ACCOUNTING FOR PRICE LEVEL CHANGES -part 2

HOLDING GAINS AND LOSSES

Just as monetary items are subject to a gain or loss as the price level changes, non-monetary assets (also called real assets) are
subject to a gain or loss as a result of change in their value.
Holding gains or losses on real assets can be divided into two parts:

 Monetary holding gains and losses - arise purely because of the change in the general price level during the period and
 Real holding gains and losses - these are the differences between general price-level-adjusted amounts and current values.

Monetary gains and losses are capital adjustments only. They are not a component of income.
Holding gains and losses can also be classified from the standpoint of being realized or unrealized in the conventional
accounting sense.

Example
Assume a piece of land was acquired for KSh 5,000 on Jan 2nd 20X0, when the general price index was 100. One-tenth of
the land was sold on December 31, 20X0 for KSh 575. The entire parcel of land was valued at KSh 5,750 on Dec. 31 20X0.
The total real and monetary holding gains are computed below:

Current value (31.12.X0) KShs 5,750

General price-level adjusted
Historical cost on 31.12.X0
(5,000 x 110)
100 5,500
Total real holding gain 250

General price-level adjusted

Historical cost on 31.12.X0 KShs5,500
Historical cost 5,000
Total monetary holding gain KShs 500

Holding gains and losses are realized by the process of selling the asset or in the case of a depreciable asset using it up over
time. The division of the holding gains in the above example is summarized below:

Analysis of Holding Gains

Holding Gain Type
Nature Real Monetary Total
KShs KShs KShs
Realized 25 50 75
Unrealized 225 450 675
Total 250 500 750

A more detailed example follows to illustrate the computation of holding gains and losses.
Example
KAMUTI Ltd's financial statements for the year 20X0 are given below:

Kamuti Ltd : Income Statement for the period ended 31.12.20X0

KShs Kshs
Sales 400,000
Cost of goods sold (240,000)
Gross profit 160,000
Less: Operating expenses

Selling and Administration (100,000)

Depreciation expense (40,000) (140,000)

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 Net profit 20,000
Dividends (10,000)
Retained profits 10,000

Kamuti Ltd - Balance Sheet As at:

31.12.20X0 31.12.1999
KShs KShs
Fixed Assets
Equipment 400,000 400,000
Acc. Depreciation (140,000) (100,000)
260,000 300,000
Current Assets – Inventory 160,000 100,000
- Accounts Receivable 20,000 40,000
- Cash 110,000 20,000
550,000 460,000
Equity
Ordinary Shares 200,000 200,000
Retained Earnings 30,000 20,000
230,000 220,000
Liabilities
Bonds payable 300,000 200,000
Accounts payable 20,000 40,000
550,000 460,000

Additional Information:
 The equipment consists of three lots acquired at different times and each has a useful life of 10 yrs. Cost information is
as follows:

At 31.12.1999
Initial cost Age (yrs) Current cost
Lot 1 KShs 240,000 3 KShs 260,000
Lot 2 120,000 2 140,000
Lot 3 40,000 1 60,000
400,000 460,000

At 31.12.1990

Lot 1 240,000 4 300,000

Lot 2 120,000 3 180,000
Lot 3 40,000 2 80,000
400,000 560,000
 Depreciation is to be charged using the straight-line method. The residual value is zero for lots of equipment.
 Inventory is accounted for using FIFO basis with an inventory turnover of approximately four times per annum. In the
year 20X0, 12,000 units were sold.
 Current cost of inventory was KSh 104,000 as at Jan 1st 20X0. KSh 166,000 on Dec 31. 20X0. The unit cost of stock
was KSh 20 and KSh 25 on 1.1.00 and 31.12.00 respectively.
 Interim dividend amounts to KSh 10,000 was paid on July 1st 20X0.
 The price indexes at relevant dates are as given below:

January 1st 20X0 250

December 31st 20X0 270
Average for 20X0 260
Last Quarter - 20X0 245
Last Quarter - 20X0 265

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Equipment
Lot 1 200
Lot 2 225
Lot 3 240

Required
(a) Income statement for period ending 31.12.90 for KAMUTI Ltd adjusted for price level changes.
(b) Balance Sheet as at 31.12.00 for Kamuti Ltd adjusted for price level changes.

