Professional Documents
Culture Documents
Introduction
Constant Dollar Accounting
Current Cost Accounting
Exercises
INTRODUCTION
One assumption made in accounting is that the monetary unit remains stable over a period of
time. But is that assumption realistic? Consider the classic story about the individual who went
to sleep and woke up 10 years later. Hurrying to a telephone, he got through to his broker and
asked what his formerly modest stock portfolio was worth. He was told that he was a
multimillionaire his General Motors stock was worth $5 million and his AT&T stock was up to
$10 million. Elated, he was about to inquire about his other holdings, when the telephone
operator cut in with "Your time is up. Please deposit $100,000 for the next three minutes."
What this little story demonstrates is that prices can and do change over a period of time, and
that one is not necessarily better off when they do. Despite the inevitability of changing prices
during a period of inflation, the accounting profession still follows the stable monetary unit
assumption in the preparation of a company's primary financial statements. While admitting that
some changes in prices do occur, the profession believes the unit of measure (e.g., the dollar)
has remained sufficiently constant over time to provide meaningful financial information.
The profession, however, at one time required and now encourages the disclosure of certain
price-level adjusted data in the form of supplemental information. The two most widely used
approaches to show the effects of changing prices on a company's financial statements are (1)
constant dollar accounting and (2) current cost accounting.
Price-Level Indexes
To restate financial information into constant dollars, it is necessary to measure a change in the
price of a "basket of goods" from one period to the next. Developing this basket of goods is a
complex process and involves judgment in selecting the most appropriate items to be part of this
market basket. Fortunately, the government puts together a number of different baskets of goods
and computes indexes for them. One of the most popular, and the one that accountants use, is
the Consumers Price Index for all Urban Consumers (CPI-U). The CPI-U reflects the average
change in the retail prices of a fairly broad group of consumer goods.
The procedure for restating reported historical cost dollars, which vary in purchasing power, to
dollars of constant purchasing power is relatively straightforward. The restatement is
accomplished by multiplying the amount to be restated by a fraction, the numerator of which is
the index for current prices and the denominator of which is the index for prices that prevailed at
the date related to the amount being restated (as determined from numbers computed by the
government). The denominator is often referred to as the base year. The formula is as follows:
Illustration 1:
Amount to be restated
= Restated amount
To illustrate how this restatement process works, assume that land was purchased in 1996 for
$100,000 and another parcel of land was purchased in 2000 for $80,000. If the price-level index
was 100 in 1996, 120 in 2000, and 180 in 2003, the land parcels would be restated to the 2003
price level as follows:
Illustration 2:
The land is restated to $300,000 in terms of 2003 dollars using the 2003 index of 180 as the
numerator for both parcels and the base year indexes of 100 and 120 as the denominators. If
historical cost dollars are not restated, dollars of different purchasing power are added together,
and the total dollar amount is not meaningful.
Illustration 4:
If the general price-level doubles during the year, and no transactions take place, then for the
company to be in the same economic position at the end of the year as it was at the beginning, it
should have the balance sheet shown below.
Illustration 5:
As illustrated, all items should have doubled if the company is to be in the same economic
position. However, only the inventory and the capital stock can be doubled. Helio still has only
$1,000 of cash; therefore, it has experienced a purchasing power loss in holding cash during a
period of inflation. Helio's balance sheet presented on a constant dollar basis would appear as
follows:
Illustration 6:
As noted, Helio Company has experienced a purchasing power loss of $1,000, which is shown
as a reduction of retained earnings.
In summary, because monetary assets and liabilities are already stated in terms of current
purchasing power in the historical cost balance sheet, they appear at the same amounts in
statements adjusted for general price-level changes. The fact that the end-of-the-current-year
amounts are the same in historical dollar statements as in constant dollar statements does not
obscure the fact that purchasing power gains or losses result from holding them during a period
of general price-level change. Conversely, nonmonetary items are reported at different
amounts in the constant dollar statements than they are in the historical cost statements,
when there is a change in the general price level. As a result, both the inventory and the
capital stock are adjusted to recognize changes in the purchasing power of the dollar.
The relevant price indexes for use in preparing constant dollar financial statements are presented
below. These price indexes are magnified here to illustrate their effect.
Illustration 9:
Price Indexes
Price Indexes
December 31, 2000
100
2001 average
160
200
2001Historical
Cash:
x RestatementRatio
Restated to
12/31/01Dollars
Beginning
balance
$110,000
200
100
$220,000
Add: Sales
190,000
200
160
237,500
Deduct:
Purchases
(135,000)
200
160
(168,750)
Operating
expenses
(20,000)
200
160
(25,000)
Total restated
dollars
Ending
balances
263,750
$145,000
145,000
Purchasing
power loss
$(118,750)
The first column of Illustration 11 provides a reconciliation of the beginning and ending cash
balances. Note that purchases is determined by adding ending inventory ($35,000) to cost of
goods sold ($100,000) for Hartley Company. The restatement ratio for the beginning cash
balance is based on the price index at the beginning of the year (100). The other ratios are based
on the average price index during the year (160). The totaled restated dollars, $263,750,
indicates how much cash the company should have in order to stay even with the price increases
that have occurred. This amount is then compared with the historical cost ending balance to
determine the amount of the purchasing power gain or loss. In this case, Hartley should have
$263,750; it has only $145,000. Therefore, it has experienced a purchasing power loss of
$118,750.
overcoming the reporting problems during periods of inflation or deflation. The following
arguments have been submitted in support of preparing such statements:
Constant dollar accounting provides management with an objectively determined quantification of the
impact of inflation on its business operations.
