
Monetary liabilities at the
beginning of the year
Accounts Payable 75,000 125/100 93,750
(75,000x125/100)
Less: Decrease in accounts payable 25,000 125/120 26/042
(25,00x125/100)
50,000 67,708
17,708
Purchasing power gain
(Kshs. 67,708 – Kshs. 50,000)
Net purchasing power gain 2,088
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ILLUSTRATION 4:
From the information given below, ascertain the cost of sales and closing inventory
under Current Purchasing Power method if the organisation follows
(i) First-in-first-out (i.e. FIFO system and
(ii) Last –in- first-out (i.e. LIFO) system
Historical Cost General Price Index
Kshs.
Inventory on 31-3-2007 40,000 200
Purchases during 2007-08 310,000 220 ( Average for 2007-08)
Inventory on 31-3-2008 50,000 230
SOLUTION
Cost of Sales is: Kshs.
Opening inventory 40,000
Add: Purchases 310,000
350,000
Less: Closing Inventory 50,000
Cost of sales 300,000
Historical Cost ConveKshs.ion Restated Figure

Factor
(I) Under FIFO System Kshs. Kshs.
a) Taken out of opening inventory 40,000 230 46,000
200 40,000 x 230
200
2,71,818
Taken out of purchases 2,60,000 230 2,60,000 x 230
200 220
3,17,818
3,00,000
b) Closing Inventory
Left out of purchases 50,000 230 52,273
220
II) Under LIFO System
a) Cost of sales: 3,00,000 230 3,13,636
Taking out of purchases 220
b) Closing Inventory: 40,000 230 46,000
Out of opening inventory 200
Out of purchases 10,000 230 10,454
220
50,000 56,454
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ILLUSTRATION 5
The Balance Sheet of Himachal Ltd as on 1 st April 2007 and Profit and Loss statement
for the year ending March, 2008 are given below
BALANCE SHEET
As on 1-4-2007
Liabilities Kshs. Assets Kshs.
Share Capital 400,00 Plant and Machinery 300,000
18% Debentures 100,00 Furniture and Fixture 40,000
Current liabilities 50,000 Inventory 60,000
Debtors 50,000
Cash 100,000
550,000 550,000
PROFIT AND LOSS STATEMENT

For the year ending 31st March, 2008
Kshs.
Sales Kshs. 1,000,000
Less: Cost of goods sold: Opening inventory 60,000
770,000
Less: Closing inventory 70,000
Gross profit 700,000
300,000
Less: Operating expenses 151,000
Interest on debentures 13,000
Depreciation on machinery 45,000
Depreciation on furniture 4,000
213,000
Net Profit 87,000
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Debtors and current liabilities balances remained constant throughout the year.
Interest on debentures was pad on 31-3-2008
The general price index was as follows:
On April 1, 2007 300
Average for the year 320
On March 31, 2008 360
You are required to prepare the financial statements for the year 2007-08 after
adjusting for price level changes under current purchasing power method.
SOLUTION
PROFIT ND LOSS STATEMENT AS PER CPP METHOD
For the year ending 31st March 2008
Particulars Historical Adjusted Price Level
Amount Factor Adjusted Amount
Kshs. Kshs.
Sales 10,000 360/320 1,125,000
Opening inventory 60,000 360/300 72,000
Purchases 710,000 360/320 798,750
Less: Closing inventory 770,000 870,750
Cost of goods sold 70,000 360/320 78,750
Gross profit ( Sales – Cost of goods sold) 700,000 792,000
300,000 333,000
Operating expenses 151,000 360/320 169,875
Depreciation on machinery 45,000 360/300 54,000
Depreciation on furniture 4,000 360/300 4,800
Interest on debentures 13,000 360/360 13,000
Total Expenses 213,000 241,675
Net profit ( Gross profit – Expenses ) 87,000 91,325
Less: Loss on monetary assets as 17,375
calculated in a separate statement shown
below
Retained earnings 73,950
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Note: FIFO method has been followed for the cost of goods sold and closing
inventory in the absence of information.
STATEMENT OF GAIN OR LOSS ON MONETARY ITEMS

Historical Adjusted Price Purchasing
Amount Factor Adjusted Power Gain
Amount or Loss
Monetary assets on 1-4-2007 Kshs. Kshs. Kshs.
Debtors 50,000 360/300 60,000
Cash 100,000 360/300 120,000
Increase in cash (1) 1,39,000 360/320 156,375
Monetary assets on 31-3-2008 2,89,000 336,375
(Kshs. 3,36,375 – Kshs. 289,000)
Monetary liabilities on 1-4-2007 1,00,000 360/300 120,000
Debentures
Current liabilities 50,000 360/300 60,000
Monetary liabilities on 31-2-2008 150,000 180,000
Less: Purchasing power gain 30,000
(Kshs. 180,000 – Kshs. 150,000)
Less on monetary items 17,375
BALANCE SHEET
As on 31-3-2008
Liabilities Kshs. Assets Kshs. Kshs.
Share Capital Plant & Machinery 360,000
( Kshs. 400,000 x 360/ 480,000 ( Kshs. 3,00,000 x 360 / 300)
300)
Retained Earnings 73,950 Less: Depreciation 15% 54,000
13 % Debentures 100,000 306,000
Current Liabilities 50,000 Furniture & Fixtures 48,000
( Kshs. 40,000 x 360/ 300) 4,800
Less Depreciation 10%
43,200
Inventory ( Kshs. 70,000 x 78,750
360 / 320)
Debtors 50,000
Cash (2) 226,000
703,950 703,950
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Working Notes:
1. Increase in cash has been calculated as follows Kshs.
Sale proceeds Kshs. 100,000
Less: Amount paid on account o purchases 710,000
Amount paid on account of operating expenses 151,000 861,000
Increase in cash 139,000
Note: Cash paid on account of interest on debentures has not been considered because
it was paid on 31-3-2008. It will have any effect on gain or loss on monetary assets.
2. Cash in hand on 31-3-2008 is calculated as follows: Kshs.

Cash in hand on 1-4-2007 100,000
Add: Increase in cash as calculated above 139,000
239,000
Less: Internet on debentures paid on 31-3-2008 (13% of Kshs. 100,000) 13,000
Cash in hand on 31-3-2008 226,000
ILLUSTRATION 6
In the context of Inflation, Accounting System adjust the following Profit and Loss
Account and Balance Sheet under the ‘Current Purchasing Power’ (or CPP) method to
ascertain the changes n Net Profit and Reserve.
PROFIT AND LOSS ACCOUNT

For the year ended 31st December, 2007
Kshs. (‘000)
Sales 500
Opening Stock 80
Purchases 420
500
Less: Closing Stock 70 430
Gross Profit 70
Depreciation (Buildings) 5
Administration 25 30
Net Profit 40
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BALANCE SHEET
As at 31st December, 2007
Kshs. (‘000)
Share Capital 200
Reserve 200
400
Land 140
Building 200
Less: Depreciation 45 155
Stock 70
Debtors 40
Cash 30
140
Less: Creditors 35 105
400
The following data are given:
1. Closing stock was acquired during last quarter of 2007 and opening stock during
the last quarter of 2006.
2. The land and building were acquired and the capital issued during 1988. The
buildings are depreciated straight line over 40 years.
3. The relevant retail prices indices are
a) 1999 average 60
b) 2006 last quarter average 108
c) 2006 December 31 110
d) 2007 last quarter average 116
e) 2007 average 114
f) 2007 December 31 118
4. Sales, Purchases and Administration expenses are assumed to occur evenly over
the year and hence at average prices.
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SOLUTION
ADJUSTMENT OF PROFIT AD LOSS ACCOUT UNDER THE CURRENT
PURCHASING POWER METHOD
For the year ended 31.12.2007
Historical Adjusted Price Level
Amount Factor Adjusted
Amount
Kshs. (‘000) Kshs. (‘000)
Sales (a) 500 118/114 415.54
Opening Stock 80 118/108 87.41
Purchases 420 118/114 434.74
500 522.15
Less: Closing Stock 70 118/116 71.21
Cost of Goods Sold (b) 430 450.94
Gross Profit ( (a) – (b) ) (c) 70 66.60
Depreciation (200 ÷ 4) 5 118/60 9.83
Administration 25 118/114 25.88
Total Expenses (d) 30 35.71
Net Profit (c) – (d) 40 30.89
BALANCE SHEET
As on 31-12-2007
Historical Adjusted Price Historical Adjusted Price
Amount Factor Level Amount Factor Level
Adjusted Adjusted
Amount Amount
(‘000) (‘000) (‘000) (‘000)
Share 200 118/60 393.33 Land 140 118/60 273.33
Capital
Reserves 200 293.04 Building 200
(Balancing
figure)
Creditors 35 35.00 Less: 45
Accumulated
Depreciation
for 9 years
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155 118/60 304.83
Stock 70 118/116 71.21
Debtors 40 40.00
Cash 30 30.00
435 721.37 435 721.37
Current Cost Accounting (CCA)

