Chapter 3

Accounting for Changing Prices

Answers to Questions for Discussion

1. Inflation refers to the decline in purchasing power of a monetary unit over time.

2. If the purchasing power of the monetary unit has changed substantially (high
inflation or deflation) then the financial statements may be distorted. Monetary
units of different purchasing power are aggregated as if they represent the same
purchasing power. This may result in presentation of the amounts in financial
statements that are not very meaningful.

Restating financial statements, by using general price-level indexes, means that all
the amounts in financial statements are expressed in a monetary unit with constant
purchasing power. This removes the distortion caused by aggregation of amounts
based on a monetary unit of different purchasing power.

3. A monetary item is either cash or a receivable or payable that will be received or

paid out in a fixed number of monetary units. Examples are accounts receivable,
cash, accounts payable and notes payable.

A nonmonetary item is one that does not represent a claim to, or for, a specified
number of monetary units. Examples are inventory, equipment, land, warranty
claims payable, common stock, retained earnings, revenues, and expenses.

4. In a country that has had an extremely high rate of inflation for many years,
unadjusted historical cost basis financial statements do little to inform the user
about an entity. This is so because the financial statements reflect monetary units of
varying dimensions.

5. Multiply the nominal amount of the fixed asset with the current index divided by
the index in effect when the asset was acquired. The related depreciation and
accumulated depreciation are restated in the same manner.

6. A net monetary gain or loss, also called purchased power gain or loss, results from
the difference between the nominal net monetary position and the constant
monetary unit net monetary position.

7. A monetary gain or loss, arising from holding monetary items, appears in the
income statement adjusted for general price level changes.
30 Chapter 3

8. a. Nonmonetary
b. Monetary if held to maturity; Nonmonetary if held for resale before maturity
c. Nonmonetary
d. Nonmonetary
e. Monetary

9. a. Maintaining a balance in a checking account: Purchasing power loss.

b. Depreciating an asset: Neither.
c. Additional paid-in capital on preferred stock: Neither

10. A specific price index is constructed by taking the current price of a specific good or
service and dividing it by price of the same good or service at the base period.

11. The replacement cost is an input price. Net realizable value is an output price.

12. When a country has a highly inflationary economy for sustained periods of time, it
is likely to introduce inflation accounting.

13. A gearing adjustment is made to recognize that it is not necessary to make current
cost adjustments to operating assets to the extent that they are financed by
creditors. The amount of the gearing adjustment is computed by multiplying the
total current value adjustments (such as for current cost of goods sold and current
cost of depreciation) to the ratio of average borrowing to average operating assets.

Gearing adjustment = Average borrowing x Total current value adjustments

Average operating assets made (for cost of goods sold
depreciation, etc.)

14. Two major ways of accounting for inflation are either the general purchasing power
approach or current cost approach. Under IAS 15, the following adjustments
should be disclosed by large public companies:
• The amounts of the adjustment to or the adjustment amount
of depreciation of property, plant, and equipment.
• The amount of the adjustment to or the adjusted amount of
cost of sales.
• The adjustments to monetary items.
• The overall effect on income.
• If the current cost method is used, the current cost of
property, plant, equipment and inventories.
• The methods used to calculate the information above as well
as the type of indices used.
Chapter 3 31

15. IAS 29 provides guidelines for characterizing a hyperinflationary economy. They

are:
• The population prefers nonmonetary assets or a relatively
stable foreign currency over local currency.
• Sales and purchases on credit incorporate amounts for
expected losses in purchasing power even for relatively short credit periods.
• Interest rates, prices, and wages are tied to a price index.
• The cumulative inflation rate for three years is approaching
or exceeds 100 percent.

16. IAS 29 applies to primary financial statements. The gain or loss on the net monetary
position should be included in the income statement and separately disclosed. IAS
29 requires that financial statements of a company reporting in a currency of
hyperinflationary economy be restated for general purchasing power changes at
the balance sheet date. This requirement applies regardless of whether the
primary financial statements were prepared on historical cost basis or current
value basis.

Solutions to Exercises/Problems
3-1 1. c 2. c 3. c
4. e 5. d 6. b
7. a 8. c

3.2 Using historical costs restating for the changing price level of the franc:

Restated cost: 500,000 x 225/200 = 562,500 francs

Depreciation:
Nominal Conversion
amount ratio
50,000 x 225/200 = 56,250 francs

Book value of machine: 562,500 – 56,250 = 506,250 francs

3-3 Lindberg Company

Calculation of Purchasing Power Gain or Loss
For the Year Ended 31 December 2002

Nominal Restatement Constant

Dollars Ratio Dollars
Net monetary position, 1 Jan. 2002 $(10,000) 132/120 $(11,000)

Increases in net monetary assets from:

Sales 300,000 132/126 314,286
32 Chapter 3

Sale of investment 50,000 132/128 51,563

Sale of common stock ($20 x 2,000) 40,000 132/124 42,581
Total increases 390,000 408,430

Decreases in net monetary assets from:

Salaries ( 90,000) 132/126 ( 94,286)
Equipment purchase (120,000) 132/132 (120,000)
Income taxes ( 40,000) 132/132 ( 40,000)
Dividends ( 10,000) 132/132 ( 10,000)
Total decreases (260,000) (264,286)

Net monetary position, 31 Dec. 2002 $120,000 133,144

Less: Nominal-dollar net monetary
position, 31 Dec. 2002 (120,000)
Purchasing power loss $ 13,144

3-4 Nominal Restatement Constant

Guilders Ratio Guilders
Accounts receivable (net) Fl. 20,000 155/155 Fl. 20,000
Machinery 100,000 155/125 124,000
Accum. depreciation on machinery 30,000 155/125 37,200
Patent (net) 10,000 155/130 11,923
Accounts payable 25,000 155/155 25,000
Bonds payable 75,000 155/155 75,000
Common stock 80,000 155/100 124,000

3-5 Z.H. Mudh Company

Restatement of Income Statement to Constant Dollars
For the Year Ended 31 December 2002

Nominal Restatement Constant

Dollars Ratio Dollars
Sales revenue: $200,000 160/150 $213,333

Expenses:
Cost of goods sold ( 90,000) 160/140 (102,857)
Depreciation expense ( 30,000) 160/130 ( 36,923)
Salaries expense ( 40,000) 160/150 ( 42,667)
Interest expense ( 15,000) 160/150 ( 16,000)
Total expenses (175,000) (198,447)

Income before tax 25,000 14,886

Income tax (30%) ( 7,500) 160/150 ( 8,000)
6,886
Purchasing power gain Given 5,000
Net income $ 17,500 $ 11,886
Chapter 3 33

3-6 (1) Accumulated depreciation in nominal Deutsche marks:

DM 80,000
2001 (60,000)
Depreciation expense 2002 DM 20,000

Depreciation expense in constant Deutsche marks for 2002:

20,000 x 150/90 DM 33,333*

(2) Purchase cost DM 300,000

Accumulated depreciation ( 80,000)
Book value in nominal DM DM 220,000

Book value in constant DM: 220,000 x 150/90 DM 366,667*

(3) Land in constant DM: 100,000 x 150/90 DM 166,667*

* Rounded

3-7 (1) Peterson Company

Calculation of Purchasing Power Gain or Loss
For the Year Ended 31 December 2002

Nominal Restatement Constant

Francs Ratio Francs
Net monetary position, 1 January 2002 SFr( 20,000) 124/120 SFr( 20,667)

Increase in net monetary assets from sales 270,000 124/122 274,426

Decreases in net monetary assets:

From purchases of merchandise (170,000) 124/122 (172,787)
From operating expenses and taxes ( 70,000) 124/122 ( 71,148)
From dividends ( 45,000)124/124 ( 45,000)
Total decreases (285,000) (288,935)

Net monetary position,

31 December 2002 SFr( 35,000) ( 35,176)
Less nominal Swiss franc net monetary
position, 31 December 2002 ( 35,000)
Purchasing power gain SFr 176
34 Chapter 3

(2) Peterson Company

Restatement of Income Statement from Nominal to Constant Swiss Francs
For the Year Ended 31 December 2002

Nominal Restatement Constant

Francs Ratio Francs
Sales SFr 270,000 124/122 SFr 274,426
*Cost of goods sold (see computation
below) (145,000) (148,463)
Selling and administrative expenses:
Depreciation expenses ( 20,000) 124/80 ( 31,000)
Other operating expense and taxes ( 70,000) 124/122 ( 71,148)
Total costs and expenses (235,000) (250,611)

Net income SFr 35,000 23,815

Purchasing power gain on net
monetary position 176
Net income adjusted for purchasing
power gain SFr 23,991

*Cost of goods sold:

Beginning inventory SFr 70,000 124/120 SFr 72,233
Purchases 170,000 124/122 172,787
Total goods available for sale 240,000 245,020
Less ending inventory ( 95,000) 124/122 ( 96,557)
Cost of goods sold SFr 145,000 SFr148,463

3-8 (1) Shahruz Co.

Restatement of Income Statement to Constant Dollars
For the Year Ended 31 December 2002

Nominal Restatement Constant

Dollars Ratio Dollars

Revenues $400,000 140/130 $430,769

Expenses:
Cost of goods sold (250,000) 140/130 (269,231)
Operating expenses ( 50,000) 140/130 ( 53,846)
Total expenses ($300,000) ($323,077)
Purchasing power loss Given ( 10,000)
Net income $100,000 $ 97,692
Chapter 3 35

(2) Restatement of Balance Sheet to Constant Dollars

Shahruz Co.
Restatement of Balance Sheet to Constant Dollars
31 December 2002

Nominal Constant
dollars Ratio dollars
Assets
Cash $ 70,000 140/140 $ 70,000
Account receivable (net) 50,000 140/140 50,000
Inventory 80,000 140/130 86,154
Land
Purchases in January 1999 250,000 140/105 333,333
Purchases in June 2000 250,000 140/120 291,667
Total land 500,000 625,000
Total assets $700,000 $831,154

Liabilities and stockholders’ equity

Notes payable $ 30,000 140/140 $ 30,000
Accounts payable 60,000 140/140 60,000
Paid-in capital 410,000 140/105 546,667
Retained earnings 200,000 Balancing 194,487
Total liabilities and
stockholders’ equity $700,000 $831,154

3-9 Zaki and Safi, Inc.