Constant dollar accounting eliminates the effects of inflation from financial information by requiring each
enterprise to follow the same objective procedure and use the same price-level index,
thereby preserving comparability of financial statements between firms.
Constant dollar accounting enhances comparability between the financial statements of a single
firm by eliminating differences due to price-level changes and thereby improves trend analysis.
Constant dollar accounting eliminates the effects of price-level change without having to develop a new
structure of accounting; that is, it preserves the historical cost-based accounting system that is
currently used and understood.
Constant dollar accounting eliminates the necessity of and attraction to the "piecemeal"
approaches used in combating the effects of inflation on financial statements, namely, LIFO
inventory costing and accelerated depreciation of property, plant, and equipment.
However, in spite of widespread publicity, discussion, and authoritative support both inside and
outside the accounting profession, the preparation and public issuance of constant dollar
financial statements up to this point has been negligible. This result is probably due to the
following disadvantages said to be associated with constant dollar financial statements:
The additional cost of preparing constant dollar statements is not offset by the benefit of receiving
sufficient relevant information.
Constant dollar financial statements will cause confusion and be misunderstood by users.
Restating the "value" of nonmonetary items at historical cost adjusted for general price-level changes is
no more meaningful than historical cost alone, that is, it suffers all the shortcomings of the historical
cost method.
The reported purchasing power gain from monetary items is misleading because it does not
necessarily represent successful management or provide funds for dividends, plant expansion,
or other purposes.
Constant dollar accounting assumes that the impact of inflation falls equally on all businesses and
on all classes of assets and costs, which is not true.
Probably the greatest deterrent to adoption of constant dollar accounting in the past has
been what it is not: constant dollar accounting is not present value, net realizable value, or
current cost accounting, and therein lies much of the opposition to its use.
increased 150%, guaranteed overnight mail delivery increased 4,575%, a gallon of gasoline
decreased over 30% and a flawless one-carat diamond decreased over 70%. Thus, changes in
the specific price of items may be very different from the change in the general price-level.
A popular means to measure the change in a specific price is current cost. Current cost is the
cost of replacing the identical asset owned. Current cost may be approximated by
reference to current catalog prices or by applying a specific index to the book value of the
asset. Unlike the constant dollar approach, which is simply a restatement of historical
dollars into constant purchasing power, the current cost approach changes the basis of
measurement from historical cost to current value.
Revenues and expenses appearing on a current cost income statement are the same as the
historical cost amounts, because at the time they are earned or incurred they represent current
cost. A major exception is the cost of goods sold, which will be explained later.
To illustrate the preparation of financial statements on a current cost basis, assume that Sensor,
Inc., starts business on December 31, 2000, by selling $90,000 of capital stock for cash. Land
costing $40,000 is purchased immediately. During the next year, the company reports $160,000
of sales revenue, cost of goods sold of $75,000, and operating expenses of $25,000. The income
statement for Sensor, Inc., on a historical cost basis is as follows:
Illustration 14:
The relevant current cost amounts for the income statement and balance sheet items for 2001 are
as follows:
Illustration 16:
Cost of Goods Sold. Goods are sold at varying times of the year. At the time these goods
are sold, the current cost of the inventory sold must be determined. The historical cost of
goods sold and the current cost of goods sold are usually different.
Total Holding Gain. The holding gain for Sensor comprises three items as shown below.
Illustration 18:
Recall that a holding gain is an increase in an item's value from one period to the next. If the
item is sold during the period, however, the holding gain (loss) is computed only to the point of
sale. Thus, the inventory sold, as reported in the current cost of goods sold amount, had
increased $20,000. Also, inventory on hand and land experienced holding gains of $25,000 and
$8,000, respectively. Holding gains or losses indicate how effective management is in acquiring
and holding assets.
As indicated from the statement above, Retained Earnings is determined by adding the current
cost net income amount to the beginning balance of retained earnings.
One final comment: Many of the arguments above also apply to a current cost/constant dollar
system(a full illustration not provided here). Additional arguments for a current cost/constant
dollar system are: (1) It stabilizes the measuring unit and provides current, comparable data, and
(2) it provides more information than either other system alone. Holding gains and losses
adjusted for inflation or deflation are reported, as well as the purchasing power gain or loss on
net monetary items. Its potential disadvantages are its cost to prepare and that more information
is not always better information because it may confuse readers or lead to information overload.
Understand and account for changing prices. The two most widely used
approaches to show the effects of changing prices are (1)constant dollar
accounting (2)current cost accounting. Constant dollar accounting
restates financial statement items into dollars that have equal purchasing
power. Current cost is the cost of replacing the identical asset owned.