The C.P.P. method takes care of changes in the value of money but it does not
account changes in the value of individual items. The value of an item may be
increased on the basis of general price index whereas the actual value of that item
might have decreased. To remove this drawback, the U.K. Government set up a
Committee known as the Inflation Accounting Committee under the chairmanship of
Mr. Francis Sandilands to consider the problem of price level accounting In its report
published in September, 1975, the committee recommended the adoption of current
cost accounting for dealing with the problem of inflation accounting.
In this method, historic values of items are not taken into account; rather current
values of individual items are taken as the basis for preparing profit and loss account
and balance sheet.
Thus, items are not adjusted as a result of the change in the general price level as they
are adjusted in the C.P.P. method.
Important Characteristics of Current Cost Accounting

1. Fixed assets are shown in the balance sheet at their current values and not at their
depreciated original costs.
2. Stocks are shown in the balance sheet at their value to the business, i.e., at the
value prevailing on the date of the balance sheet. These are not shown at cost or
market price whichever is lower as is done in case of historical accounting.
3. To find out profit for the year, depreciation is calculated on the current values of
the relevant fixed assets.
4. The difference between the current values and the depreciated original costs of
fixed assets is transferred to Revaluation Reserve Account and is written on the
liabilities side of the balance sheet. The revaluation reserve is not available for
distribution as dividend but is utilized for increased replacement cost of fixed
assets and under provision of depreciation in the past years.
5. The cost of stock consumed during the year is taken at current value of the stock
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at the date of consumption and not the purchase price of the stock consumed.
6. Monetary assets and liabilities are not adjusted under this method because they
are always recorded at their value to the business. The values of these items do
not change with changes in price level because we are not going to receive more
or pay less on account of these items.
7. Under current cost accounting approach of inflation accounting, accounting profit
is divided into three parts: (i) current operating profit, (ii) realized holding gain,
and (iii) unrealized holding gain. The above classification is made to show
separately the effect of holding non-monetary assets (i.e., holding activities)
during inflation. It will also help to assess properly the result of operating
activities. Now, we may give below the meaning of these types of profits.
Realised Holding Gain. It is the excess of the replacement cost of a non-monetary
asset sold on the date of its sale over its historical cost.
Unrealised Holding Gain. It is the excess of the replacement cost of a non-monetary
asset on the closing date over its historical cost. Such a gain is shown separately in
the balance sheet as revaluation reserve and is not available for distribution as
dividend but is utilized for increased replacement cost of the non-monetary asset.
Current Operating Profit. It is the excess of the sale proceeds of goods and services
sold during a particular accounting period over the replacement cost of the goods or
services sold on the dates the sales were effected.
For calculating current operating profit, following adjustments are to be made
in the current cost accounting method:
(a) Depreciation adjustment
(b) Cost of sales adjustment (COSA)
(c) Monetary working capital adjustment (MWCA)
(d) Gearing adjustment.
a) Depreciation Adjustment. Profit and Loss Account should be debited for
depreciation calculated on the basis of current value of the fixed asset to the
business. Depreciation should not be calculated on the basis of historical cost of
the fixed asset; rather it should be calculated on the replacement cost of the asset
(i.e., current value of the asset to the business). The current depreciation charge
under CCA method is obtained by apportioning the average net replacement cost
over the expected remaining useful life of the fixed asset at the beginning of the
period. When fixed assets are revalued every year, there will be a shortfall of
20
depreciation known as backlog depreciation representing the effect of price rise
during the period. Backlog depreciation can be taken as the additional amount
required to increase the total of the accumulated depreciation at the beginning of
any accounting year and the charge for depreciation for that year to the amount
required to equal the difference between the gross and net replacement cost of an
asset at the end of the year.
For example, a concern uses a fixed asset which has a historical gross value of
Kshs.50,000 and the accumulated depreciation of Kshs. 20,000 including Kshs. 5,000
depreciation for the current year.
The gross replacement cost of the machine is Kshs. 100,000 and it is estimated that its
remaining useful life will not change. In this case, depreciation and backlog
depreciation under CCA method will be calculated as given below:
Historical Cost Current Cost

Accounting Accounting
Kshs. Kshs.
Value of the asset 50,000 100,000
Current depreciation 5,000 10,000
Previous accumulated depreciation 15,000 30,000
Total accumulated depreciation 20,000 40,000
Balance sheet value 30,000 60,000
Backlog depreciation = Gross replacement cost - net placement cost
- (previous accumulated depreciation + depreciation for
the current year)
= Kshs. 100,000 - Kshs. 60,000 - (Kshs. 15,000 + Kshs. 10,000)
= Kshs. 40,000 - Kshs. 25,000 = Kshs. 15,000
The amount of backlog depreciation should adjusted against revaluation surplus on
the fixed assets.
In the above example, the current cost depreciation is Kshs. 10,000 against the
historic cost depreciation of Kshs. 5,000. Therefore, depreciation adjustment required
is Kshs. 5,000 (i.e., Kshs. 10,000 Kshs. 5,000).
21
QUESTION4.
A firm purchased a machinery for a sum of Kshs. 200,000 on January 1, 2014. It has
as an expected life of 10 years without any scrap value. The price indices for the asset
were as follows: .
January 1, 2014 100
January 1, 2017 160
December 31, 2017 175
You are required to value the machinery on January 1, 2017 and December 31, 2017,
both according to historical cost accounting system and current cost accounting
system, charging depreciation on straight line basis. Also find the amount which
needs to be adjusted for depreciation during 2017.
SOLUTION
STATEMENT SHOWING THE VALUE OF MACHINERY
1-1-2007 31-12-2007
Historical Current Cost Historical Current Cost
Cost Cost
Cost 2,00,000 3,20,000 2,00,000 3,50,000
(2,00,000 x 160/ 100) ( 2,00,000 x 175/ 100)
Depreciation (3 60,000 96,000 80,000 1,40,000
years / 4 years)
Written Down 1,40,000 2,24,000 1,20,000 2,10,000
Value
The balance sheet as on 31-12-2007 prepared under current cost accounting would
show the machinery at Kshs. 210,000 as compared to Kshs. 1,20,000 under Historical
Cost Accounting. The excess of Kshs. 90,000 would be put to Current Cost
Accounting Reserve.
(b) Cost of Sales Adjustment (COSA).
22
This adjustment is made for determining current cost operating profit and represents
the difference between value to the business and the historical cost of stock consumed
in the period, it is determined as given below :
COSA = (C – O) – 1a C – O
1c 10
Where O = Historical cost of opening stock
C = Historical cost of closing stock
Ia = Average index number for the period
10 = Index number appropriate to opening stock
Ic = Index number appropriate to closing stock.
QUIZ
From the following information, calculate the cost of sales under Historical and
Current Cost Accounting System.
Opening Stock of Raw Materials on 1-1-2017 (200 tons @ Kshs. 40 per tonne)Kshs.
8,000
Purchases during the year 2017 Nil
Material Consumed during 2017 160 tonnes
Price of Raw Material on 1-1-2017 Kshs. 50 per tonne
Average price during 2017 Kshs. 60 per tonne
Price of Raw Materials on 31-12-2017 Kshs.70 per tonne
SOLUTION
Historical Cost Current Cost Accounting
Accounting System System
Kshs. Kshs.
Cost of Sales 6,400 9,600
(160 tonnes x Kshs. 40) ( 160 tonnes x Kshs. 60)
Closing Stock 1,600 2,800