Income Statement—Current Cost Basis
For the Year Ended 31 December 2002

Sales $350,000
Cost of goods sold ( 230,000)
Gross margin 120,000
Operating expenses ( 70,000)
Income before holding gains 50,000
Holding gains:
Inventory ($120,000 - $100,000) $20,000
Fixed assets ($275,000 - $250,000) 25,000 45,000
Net income current cost basis $ 95,000

3-10 Units
(1) Beginning inventory 20,000
36 Chapter 3

Purchases (25,000 + 30,000 + 20,000) 75,000

Available for sale 95,000
Sold (80,000)
Ending inventory 15,000
Ending inventory at current cost:
15,000 units x $2.40 = $36,000

(2) Cost of goods sold at current cost:

80,000 units x $2.40 = $179,200

Note: Any difference between the historical cost and the current cost is accounted for
as a holding gain or loss.

3-11 Historical cost Ps 102,000,000

Less accumulated depreciation 34,000,000

Historical cost, net of accumulated depreciation Ps 68,000,000

Current cost, net of accumulated depreciation:

Ps 68,000,000 x 127.5/102.0 = Ps 85,000,000

3-12 (1) Gearing adjustment = fl 3,000,000 x fl 2,000,000 = fl 600,000

fl 10,000,000

(2) Rationale: It is not necessary to make a current cost adjustment for the
portion of assets that were financed from borrowings.

3-13 (1) Historical cost basis:

Operating income $7,000,000
Add: Interest income 600,000
$7,600,000
Subtract: Interest expense $ 750,000
Income taxes 2,200,000 ( 2,950,000)
Net income $4,650,000

Current value basis:

Historical cost basis net income $4,650,000
Add: Unrealized gains $ 2,500,000
Gearing adjustment 580,000 3,080,000
7,730,000
Subtract: Cost of goods sold $ 500,000
Depreciation expense 1,500,000 ( 2,000,000)
Net income $5,730,000

(2) Current value basis

Chapter 3 37

Historical cost basis net

income from (1) $4,650,000
Add: Unrealized gains 2,500,000
7,150,000
Subtract: Cost of goods sold $ 500,000
Depreciation expense 1,500,000 (2,000,000)
Net income $5,150,000

Note: No gearing adjustment made a deflationary economy.

Case: Accounting for Changing Prices

(1) Financial statements restated for general price-level changes are historical cost
statements that are adjusted to show the impact of inflation (general price level
changes) on nominal amounts. This is accomplished by using general price level
indices at the appropriate dates.

Current value statements attempt to portray current values in the financial

statements. Most commonly it is accomplished by using specific indices applicable
to the particular item. The specific index reflects changes in the value of an item
over a period of time. Alternately, appraisals or market prices, if available, may be
used. There are different interpretations of what constitutes current value. For
example, it may be interpreted as replacement cost of the item (current purchase
price) or its estimated disposal value (net sale proceeds) that can be expected to be
realized if the item were sold.

(2) A monetary item is cash or another asset or a liability that will be either received
or paid out in a fixed number of monetary units.

A nonmonetary item, on the other hand, does not represent an asset or a liability
that will require either receipt or payment in a specified number of monetary
units.

(3) Balance sheet:

• Identify assets and liabilities as either monetary or nonmonetary.
• Monetary items require no restatement.
• Nonmonetary items are adjusted for changes in the monetary unit’s
purchasing power since their acquisition or incurrence.
• If price level statements were prepared for the previous period, all
balances to be used for comparison with the current year must be rolled
forward.

Income statement:
• Identify and restate each item by using the past index that was in effect
for the item.
• Compute depreciation using restated amount of the related asset.
38 Chapter 3

• Using an average index, adjust the items that occur evenly during the
period (e.g., interest expense, rent expense, etc.)
• Compute cost of goods sold using appropriate indices for beginning and
ending inventories and the restated purchases amount.
• Calculate the purchasing power gain or loss from a net monetary
position.
(4) Similarities:
• Both are historical cost basis statements.
• Both can be developed objectively, and are thus easily verifiable.
• Neither attempts to reflect current values.

Differences:
• Constant monetary unit financial statements show adjusted amounts for
the effect of change in purchasing power of the monetary unit.
• Only the constant monetary unit income statement includes purchasing
power gain or loss from holding monetary items.

(5) No. As mentioned earlier in Part (3), the 2002 supplementary statement amounts
would be rolled forward. For example, if there was 8 percent inflation in 2003, all
balances in the 2002 statements would be multiplied by 108 percent.