EXERCISES
Exercise 1
(Constant Dollar Income Statement) B. Jenner, Inc. had the following income statement
data for 2001:
Sales
$250,000
168,000
Gross profit
82,000
Operating expenses
34,000
Net income
$ 48,000
150
2001 average
125
100
Instructions
Determine Jenner's constant dollar income before purchasing power gain or loss for 2001.
Exercise 2
(Constant Dollar-Purchasing Power Computation) Presented below is comparative
financial Statement information for Joe Tinker Corp. for years 2001 and 2000.
December 31, 2001
Cash
$ 78,000
Inventory
40,000
25,000
Sales
230,000
200,000
150,000
132,000
44,000
30,000
Operating expenses
The following price level indexes were observed during the year:
Price Index
December 31, 2001
140
2001 average
125
100
Instructions
Determine Tinker's purchasing power gain or loss for 2001. Assume all transactions involved
cash.
Exercise 3
(Constant Dollar Financial Statements) Spitz Corp. in its first year of operations reported
the following financial information for the year ended December 31, 2001, before closing:
Cash
$ 90,500
Retained earnings
$ 67,500
Inventory
42,000
Sales
220,000
Land
90,000
122,500
Capital stock
150,000
Operating expenses
25,000
The following price level indexes were observed during the year:
Price Index
December 31, 2001
121
2001 average
110
January 1, 2001
100
Spitz experienced a purchasing power loss of $15,650 during 2001. Land was purchased and
capital stock issued on January 1, 2001. No inventory was on hand at the beginning of the year.
Instructions
Prepare the following financial statements for Spitz Corp.
A.
Constant dollar income statement for the year ended December 31, 2001.
B.
Exercise 4
(Determine Current Cost Income Components) Carnelian Chemical, Inc. is experimenting
with the use of current costs. In 2001, the company purchased inventory that had a cost of
$50,000, of which $30,000 was sold by year end at a sales price of $50,000. It is estimated
that the current cost of the inventory at the date of the sale was $35,000, and the current
cost of the ending inventory at December 31, 2001 is $26,000. Operating expenses are
$10,000.
Instructions
A.
B.
Exercise 5
(Constant Dollar Purchasing Power Computation) Assume that the Aretha Franklin
Company has the following net monetary assets (monetary assets less monetary liabilities)
at the beginning and the end of 2001.
Net monetary assets
1/1/01
12/31/01
$300,000
$200,000
Transactions causing a change in net monetary assets during the period were incurrence and
payments of accounts payable, collections of accounts receivable and purchase and sales of
merchandise during the period. All these transactions occurred evenly throughout the year.
Assume the following price-level indexes:
Price Index
January 1, 2001
125
150
175
Instructions
(Round all computations to the nearest dollar.)
A.
What is the amount of purchasing power gain or loss from holding the January 1 balance of net
monetary items throughout the year?
B.
What is the amount of purchasing power gain or loss from holding net monetary items?
C.
Exercise 6
(Current Cost Financial Statements) Grupo Rana Enterprises is considering the adoption
of a current cost system. Presented below is Rana's balance sheet based on historical cost
at the end of its first year of operations.
$25,000
Accounts payable
$ 9,000
Inventory
42,000
Capital stock
50,000
Land
16,000
Retained earnings
24,000
$83,000
$83,000
Instructions
A.
Prepare an income statement for the current year on a (1) historical cost basis and a (2) current cost
basis.
B.
Prepare a balance sheet for the current year on a current cost basis.
C.
Assume the general price level at the beginning of the year was 100; the average for the year was
160; and the ending 200. Also assume that revenues were earned and costs were incurred uniformly
during the year. The land was purchased and the capital stock was issued at the beginning of the year.
Amount reported for land on a constant dollar balance sheet at December 31, 2001.
Amount reported for cash on a constant dollar balance sheet at December 31, 2001.
Exercise 7
(Accounting for Changing Prices) Carl Lewis Corp., a wholesaler with investments in
plant and equipment, began operations in 1949. The company's history has been one of
expansion in sales, production, and physical facilities. Recently, some concern has been
expressed the conventional financial statements do not provide sufficient information for
decisions by investors. After consideration of proposals for various types of supplementary
financial statements to be included in the 2000 annual report, management has decided to
present a balance sheet as of December 31, 2000, and a statement of income and retained
earnings for 2000, both restated for changes in the general price level.
Instructions
A.
On what basis can it be contended that Lewis's conventional statements should be restated for
changes in the general price level?
B.
Distinguish between financial statements restated for general price-level changes and current value
financial statements.
C.
Distinguish between monetary and nonmonetary assets and liabilities as the terms are used in
constant dollar accounting. Give examples of each.
D.
Outline the procedures Lewis should follow in preparing the proposed supplementary statements.
E.
Indicate the major similarities and differences between the proposed supplementary statements and
the corresponding conventional statements.
F.
Assuming that in the future Lewis will want to present comparative supplementary statements, can the
2000 supplementary statements be presented in 2001 without adjustments? Explain.
(AICPA adapted)