( 40 tonnes x Kshs. 40) ( 40 tonnes x Kshs. 70)
The increase in stock of Kshs. 1,200 in CCA method over historical cost basis will be
credited to Current Cost Accounting Reserve. The closing stock in the Balance Sheet
will be shown at Kshs. 2,800. The cost of sales adjustment amounting to Kshs. 3,200
23
(i.e. Kshs. 9,600 - Kshs. 6,400) will be charged to Profit & Loss Account and credited
to Current Cost Accounting Reserve.
c) Monetary Working Capital Adjustment (MWCA). Monetary working
capital is represented by difference between trade Debtors and Creditors and this
adjustment shows the effect of changes in prices arising from volume. For
ascertaining current cost operating profit necessary to know the effect of
changing prices on working capital. Monetary working adjustment is calculated
by the following formula:
MWCA = (C – O) – 1a C – O
1c 10
Where O = Opening monetary working capital
C= Closing monetary working capital
1a = Average index number for the period
10 = Index number appropriate to opening MWC
1c = Index number appropriate to closing MWC
ILLUSTRATION 9
From the following information, as per historical cost accounting method, compute
the Monetary Working Capital adjustment under current cost accounting method:
Jan 1, 2007 Dec. 31, 2007
Accounts Receivable (Kshs.) 7,000 12,600
Accounts Payable (Kshs.). 3,850 6,440
Monetary Working Capital (Kshs.) 3,150 6,160
Price Index for materials 200 230
Price index for finished goods 150 180
SOLUTION
January 1, 2007 December 31, 2007
a) Accounts Receivable Kshs. 7,000 x 165 / 150 = 12,600 x 165 / 180 =
7,700 Kshs. 11,550
b) Accounts Payable Kshs. 3,850 x 215 / 200 = 6,440 x 215 / 230 = 6,020
4,139
c) Monetary Working
Capital (a – b) 3,561 5,530
24
The increase in monetary Working Capital on account of increase in volume of
business is Kshs. 1,969 (i.e., Kshs. 5,530 - Kshs. 3,561).
However, the actual increase in monetary Working Capital as shown by Historical
Cost Accounting comes to Kshs. 3,010 (i.e. Kshs. 6,160 - Kshs. 3,150).
The excess of Kshs. 1,041 represents excess working capital required in Monetary
Working Capital Adjustment. The amount would be charged to Profit & Loss
Account and Credited to Current Cost Accounting Reserve.
Note: Index Number to be assigned correctly.
(e) Gearing Adjustment. Gearing is the ratio of borrowed capital and shareholders'
funds. Fixed assets and working capital are partly financed by borrowed capital
and partly by shareholders' funds. But the amount of borrowed capital to be repaid
will not change on account of changing prices because it is fixed by agreement.
During inflation the value to the business of assets exceeds the amount of
borrowings that has financed them. Thus, shareholders enjoy an advantage in the
period of rising prices because the benefit of increase in prices is fully given to
shareholders reverse effect is experienced when prices decline. As a result the
profit attributable to shareholders would be understated/overstated if the whole of
additional depreciation cost of sales adjustment and monetary working capital
adjustment were charged in the profit and loss account. The total of these
adjustments is abated by another adjustment known as gearing adjustment. After
gearing adjustment, current cost operating profit will be abated and this abated
profit will be attributable to shareholders which will reflect the result of
adjustment to the historical cost trading profit. Gearing adjustment is calculated by
applying the following formula:
Gearing Adjustment = L xA
L+S
Where L = Average net borrowing
S = Average shareholders' funds
A= Total of current cost adjustments.
It may be noted that in the calculation of net borrowing, cash or any monetary asset
which is not considered in the calculation of monetary working capital adjustment
must be deducted from the total borrowings.
ILLUSTRATION 10
25
From the data below, calculate the gearing adjustment required under Current Cost
Accounting Method:
Opening Closing
Kshs. Kshs.
Convertible Debentures 200 240
Bank Overdraft 120 160
Cash 20 60
Paid up Share Capital 300 400
Reserves 100 160
Kshs.
Cost of Sales Adjustment 40
Monetary Working Capital Adjustment 30
Depreciation Adjustment 10
Total of Adjustments 80
SOLUTION
Calculation of Net Borrowings
Opening Closing
Kshs. Kshs.
Convertible Debentures 200 240
Bank Overdraft 120 160
Total Borrowings 320 400
Less: Cash ( as this does not enter into MWCA) 20 60
Net Borrowings 300 340
Calculation of shareholder
Kshs. Kshs.
Paid up Share Capital 300 400
Reserves 100 160
400 560
Average Net borrowings (L) = 300 + 340 = Kshs. 320

2
Average Shareholders’ Interest (S) = 400 + 560 = Kshs. 480
26
2
Gearing Adjustment = L = 320 = 320
L+S 320 + 480 800
As the total of all Adjustments (A) = Kshs. 80 given
Or Gearing Adjustment = 320 x Kshs. 80 = Kshs. 32.
800
ILLUSTRATION 11
From the following information, calculate the amount of Gearing Adjustment in case
of a company which has a capital mix of 40% debt and 60% equity
Kshs.
Depreciation Adjustment 2,000
Cost of Sales Adjustment 1,000
Monetary Working Capital Adjustment 1,000
4,000
SOLUTION
As the amount of debt content is 40% of the total capital employed, a sum of Kshs.
1,600 (i.e. 40% of Kshs. 4,000) is of Gearing Adjustment. This amount will be
debited to Current Cost Accounting Reserve and credited to Profit & Loss Account.
In other words a sum of 2,400 (shareholders share) will be charged to Profit and Loss
Account and credited to Current Cost Accounting Reserve on account of three
adjustments referred to the in the question.
ILLUSTRATION 12.
Following data relate to Gearing Ltd:
Kshs. 000
27
i) Beginning of the End of the year
year
Net Long Term Borrowings 14,000 14,000
Creditors 4,000 2,800
Bank Overdraft 5,000 5,600
Taxation 1,500 1,400
Cash (5,000) (8,400)
Net Borrowings 19,500 15,400
ii) Share Capital & Reserve from
Current Cost Balance Sheet 37,080 47,056
Proposed Dividend 500 600
Total Shareholders’ Internet 37,580 47,656
iii) Current Cost Adjustment
Depreciation 1,700
Fixed Assets Disposal 1,800
Cost of Sales Adjustment 1,620
Monetary Working Capital Adjustment 1,120
6,240
Find out:
i) Gearing Adjustment Ratio
ii) Current Cost Adjustment after Abating Gearing Adjustment
SOLUTION
i) Calculation of Gearing Adjustment Ratio:
(Figures in Kshs. ‘000)

Beginning of the year End of the year
Net Borrowings as given 19,500 15,400
Total Shareholders’ Interest 37,580 47,656
Net Operating Assets 57,080 63,056
Gearing Adjustment Ratio:
= ½ (19,500 + 15,400) x 100
½ (57,080 + 63,056)
28
= 17,450 x 100 = 29.1%
60,068
ii) Calculation of Current Cost Adjustment after Abating Gearing Adjustment:

Kshs.’ 000
Total Current Cost Adjustment as given 6,240
Less: Gearing Adjustment (29.1 % of 6,240) 1,816
Current Cost Reserve after Abating Gearing Adjustment 4,424
ILLUSTRATION 13
a) The current cost balance sheet of a company contained the following figures
Kshs. ‘000
Current Assets
Bank and cash (not included in monetary working capital) 450
Current liabilities
Creditors (Hire purchase) 170
Taxation 210
Proposed dividends 250
Bank overdraft (not included in monetary working capital) 190
Net Assets employed 3,540
Shareholders Funds 2,680
Long term Loans
Debentures 540
Deferred Liabilities
Deferred Taxation 320
Required: Calculate the current cost gearing proportion
b) The facts are exactly the same as 9a) above and the current cost adjustments were
Depreciation 870
Fixed asset disposals 80
29
Cost of sales 1,050
Monetary working capital 320
Required: calculate the current cost gearing adjustment
SOLUTION
a) Calculation of Current Cost Gearing Proportion
Kshs. ‘000
Debentures 540
Deferred Taxation 320
Creditors (Hire purchase) 170
Taxation 210
Bank Overdraft 190
1,430
Less: Bank and Cash Balance 450
Net Borrowing (I) 980
Shareholder’s Funds as given 2,680
Add: Proposed Dividends 250
Shareholders’ Funds (2) 2,930
Net Operating Assets (1) + (2) 3,910
Current Cost Gearing Proportion

= Net Borrowing x 100 = 980 x 100 = 25.1%
Net Operating Assets 3,910
b) Calculation of Current Cost Gearing Adjustment
Kshs. ‘000
Current Cost Adjustments
Depreciation 870
Fixed Asset Disposal 80
Cost of Sales 1,050
Monetary Working Capital 820
Total Current Cost Adjustments 2,320
Current Cost Gearing Adjustment x Gearing Proportion = 2,320 x 25.1 = 582

100
ILLUSTRATION 14
Calculate the amount of depreciation under “Current Cost Accounting” (CCA)
30
method for each of the four years as well as the backlog depreciation for a certain item of the
asset from the following details
Cost of machine Kshs. 40,000
Estimated life 4 years
Residual value Nil
Inflation factor 10% p.a
Assume straight line method of depreciation
SOLUTION
CALCULATION OF DEPRECIATION UNDER CCA METHOD
Depreciation Additional
@ 25% on Depreciation
Year Historical (CCA
Cost Replacement Cost HC RC Adjustment)
Kshs. Kshs. Kshs. Kshs. Kshs.
1 40,000 44,000 10,000 11,000 1,000 (i.e.
11,000 –
10,000)
2 40,000 ( 40,000 x 110/ ( 40,000 x 25 / ( 44,000 x 25/ 2,100
100) 100) 100)
48,4 10,000 12,100
00
3 40,000 ( 40,000 x 110/ 10,000 13,310 3,310
100)
53,240
4 40,000 ( 48,400 x 110/ 10,000 14,641 4,641
100)
58,564
( 53,240 x 110/
100)
40,000 51,051 11,051
CALCULATION OF BACKLOG DEPRECIATION

Total Depreciation
End @ 25% on Total Additional
31
of Historical Replacement HC RC Additional Annual
Year Cost Cost Depreciation Depreciation
Kshs. Kshs. Kshs. Kshs. Kshs.
1 40,000 44,000 10,000 11,000 1,000 1,000
2 40,000 48,400 20,000 24,200 4,200 3,200
(for 2 yrs (for 2yrs ( 4,200 – 1,000)
Kshs.) Kshs.)
3 40,000 53,240 30,000 39,930 9,930 5,730
(for 3yrs (for 3 yrs ( 9,930 – 4,200)
Kshs.) Kshs.)
4 40,000 58,564 40,000 58,564 18,564 8,634
(for 4yrs (for 4yrs (18,564 -9,930)
Kshs.) Kshs.)
18,564
Year Additional Depreciation CCA Depreciation Backlog Depreciation

Adjustment
Kshs. Kshs. Kshs.
1 1,000 1,000 Nil
2 3,200 2,100 1,100
3 5,730 3,310 2,420
4 8,634 4,641 3,993
18,564 11,051 7,513
ILLUSTRATION 15
The balance sheet of S. ltd at 31st December, 2006 and 31st December, 2007 were as
follows.
31st Dec. 2006 31st Dec. 2007 31st Dec. 2006 31st Dec. 2007
(Kshs. (000) (Kshs. ‘000) (Kshs. ‘000) (Kshs. ‘000)
Equity Shares 150 150 Land and Buildings 152 148
( Cost Kshs. 160)
Reserves 60 70 Equipment ( Cost 50 40
Kshs. 100)
Debentures 10% - 20 Stock 30 40
Creditors 10 15 Debtors 13 28
Proposed 5 15 Bank (10) 14
Dividend
235 270 235 270
The Profit and Loss Account for the year ended 31st December, 2007 was:
( Kshs. ‘000) (Kshs. ‘000)
Sales 100
32
Opening Stock 30
Purchases 61
91
Less: Closing Stock 40 51
Gross Profit 49
Expenses (including debenture interest) 10
Depreciation - Building 4
Depreciation - Equipment 10 24
Net Profit 25
Proposed Dividend 15
Balance carried forward 40
The relevant prices indices are:

(i) 2005 (average) – Date of building acquisition 105
(ii) 2002 (average) – Date of equipment acquisition and issue of 80
equity shares
(iii) 2006 – Last quarter average 114
(iv) 2007 – ( 1st January) debentures issued 116
(v) 2007 – Last quarter average 122
(vi) 2007 – Average 118
(vii) 2007 – 31st December 126
Closing stock of 2007 was required during whole of 2007 and opening stock during
2006.
Required:
S. Ltd wishes to adjust its historic accounts to reflect current costs in line with
Current Cost Accounting (CCA) method. Assuming that the “value of the business”
of the assets is given by the prices indices above, prepare the accounts on a current
cost basis showing current cost adjustments for the year ended 31 st December 2007
under the following heads:
a) Cost of Sales b) Depreciation c) Working Capital d) Gearing
SOLUTION
Current Cost Adjustments:
a) Cost of Sales Adjustment
33
COSA = (C – O) – 1a C – O
1c 10
Where C = Historical cost of closing stock
O = Historical cost of opening stock
10 = Index number appropriate to opening stock
1c = Index number appropriate to closing stock
COSA = (40 – 30) – 118 40 – 30
125 116
= 10 – 40 x 118 + 30 x 118
125 116
= 10 – 37.8 + 30.5 = Kshs. 2.7 thousands
Financed by Net Borrowing
Debentures - 20
Less: Bank 10 (overdraft) 14
10 6
Cost of Sales Adjustment 2.7
Depreciation Adjustment 6.4
MWC Adjustment 0.8
Total Current Cost Adjustment 9.9
Gearing Adjustment = 9.9 x ½ ( 10 + 6) 0.3
½ (235 + 241)
Current Cost Reserve Kshs. ‘000
Current Cost Adjustment 9.9
Less: Gearing Adjustment 0.3
9.6
Fixed Asset Replacement Reserve 50.7
Stock Replacement Reserve 2.4
62.7
TRADING AND PROFIT AND LOSS ACCOUNT

For the year ending 31st December, 2007 according to CCA Method
Kshs. ‘ 000
34
Profit on historical cost basis 25.00
Less: Current cost operating adjustment 9.9
15.1
Add: Gearing adjustment 0.3
Current cost profit attributable to shareholders 15.4
Less: Proposed dividend 15.00
Transfer to Reserve 0.4
BALANCE SHEET
As at 31.12.2007 as per CCA Method
Kshs. ‘000
Equity Share Capital 150.00
Reserve as at 1-1-2007 60.0
Add: Transfer to Reserve 0.4
60.4
Current Cost Reserve 62.7
Shareholders’ Fund 273.1
Value of closing stock at current cost value to be shown in Balance Sheet

= 40 x 125/ 118 = 42.4 (thousands)
Stock Replacement Reserve = Current Cost Value = Historical Cost
= 42.4 – 40 = Kshs. 2.4 thousands
b) Depreciation Adjustment
Kshs. ‘000
Depreciation charge on CCA basis
Building ( 4 x 125 / 105) 4.8
Equipment ( 10 x 125/80) 15.6 20.4
Less: Depreciation on Historical Cost basis
Building 4
Equipment 10 14.0
Depreciation Adjustment 6.4
Current Cost Value of Fixed Assets
Building ( 148 x 125 / 105) 176.2
Equipment ( 40 x 125 / 80) 62.5 238.7
Less: Historical Cost ( 148 + 40) 188.0
Fixed Asset Replacement Reserve 50.7
c) Monetary Working Capital Adjustment (MWCA)
35
MWCA = C – O – 1a C – O
1c 10
Where O = Opening monetary working capital
C = Closing monetary working capital
10 = Index number appropriate to opening MWC
1c = Index number appropriate to closing MWC
MWCA = 13 – 3- 118 (13/125 – 3/116)
= 10 – 13 x 118 / 125 + 3 x 118 / 116
= 10 – 12.3 + 3.1 = Kshs. 0.8 thousand
(Working Capital = Debtors – Creditors)
d) Gearing Adjustment
Kshs. ‘000
2006 2007
Fixed Assets ( Building and Equipment) 202 188
Stock 30 40
Monetary Working Capital 3 13
Net Operating Assets 235 241
Represented by:
Land 148 x 125/ 105 176.2
Equipment 40 x 125 / 80 62.5
Stock 40 x 125 / 18 42.4
Debtors (No Adjustment) 28.0
Bank (No Adjustment) 14.0
323.1
Less: Creditors (No Adjustment) 15.0
Dividend (No Adjustment) 15.0
Debentures (No Adjustment) 20.0 50.0
273.1
ILLUSTRATION 16:
The summarized current cost Balance Sheets of Naveen Ltd and its 60% owned subsidiary Pracheen
Ltd are as follows.
Kshs. ‘000
36
Naveen Ltd Pracheen Ltd
31.3.2008 31.3.2007 31.3.2008 31.3.2007
Fixed Assets 5,950 5,600 3,825 3,700
Investment in Pracheen Ltd 600 600 - -
Stock 3,450 1,500 1,155 1,040
Debtors Less Creditors 1,725 1,200 750 510
Taxation ( 550) (430) (450) (220)
Proposed Dividends (350) (250) - -
10,825 8,220 5,280 5,030
Share Capital 3,000 3,000 1,000 1,000
Reserves 3,490 2,165 2,250 1,300
6,490 5,165 3,250 2,300
Loans Less Cash 4,335 3,055 2,030 2,730
10,825 8,220 5,280 5,030
The historical cost profit and los accounts for the year ended 31.3.2008 are as follows:
( Kshs. ‘000)
Naveen Ltd Pracheen Ltd.
Turnover 15,500 12,100
Operating Profit 1,700 1,300
Interest Payable 400 340
Profit before Tax 1,300 960
Tax 550 450
Profit after Tax 750 510
Proposed dIvidend 350 -
Retained Profit 400 510
Notes:
i) The following current cost adjustments have been calculated:
Naveen Ltd Pracheen Ltd
Cost of Sales 275 150
37
Depreciation 350 375
ii) The following are the movements of the current cost reserves:
Surplus on revaluation
Fixed Assets 1200 800
Stocks 350 165
Monetary working capital adjustment (as above)

You are required to prepare
a) The consolidated current cost profit and loss account for the year ending
31.3.2008 for the Naveen Group.
b) A statement of the movements on the group current cost reserve for the year
ending 31.3.2008.
SOLUTION
a) Consolidated Current Cost Profit and Loss Accounting for the year ending 31.3.2008.
( Kshs. ‘000) ( Kshs. ‘000)
Turnover: Naveen Ltd. 15,500
Pracheen Ltd 12,100 27,600
Profit before interest and tax on historical cost basis
Naveen Ltd. 1,700
Pracheen Ltd. 1,300 3,000
Less: Current cost operating 1,445
adjustment (1)
Current cost operating profit 1,555
Gearing adjustment (2) 656
Interest payable : Naveen Ltd 400
Pracheen Ltd 340 740 84
Current cost profit before tax 1,471
Less: Tax : Naveen Ltd 550
Pracheen Ltd 450 1,000
Current cost profit after tax 471
Less: Profit attributable to outside shareholders i.e. 80
minority interest (3)
Current cost profit belonging to shareholders of 391
Naveen Ltd
Less: Proposed dividend- Naveen Ltd 350
38
Retained current cost profit for the year 41
Add: Movement on the group current cost reserve 1,854
(see part b)
1,895
Add: Retained reserves at the beginning of the year
Naveen Ltd 2,165
Pracheen Ltd ( 60 % of 1,300) 780 2,945
Retained reserves at the en of the year 4,840
b) Statement of the Movements on the Group Current Cost Reserve for the year ending 31.3.2008
( Kshs. ‘000)
Total Minority Interest Attributable to
Group)
Surplus on Revaluation:
Fixed Assets: Naveen Ltd 1200 - 1,200
Pracheen Ltd 800 320 ( 40% of 800) 480
Stock : Naveen Ltd 350 - 350
Pracheen Ltd 165 66 ( 40% of 165) 99
Monetary Working Capital
Adjustment: Naveen Ltd 205 - 205
Pracheen Ltd 90 36 ( 40% of 90) 54
2,810 422 2,388
Less: Gearing adjustment (2) 656 122 ( 40% of 304) 534
2,154 300 1,854
Working Notes:
Adjustments made for the calculation of current cost operating profit are as follows:
1. Calculation of Current Cost ( Kshs. ‘000) ( Kshs. ‘000)
Operating Adjustment
Cost of Sales: Naveen Ltd 275
Pracheen Ltd 150 425
39
Monetary Working Capital:
Naveen Ltd 205
Pracheen Ltd 90 295
Working Capital Adjustment 720
Depreciation: Naveen Ltd 350
Pracheen Ltd 375 725
Current Cost Operating Profit Adjustment 1,445
2. Calculation of Gearing Adjustment

Fixed Assets 31.3.2008 31.3.2007
Kshs. ‘ 000 Kshs. ‘ 000 Kshs. ‘ Kshs. ‘ 000
000
Naveen Ltd: 5,950 5,600
Pracheen Ltd 3,825 9,775 3,700 9,300
Stock: Naeeen Ltd 3,450 - 1,500
Pracheen Ltd 1,155 4,605 1,040 2,540
Monetary Working Capital
Naveen Ltd 1,725 1,200
Pracheen Ltd 750 2,475 510 1,710
Net Operating Assets 16,855 13,550
Financed By Net Borrowing
Loans Less Cash:
Naveen Ltd 4,335 3,055
Pracheen Ltd 2,030 6,365 2,730 5,785
Tax: Naveen Ltd 550 430
Pracheen Ltd 450 1,000 220 650
7,365 6,435
Gearing Proportion = Average Net Borrowing x 100

Average Net Opening Assets
= ½ (7,365 + 6,435) x 100 = 45.4%
½ (16,855 + 13,550)
Current Cost Operating Adjustment = 1,445 (thousands)
Gearing Adjustment = 45.4 % of 1,445 = 656 (thousands)
40
3. Calculation of Current Cost Profit of Pracheen Ltd. Attributable to outside
Shareholders
Kshs. ‘000 Kshs. ‘000
Profit after Tax on Historical Cost Basis 510
Less: Current Cost Operating Adjustments
Cost of Sales 150
Monetary Working Capital 90
Depreciation 375
615
Add: Gearing Adjustment (4) - 105
Current Cost Profit for the year 304
Minority Share ( 40 % of 199) 199
80
4. Calculation of Gearing Adjustment of Pracheen Ltd

31.3.2008 31.3.2007
Kshs. ‘000 Kshs. ‘000
Fixed Assets 3,825 3,700
Stock 1,155 1,040
5,730 5,250
Financed by Net Borrowing
Loans Less Cash 2,030 2,730
Tax 450 220
2,480 2,950
Gearing Adjustment = ½ (2, 480 + 2,950) x 615

½ (5,730 + 5,250)
= Kshs. 304 (thousands)
ILLUSTRATION 17
Rising Ltd. A company that was established in 2005 is in the grip of rising prices. It
depreciates its plant and machinery by the reducing balance method, charging 33 ⅓ %
of the reducing balance each year. All fixed assets can be assumed to have purchased
at the beginning o the year in which they are acquired.
Capital employed is taken at the year end value. Details of the company’s capital
employed and profits are as follows:
41
Plant and Machinery Working Capital at Profit before
year end depreciation
(Kshs. ‘000) ( Kshs. ‘000)
Year of Cost ( Kshs.
Purchase ‘000)
2005 324
2006 81
2007 54 130 142
The replacement cost of plant and machinery has been rising and a price index for
plant and machinery costs is as follows:
End of Index
2004 244.8
2005 260.1
2006 275.4
2007 306.0
Required: Calculate Rising Ltd.’s Return on Capital Employed using:

a) Historical costs and net book values to value fixed assets.
b) Replacement costing for fixed assets values and depreciation.
SOLUTION
a) Calculation of Return on Capital Employed Using Historical Costs and Net Book Values
Year of Cost of Plant Total Netbook value
purchase & 2005 2006 2007 accumulated of plant &
Machinery (Kshs. (Kshs. (Kshs.‘000) depreciation at machinery at
( Kshs. ‘000) the end of 2007 the end of
‘000) ‘000) ( Kshs. ‘000) 2007
( Kshs. ‘000)
2005 324 108 72 48 228 96
42
(324 x ⅓) ( 216 x ⅓) (144x ⅓) ( 108 + 72 + 48 ) (324 – 228)
2006 51 - 27 18 43 36
2007 54 - - 18
84 168
Calculation of Capital Employed ( Kshs. ‘000)

Net book value of plant & machinery at the end of 2007 168
Working capital at the end of 2007 130
Capital Employed 295
Calculation of Profit
Profit before depreciation 142
Less: Depreciation for 2007 84
Profit after depreciation 58
Return on Capital Employed = Profit x 100

Capital Employed
= Kshs. 58,000 x 100 = 19.5%
Kshs. 298,000
b) Calculation of Return on Capital Employed using Replacement Costing for

Fixed Assets Values and Depreciation.
Depreciation 2007 ( Figures in thousands)
Year of Adjustment On On Historical Replacement
Purchase Factor Historical Replacement Cost ( i.e. net Cost of Assets
Cost Basis Cost Basis book value of
assets)
2005 306 48 60 96 120
43
244 .8
( 48 x 306 ) ( 96 x 306)
244.8 244.8
2006 306 18 21.2 36 42.4
260 .1
2007 306 18 20 36 40
275.4
All fixed assets have been purchase at the beginning of the year in which they were
acquired, so the appropriate index figure for the purchase date is the figure for the end
of the previous year.
Calculation of Capital Employed ( Kshs. ‘000)
Plant and machinery ( net replacement cost at the end of 2007) 202.4
Working capital as given 130.0
Capital Employed 332.4
Calculation of Profit
Profit before depreciation 142
Less: Depreciation for 2007 101.2
Profit after depreciation 40.8
Return on Capital Employed = 40.8 x 100 = 12.3%
332.4
Comment. Due to inflation return on capital employed based on replacement cost is

lower than the return on capital employed calculated on the basis of historical cost.
ILLUSTRATION 18
The following are the Balance Sheets and Profit and Loss Account of Bharat Ltd,
prepared on the basis of historical cost accounting.
BALANCE SHEET
As at 1-4-2007
Kshs. Kshs.
Profit & Loss Account 50,000 Furniture and Fixtures 50,000
Sundry Liabilities 150,000 Inventory 100,000
Debtors 80,000
Cash 170,000
44
600,000 600,000
BALANCE SHEET
As at 31-3-2008
Kshs. Kshs. Kshs.
Profit & Loss Account 145,000 Less: 10% Depreciation 20,000
Sundry Liabilities 65,000 180,000
Furniture & Fixtures 50,000
Less: 10% Depreciation 5,000
45,000
Inventory 80,000
Debtors 120,000
Cash 185,000
610,000 610,000
PROFIT AND LOSS ACCOUNT

Kshs. Kshs.
To Inventory ( 1-4-2007) 100,000 By Sales 1,000,000
To Purchases 760,000 By Inventory ( 31-3-2008) 80,000
To Depreciation 25,000
To Other Operating Expenses 100,000
To Net Profit 95,000
1,080,000 1,080,000
Additional Information
i) The replacement cost of the good sold on the dates the sales were made,
amounted to Kshs. 800,000
ii) The current replacement cost of the inventory on 31-3-2008 is Kshs. 85,000.
iii) On 31-3-2008, the replacement costs of the Plant and Machinery and Furniture
and Fixtures were Kshs. 220,000 and Kshs. 400,000 respectively.
You are required to prepare Profit and Loss Statement for the year ending 31 st March,
2008 and Balance Sheet as on 31-3-2008 on the basis of Current Cost Accounting.
PROFIT AND LOSS STATEMENT OF BHARAT LTD
45
For the year ending 31t March, 2008
Kshs. Kshs.
Sales 1,000,000
Less: Cot of Goods Sold at Replacement Cost 800,000
Less: Depreciation on Replacement Cost Basis Kshs. 200,000
10 % on Plant & Machinery ( 10 / 100 x Kshs. 220,000) = 22,000
10 % on Furniture & Fixture ( 10 / 100 x Kshs. 40,000) = 4,000 26,000
Other Operating Expenses 100,000
126,000
Operating Profit 74,000
Add: Realised Holding Gain (1) 20,000
Realised Profit 94,000
Add: Unrealised Gain (2) 15,000
Total Profit 109,000
BALANCE SHEET
As at 31st March, 2008
Liabilities Kshs. Assets Kshs. Kshs.
Shares Capital 400,000 Plant & Machinery 220,000
Profit & Loss Account Kshs. Less: 10% Depreciation 22,000
Balance on 1-4-2007 50,000 198,000
Realized Profit for the 94,000 Furniture & Fixtures 40,000
year
144,000 Less: 10 % Depreciation 4,000
36,000
Unrealized Holding Inventory 85,000
Gain ( i.e Revaluation 15,000 Debtors 120,000
Reserve)
Sundry Liabilities 65,000 Cash 185,000
624,000 624,000
Working Notes:
1. Calculations of Realised Holding Gain
Kshs. Kshs.
Replacement cost of the goods sold 800,000
Less: Historical cost of goods sold:
Opening inventory 100,000
46
860,000
Less: Closing Inventory 80,000
780,000
Realised Holding Gain 20,000
2. Calculation of Unrealised Holding Gain

Kshs.
Replacement cost of plant and machinery ( 31-3-2008) 220,000
Replacement cost of furniture and fixtures ( 31-3-2008) 40,000
Replacement cost inventory on ( 31-3-2008) 85,000
Kshs. 345,000
Less: Historical cost of plant and machinery on 1-4-2007 200,000
Historical cost of furniture and fixtures on 1-4-2007 50,000
Historical cost inventory on ( 31-3-2008) 80,000
33,000
Unrealised Holding Gain 15,000
Note: Sales and operating expenses will be same in Current Cost Accounting as these
are in historical cost accounting because these are always measured in terms of prices
prevailing at the time of actual sales or operating expenses. Therefore no adjustment
has been made in these items.
ILUSTRATION 19.
The Balance Sheet of Pracheen and Naveen, a partneKshs.hip firm as at 31 st March
2008 had the following assets and liabilities.
BALANCE SHEET
As at 31.3.2008
Current Liabilities 1,475,000 Cash 500,500
Pracheen’s Capital 1,815,000 Accounts 950,000
Receivable net
47
Naveen’s Capital 1,210,000
Inventory ( LIFO basis) 1,500,000
Prepaid Insurance 18,000
Land 58,000
Machinery and 1,473,500
Equipment
4,500,000 4,500,000
Pracheen and Naveen are considering selling their business but are concerned that the
financial statements do not reveal their current worth.
You have been requested to assist in determining the current value of the assets.
The following data are relevant:
1. An ageing statement of Accounts Receivable disclosed the following.

Accounting Year Amount Allowance for Doubtful Debts
2004-05 40,000 35,000
2005-06 125,000 105,000
2006-07 160,000 67,500
2007-08 925,000 92,500
1,250,000 300,000
A review of past experience shows that all receivables over two year old have been
uncollectable, those over one year old have been 50% collectable and those less than
one year old have been 90% collectable.
2. The inventory prices increases are:

Accounting Year acquired Cost Period PRICE INCRESE
Kshs. Increase
2003-4 60,000 2003- 4 20%
2004-05 150,000 2004 - 05 18%
2005-06 2,40,000 2005 - 06 15%
2006-07 350,000 2006 - 07 11%
48
2007-08 700,000 2007 - 08 5%%
1,500,000
The inventory has been valued on the LIFO basis and the cost of the LIFO is based at
the average price for the indicated year of acquisition.
3. Machinery was purchased in accounting years 2003-04, 2005-06 and 2006-07 for
Kshs. 500,000, Kshs. 850,000 and Kshs. 660,000 respectively. The straight line
depreciation and a 10 year estimated life has been used for all machinery with a
half year of depreciation taken in the year of acquisition. The market conditions
indicate that the machinery can be sold at 12% of its boo value.
4. An independent appraisal made in March, 2008 put the o the land at Kshs. 70,000.
Prepare a comparative statement of assets showing historical costs and current values
as at 31st March, 2008 with supporting schedules.
SOLUTION
COMPARATIVE STATEMENT OF ASSETS SHOWING HISTORICAL
COSTS AND CURRENT REALISABLE VALUES OF PRACHEEN AND
NAVEEN.
Historical Cost Current Value
Kshs. Kshs.
Cash 500,500 500,500
Account Receivable (Net) 950,000 912,500 (1)
Inventory ( LIFO Basis) 1,500,000 1,648,500 (2)
Prepaid Insurance 18,000 18,000
Land 58,000 70,000
Machinery & Equipment 1,473,500 1,841,875 (3)
4,500,000 4,991,375
Working Notes:
1) Current value of Accounts Receivable
Accounting Amount Allowance for Doubtful Current Value of
Year Debts Required Collectable Amount
Kshs. Kshs. Kshs.
2004-05 40,000 100% 0
49
2005-06 125,000 100% 0
2006-07 160,000 50% 80,000
2007-08 925,000 10% 832,500
( 925,000 – 92,500)
912,500
2) Calculation of Current Value of Inventory

Accounting Year of Amount Increase Current Value
Inventory Acquired Kshs. Kshs.
2003-04 60,000 20% 72,000 ( i.e. 60,000 x 120 / 100)
2004-05 150,000 18% 177,000 ( i.e. 1,50,000 x 118/100)
2005-06 240,000 15% 276,000 ( i.e. 2,40,000 x 115/100)
2006-07 350,000 11% 388,500 ( i.e. 3,50,000 x 111/100)
2007-08 700,000 5% 735,000 ( i.e. 7,00,000 x 105/100)
1,500,000 1,648,500
3) Calculation of Current Value of Machinery and Equipment

Accounting Year Cost of Accumulated Amount of Accumulated
Machinery Depreciation Depreciation
Kshs. Kshs.
2003-04 500,000 45% 225,000 ( 45 /100 x 500,000)
2005-06 850,000 25% 212,500 ( 25 / 100 x 850,000)
2006-07 660,000 15% 99,000 ( 15/100 x 660,000)
2,010,000 536,500
Book Value of Machinery = Kshs. 2,010,000 – Kshs. 536,500 = Kshs. 1,473,500

Current Value (125% of book value) Kshs. 1,473,500 x 125/100 = Kshs. 1,841,875.
Advantages of CCA
The following are the main advantages of this approach:
(i) It maintains intact the operative capacity of the enterprise as this method seeks
to closely approximate the impact of inflation on the enterprise.
(ii) The theory underlying in this approach (i.e., earnings and assets of an enterprise
50
should be Measured by reference to the value to the business) is quite logical and
useful for some group of users of financial statements.
(iii) The break up of the assets and liabilities under CCA approach is more accurate
and real financial picture of an enterprise will be available as compared to
historical cost accounting as CCA figures are with reference to the current prices.
Limitations of CCA
The following are the main limitations of this approach:
1. There is an element of subjectivity inherent in periodic valuations especially
where reliable indices are not available. Under CCA accounts are not objective
so as to provide information capable of independent verification. The valuation
of assets is influenced by the discretion and subjective judgement.
2. Under CCA approach, figures of operative profit and capital employed in
different years are not comparable as current cost accounts are prepared in
monetary units having a different purchasing power in each year.
3. Under this approach, operating profits do not reflect the real earnings of the
firm. Profits when distributed will be out of capital and will not help to maintain
the operating capability of the firm.
4. External users will not be able to predict future cash flows (as CCA will not be
applicable to sash flow statements) which is very necessary for investment
decision making.
5. Under this approach, accounts of an enterprise shall have to be adjusted even if
changes in specific prices occur without any changes in the purchasing power of
money.
6. The valuation method under this approach is ill-defined. There is no integrated
and comprehensive body of procedures which is followed for valuation in CCA.
7. The various aspects of the CCA are not easily understood as it introduces into
accounts nolotional concept of valuation amount in place of the existing
historical cost of assets. Thus, the method is less intelligible.
8. The ultimate aim of CCA is to replace gradually historical cost accounts but
there may be legal problems in replacement as the income tax authorities may
not recognize CCA.
In view of the above limitations, CCA may not be generally acceptable to the
enterprise and professional bodies in various countries.
51
Specific and General Price Level Accounting (SGPLA)
This approach of accounting for price level changes combines the two approaches—
CCA and PP. Financial statements can be prepared by combining the factors of CCA
and CPP. This approach takes into consideration both changes in specific prices of
individual items and the influences of general price level changes. Under this
approach, values shown in the financial statements are based on current costs and are
measured in units of purchasing power. This approach of accounting has not become
popular because it has not been proposed so far by any institutional body as other
approaches (CCA and CPA) have been recommended by institutional bodies.
Periodic Evaluation of Fixed Assets along with Adoption of LIFO Method of

Inventory
In 1938, last-in-first out (LIFO) method of inventory valuation was permitted for
limited class fax payers in U.S.A. and in 1939 the LIFO privilege was generalized for
tax payers because of price inflation. As a result of this, the LIFO method of
inventory valuation got the world-wide general acceptance and is made use of during
inflation. The advocates of this method are of the view that periodic revaluation of
fixed assets along with the adoption of LIFO method (for getting the cost of goods
sold and value of closing stock) can considerable reduce the effect of increasing
prices. The purpose of periodic revaluation of fixed assets is to charge depreciation on
current cost of replacement and the objective of following LIFO method is to charge
current cost of good consumed to Profit and Loss Account.
By following this method, the enterprise will be able to keep its operating capability
intact with regard to fixed assets and inventories. But this method is of adhoc nature
and appears to be compromise till a universally accepted method of accounting for
changing prices is developed by the adoption of LIFO method stock in hand is valued
at price which does not reflect current market price and as a result closing stock will
be understated or overstated in the Balance Sheet. Periodic revaluation say after every
three or five years may be inadequate for the purpose of maintaining operating
capability as is claimed in this method if there is stepping inflation.
Of the four approaches discussed, Current Cost Accounting is a better approach as
under this approach all assets and liabilities are shown at their realistic values and
operative profit is arrived at after charging the value to the business of company's
52
assets consumed during the period According to Hendriksen, "From an
interpretational point of view, the current cost concept appears to be more relevant
than the general purchasing power concept. That is, cost restated by the use of
specific indexes or replaced by current cost measurements are probably closer to
current values than are historical costs adjusted for general purchasing power
changes." But critics have also criticized this method. They are of the view that CCA
fails to reflect the general increase in price and is subjective in its approach. The
system offers some discretion to the directors in the valuation of assets. The effect of
inflation on monetary assets and liabilities is not taken into consideration while
preparing final accounts, so CCA approach does not take into account all aspects of
inflation It lays emphasis on the concept of maintenance of capital than on the
concept of general purchasing power.
We give below an illustration to make clear-cut distinction between historic cost
accounting current purchasing power accounting, current cost accounting and
specific and general price level accounting:
ILLUSTRATION 20.
A broker starts a business on January 1 with Kshs. 100,000 cash and no other assets
and liabilities. He buys shares on January 1 for Kshs. 100,000 and sells half of the
shares for Kshs. 88,000 on June 30. During the year, general price level has increased
by 12.35% (7% in the first 6 months and 5% in the last 6 months of the year). The
current cost of shares which were bought on January 1 for Kshs. 50,000 was Kshs.
73,500 on June 30, and Kshs. 84,000 on December 31.
From the above information, you are required to prepare the financial statements
under alternative accounting methods, viz., historical cost accounts, purchasing
power-adjusted accounts, current cost accounts and specific and general price-
adjusted accounts.
SOLUTION
Particulars. Under Under Under Cost Under Specific
Historical Current Accounting and General
Cost Purchasing Method Price Adjusted
Accounting Power Accounting
53
Sale of shares 88,000 92,400 (1) 88,000 92,400 (1)
Less: Cost of shares sold 50,000 56,175 (2) 73,500 77,175 (3)
Operating Income 38,000 36,225 14,500 15,225
Realised Holding Gain - - 23,500 (4) 21,000 (5)
( on shares sold)
38,000 36,225 38,000 36,225
Less: Less on - 4,400 (6) - 4,400 (6)
Monetary items
Realized Income 38,000 31,825 38,000 31,825
Unrealized Holding - - 34,000 (7) 27,825 (8)
Gain (on shares still unsold)
Net Income 38,000 31,825 72,000 59,650
54
BALANCE SHEET
As on 31st December
Historical Current Current Specific & Historical Current Current Specific &
Cost Purchasing Cost General Price Cost Purchasing Cost General Price
Accounting Power Accounting Adjusted Accounting Power Accounting Adjusted
Accounting Accounting Accounting Accounting
Kshs. Kshs. Kshs. Kshs. Kshs. Kshs. Kshs. Kshs.
Capital 100,000 112,350 (9) 100,000 112,350 (9) Cash 88,000 88,000 88,000 88,000
Retained 38,000 31,825 38,000 31,825 Inventory 50,000 56,175 (10) 84,000 84,000
Earning
(Realized (Unsold
income) shares)
Unrealized - - 34,000 27,825
Holding Gain
(i.e.
Revaluation
Reserve)
138,000 144,175 172,000 172,000 138,000 144,175 172,000 172,000
Working Notes:
1. Sale of shares Kshs. 88,000 on June 30 restated to December 31 value
(Kshs. 88,000 x 1.05) = Kshs. 92,400
2. Cost of shares sold: Kshs. 50,000 on January 1 restated to December 31 shillings
(Kshs. 50,000 x 1.1235) = Kshs. 56,175.
3. Replacement cost of shares sold on June 30: Kshs. 73,500 restated to December
31, purchasing power (Kshs. 73,500 x 1.05) = Kshs. 77.175.
4. Current replacement cost of shares sold on June 30 Kshs. 73,500 – Kshs. 50,000
acquisition cost of shares sold = Kshs. 23,500.
5. Realized holding gain in terms of June 30 purchasing power, Kshs. 73,500 –
Kshs. 50,000 x 1.07 = Kshs. 20,000 restated December 31 purchasing power
(Kshs. 20,000 x 1.05) = Kshs. 21,000
6. Loss on monetary items:
Cash received on shares sold on June 30 = Kshs. 88,000
Loss of purchasing power @ 5% for retaining
Cash from June 30 to December 31 (Kshs. 88,000 x 5 / 100) = Kshs. 4,400
7. Current cost of shares unsold on 31December = Kshs. 84,000
Less: Acquisition cost of shares unsold = Kshs. 50,000
= Kshs. 50,000
Unrealized holding gain = Kshs. 34,000
8. Unrealized holding gain is current replacement cost of shares remained unsold
upto 31st December minus acquisition cost of these shares restated to December
31 purchasing power ( Kshs. 84,000 – Kshs. 50,000 x 1.1225) = Kshs. 27,825.
9. Capital constituted on January 1 restated to December 31 purchasing power
(Kshs. 100,000 x 1.1235) = Kshs. 112,350.
10. Cost of unsold shares on January 1 for Kshs. 50,000 restated to December 31
purchasing power (Kshs. 50,000 x 1.1235) = Kshs. 56,175.
ILLUSTRATION 21
BALANCE SHEET
(On the Basis of Historical Cost Accounting)
Share Capital 500,000 Plant 500,000
During the year wholesale index has gone up by 10%. On 31 st March, 2008 the
replacement cost of the plant was Kshs. 650,000. It is supposed further that the plant
is sold for Kshs. 750,000. You are required to prepare the financial statements for the
year ending 31st March, 2008 under the following approaches:
a) Historical Cost Accounting
b) Current Purchasing Power Accounting
c) Current Cost Accounting
SOLUTION
INCOME STATEMENT
Historical Current Current Cost
Cost Purchasing Power Accounting
Kshs. Kshs. Kshs.
Sale of the plant 750,000 750,000 750,000
Less: Cost of the plant 500,000 550,000 650,00
( Kshs. 5,00,000 ( Present
cost + 10% general replacement value)
increase in price)
Profit on sale of plant 250,00 200,000 100,000
BALANCE SHEET
As on 31.3.2008
Liabilities Historical Current Current Assets Historical Current Current
Cost Purchasing Cost Cost Purchasing Cost
Accounting Power Accounting Accounting Power Accounting
Kshs. Kshs. Kshs. Kshs. Kshs. Kshs.
Share Capital 500,000 550,000 500,000 Cash 750,000 750,000 750,000
( increased
by 10%
because of
general
increase in
price)
Profit on Sale 250,000 200,000 100,000
of Plant
Revaluation 150,000
Reserve
(Replacement
cost –
Original Cost)
750,000 750,000 750,000 750,000 750,000 750,000
ILLUSTRATION 22
A company has a number of plants as given below
Year of Cost Life in Years Rate of Hypothetical
Purchase Kshs. Depreciation p.a Price Index at
on original cost the time of
purchase
1994 40,000 20 5% 100
2002 50,000 10 10% 200
2008 60,000 8 12.5% 300
Keeping in view the above facts you are required to show entries necessary for
recording the changes in the ledger using the index numbers.
SOLUTION
STATEMENT OF REVALUATION OF FIXED ASSETS
Year of Historical Cost Index Current Valuation Kshs.
Purchase Kshs. Number
1994 40,000 100 40,000 x 300/100 = 120,000
2002 50,000 200 50,000 x 300/ 200 = 75,000
2008 60,000 300 60,000 x 300/300 = 60,000
150,000 255,000
STATEMENT OF DEPRECIATION
Historical Basis
Year Total Rate of Cost Depreci Value (on Current value basis
number depreci ation the basis of Depreciation
of years ation index
used number)
1994 15 5% 40,000 30,000 1,20,000 90,000 ( 1,20,000 x 5 x 15)
100
2002 7 10% 50,000 35,000 75,000 52,500 (75,000 x 10 x 7)
100
2008 1 12 ½ % 60,000 7,500 60,000 7,500 ( 60,000 x 25 x 1 )
2 x 100
150,000 72,500 255,000 150,000
JOURNAL ENTRIES
Dr. Cr.
Plant Account Dr. 105,000
To Capital Reserve 105,000
(Being Entry for revaluation of plant on index
number basis)
Profit and Loss Account Dr. 77,500
To Depreciation Provision 77,500
(Being entry for excess depreciation required on
current value basis i.e. Kshs. 1,50,000 on current
value basis minus Kshs. 72,5000 on historic basis)
ILLUSTRATION 23
Zero Limited commenced its business on 1 st April 2007. 2,00,000 equity shares of
Kshs. 10 each at par and 12.5% debentures of the aggregate value of Kshs. 2,00,000
were issued and fully taken up. The proceeds were utilized as under:
Kshs.
Fixtures and Equipments 1,600,000
(Estimated life 10 years, no scrap value)
Goods purchased for resale at Kshs. 200 per unit 600,000
The goods were entirely sold by 31st January, 2008 at a profit of 40% on selling price
Collections from debts outstanding on 31st march amounted to Kshs. 60,000 goods
sold were replaced at a cost of Kshs. 7,20,000, the number of units purchases being
the same as before. A payment of Kshs. 40,000 to a supplier was outstanding as on
31st March, 2008.
The replaced goods remained entirely in stock on 31st March, 2008.
Replacement cost as at 31st March, 2008 was considered to be Kshs. 280 per unit.
Replacement cost of fixtures and equipments (depreciation on straight line basis) was
Kshs. 2,000,000 as at 31st March, 2008.
Draft the Profit and Loss Account and the Balance Sheet on replacement cost (entry
value) basis and on historical cost basis.
SOLUTION
PROFIT AND LOSS ACCOUNT OF ZERO LIMITED
Historical Basis Replacement Cost
Kshs. Kshs.
Sales 1,000,000 1,000,000
Less: Cost of Sales 600,000 (1) 720,000
Gross Profit 400,000 280,000
Less: Depreciation 160,000 200,000
( 10% of 160,000) (10% of 20,00,000)
240,000 80,000
Less: Debenture Interest 25,000 25,000
Net Profit 2,15,000 55,000
BALANCE SHEET OF ZERO LIMITED
As on 31st March, 2008
Historical Replacement Historical Replacement
Equity Shares Capital 200,000 2,00,000 Fixtures & (2) 18,00,00
Equipments
Profit & Loss A/c 215,000 55,000 Less: 1,440,000 840,000
depreciation
Realised Holding Gain 120,000 Stock 720,000 (3,000 x 280)
(3)
Unrealised Holding 520,000 60,000
Gain (4) (i.e.
Replacement Reserve)
12.5% Debentures 200,000 200,000 Debtors 60,000 235,000
Creditors 40,000 40,000 Cash at Bank 235,000
2,455,000 2,935,000 2,455,000 2,935,000
Working Notes:
1. Calculation of Replacement Cost of Sales
3,000 units @ Kshs. 240 replacement cost at the date of sales Kshs. 7 20,000
(Units = Purchases = Kshs. 600,000 = 3,000 units)
Prices per unit Kshs. 200
2. Fixtures and Equipments at Net Current Replacement Cost
Kshs.
Gross replacement cost 2,000,000
Less: Depreciation 10% of Kshs. 2,000,000) 200,000
1,800,000
3. Calculation of Realized Holding Gain
Kshs.
Replacement cost of goods sold 720,000
Less: Historical cost of goods sold 600,000
Realized Holding Gain 120,000
4. Calculation of Unrealized Holding Gain Kshs.

Closing stock at replacement cost on 31-3-2008: 3,000 units @ Kshs. 280 840,000
Less: Purchase Price: 3,000 units @ Kshs. 240 720,000
120,000
Add: Unrealized holding gain on fixtures and equipments
Replacement cost Kshs. 2,000,000
Less: Purchase price Kshs. 1,600,000
Total Unrealized Holding Gain 400,000
520,000
Advantages and Disadvantages of Accounting for the Price Level Changes

It is useful to list the advantages- and disadvantages of the practice of recognizing the
effect of price level changes in accounts.
Advantages
1. Historical accounting tends to inflate profits because less depreciation based on
historical costs of assets (which are usually lower) is charged. Inflated profits if
distributed as dividend will lead to erosion of capital. Accounting adjusted to
price level changes tends to correct this malady by charging depreciation on
current values of assets. In this way, capital is kept intact which is essential in a
limited liability business.
2. Inflation accounting helps to maintain the physical capital (i.e., fixed assets)
intact because sufficient funds are-made available for replacement of fixed assets
when they are worn out by charging depreciation on their current values.
3. Balance Sheet exhibits a true and fair view of the financial position of a firm
because assets are shown at their current values.
4. For managerial decisions, the anticipated and actual profit must be expressed in
shillings of the same purchasing power. Inflation accounting does this by
matching the cost and revenue at current values.
5. Inflation accounting helps in making better comparison of the profitability of this
two plants set up at different dates because current values and not historical costs
of the plants will be taken for comparison purposes.
6. Financial ratios calculated on the basis of balance sheets and profit and loss
account adjusted to current values would provide more meaningful information as
compared to the ratios based on the historical costs.
7. A rate of return on capital employed adjusted to the current price index is more
useful in the valuation of business by its owners Creditors and management.
8. Employees, shareholders and public are not misled because inflation accounting
shows current profit based on current prices. Historical accounting shows
exaggerated profits by relying on historical values which may be very low.
Exaggerated profit may induce employees and shareholders to make a claim for
higher wages and dividends.
Disadvantages
1. Charging depreciation on current values of fixed assets is not acceptable to
income tax authorities, so no useful purpose will be served by following
accounting for changing prices |o for as income tax is concerned.
2. Too many calculations are involved for adjusting accounting to changing prices
and making financial statements complicated.
3. Charging depreciation is a process of distribution of original cost of a fixed asset
over its effective life, so charging anything in excess over the effective life of an
asset is against the concept of depreciation.
4. Adjusting accounts to changing prices is a never ending process because prices
go on changing every day.
5. Price level accounting is not free from prejudice. Assets are recorded at current
values which will be according to the whims of an individual or group of
individuals. It would enable people to dress up their balance sheets according to
their whims. On the other hand, actual cost recorded in historical accounting is an
objective evidence and is free from prejudice.
6. The profit disclosed by system of price level accounting by taking items at
current values is not a realistic profit and, therefore, to that extent, it should not
be distributed as dividend, Distribution of unrealized profit as dividend amounts
to erosion of capital which is not desirable.
7. In times of deflation, lower depreciation will be charged because assets will have
lower current value. It will increase profit which will lead to payment of
excessive dividend. It is not desirable because it amounts to payment of capital
profit.

Accounting For Price Level Changes

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Accounting For Price Level Changes

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Accounting for Price Level Changes (Inflation Accounting)

Limitations of Historical Accounting

Return on capital employed = Kshs. 180,000 x 100 = 8.2%

Meaning of Accounting for Changing Prices

Approaches to Price Level Accounting (or Inflation Accounting)

1. Current Purchasing Power Accounting (CPPA)

In 1974 the English Institute of Chartered Accountants recommended that companies

The transactions affecting monetary items during the year were:

The general price index was as follows:

Historical Cost ConveKshs.ion Restated Figure

PROFIT AND LOSS STATEMENT

STATEMENT OF GAIN OR LOSS ON MONETARY ITEMS

2. Cash in hand on 31-3-2008 is calculated as follows: Kshs.

PROFIT AND LOSS ACCOUNT

Current Cost Accounting (CCA)

Important Characteristics of Current Cost Accounting

Historical Cost Current Cost

(b) Cost of Sales Adjustment (COSA).

Closing Stock 1,600 2,800

Average Net borrowings (L) = 300 + 340 = Kshs. 320

(Figures in Kshs. ‘000)

ii) Calculation of Current Cost Adjustment after Abating Gearing Adjustment:

Required: Calculate the current cost gearing proportion

Current Cost Gearing Proportion

Current Cost Gearing Adjustment x Gearing Proportion = 2,320 x 25.1 = 582

40,000 51,051 11,051

CALCULATION OF BACKLOG DEPRECIATION

Year Additional Depreciation CCA Depreciation Backlog Depreciation

The relevant prices indices are:

TRADING AND PROFIT AND LOSS ACCOUNT

Value of closing stock at current cost value to be shown in Balance Sheet

c) Monetary Working Capital Adjustment (MWCA)

Monetary working capital adjustment (as above)

2. Calculation of Gearing Adjustment

Gearing Proportion = Average Net Borrowing x 100

4. Calculation of Gearing Adjustment of Pracheen Ltd

Gearing Adjustment = ½ (2, 480 + 2,950) x 615

Required: Calculate Rising Ltd.’s Return on Capital Employed using:

Calculation of Capital Employed ( Kshs. ‘000)

Return on Capital Employed = Profit x 100

b) Calculation of Return on Capital Employed using Replacement Costing for

Comment. Due to inflation return on capital employed based on replacement cost is

PROFIT AND LOSS ACCOUNT

PROFIT AND LOSS STATEMENT OF BHARAT LTD

2. Calculation of Unrealised Holding Gain

1. An ageing statement of Accounts Receivable disclosed the following.

2. The inventory prices increases are:

2) Calculation of Current Value of Inventory

3) Calculation of Current Value of Machinery and Equipment

Book Value of Machinery = Kshs. 2,010,000 – Kshs. 536,500 = Kshs. 1,473,500

Periodic Evaluation of Fixed Assets along with Adoption of LIFO Method of

4. Calculation of Unrealized Holding Gain Kshs.

Advantages and Disadvantages of Accounting for the Price Level Changes

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