SOLUTION
(A) KAMUTI Ltd: Income Statement
For the year ended 31.12.20X0

KShs KShs
Sales 400,000
Cost of sale (W1) (249,140)
Gross profit 150,860
Operating Expenses
Selling and Administration (100,000)
Depreciation Expense (W2) (49,000) 149,400
Net income from normal operations 1,460
Add: Purchasing power Gain (W3) 14,240

Net income for the year 15,700

Dividends (10,000)
Retained profits 5,700

Workings:
W1 - Cost of sales
Amount HCA Adjustment factor Adjusted amount
KShs KShs KShs
Opening inventory (1.1.00) 100,000 260/245 106,120
Add purchases 300,000 260/260 300,000
Cost of goods available for sales 400,000 406,120
less:closing inventory (31.12.00) (160,000 ) 260/245 (156,980)
Cost of sales 240,000 249,140

W2. Depreciation Expense

KShs
Lot 1 240,000 x 260 x 10% =31,200
200

Lot 2 120,000 x 260 x 10% =13,866

220

Lot 3 40,000 x 260 x 10% = 4,334

240
Total 49,400
W3. Purchasing Power Gain/Lossses

31/12/99 31/12/00
KShs KShs
Monetary Assets 60,000 130,000
Monetary Liabilities (240,000) 320,000
Net Monetary Liabilities 180,000 190,000

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 1.1.00- Purchasing power equivalent (180,000 x 260/250) 187,200

Add net charge during 10 years 10,000 x 260/200 10,000

Less
31.12.00- Purchasing power equivalent (190,000 x 260/270) 182,960
Purchasing power gain 14,240

(B) KAMUTI Ltd - Balance Sheet As at 31.12.20X0

Fixed Assets Kshs Kshs

Equipment (W1) 513,000
Acc. Depreciation (W2) (145,390)
367,610
Current Assets
Inventory (W3) 163,020
Accounts Receivable (W4) 20,000
Cash (W4) 110,000 293,020
980,630
Equity
Ordinary Shares (W5) 216,000
Retained Earning (W6) 31,160
Holding Gain (W7) 93,470 340,630
660,630
Liabilities
Bonds Payable (W4) 300,000
Accounts Payable (W4) 20,000
980,630

Workings
W1 - Equipment
Initial cost Adjust Factor Adjusted Amount
Lot 1 240,000 (270/260) 324,000
Lot 2 120,000 (270/225) 144,000
Lot 3 40,000 (270/240) 45,000
400,000 513,000
W2 - Accumulated Depreciation - Equipment

(140,000 x 270) = KShs 145,390

260

W3 - Inventory - 31.12.90

(160,000 x 270) = KShs 163,020

265

W4 - Monetary Assets and liability remain the same

W5 - Ordinary Shares

(200,000 x 270) = KSh 216,000

250

W6 - Retained Earnings

(30,000 x 270) = KShs 31,160

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 260

W7 - Holding Gain/Loss

Non monetary items General Price

Level Adjusted Historical Difference
Amount Cost
KShs KShs KShs

Equipment 513,000 400,000 113,000

Accumulation Depreciation 145,390 (140,000) (5,390)
Inventory 163,020 160,000 3,020
Ordinary Shares 216,000 200,000 (16,000)
Retained Earnings 31,160 30,000 1,160
Holding Gain 93,470

2.7 ADJUSTMENTS TO CURRENT COST ACCOUNTING

Current cost accounts are usually produced by making adjustments to Historical cost accounts. The following adjustments are
be incorporated in current cost accounts:

 Depreciation adjustment (DA)

 Cost of sales adjustment (COSA)
 Monetary working capital adjustment (MWCA)
 Gearing adjustment (GA)

Depreciation adjustment is the additional depreciation arising due to increase in prices of goods. It is calculated as follows:

Apply the depreciation rate to the current value of the asset. From the resultant figure, deduct depreciation already charged
in the profit and loss account (HCA). The DA should be treated as follows:

Dr. Current cost P/L Account xx

Cr. Provision for Depreciation xx

Cost of sales adjustment (COSA) is the additional cost of sales arising due to inflation. There are two ways of computing
the COSA.

i. If one or many items are involved, then the cost of the items sold is deducted from the current value of those items to get
the COSA.

Example:
Assume 100 items were purchased at KShs 250 each and were sold at 400 each during the period. Extra stock was purchased
at 310/= each. Then the COSA will be

= Change in cost of item x No. of units sold

= (310 - 250) x 100 = KShs 6,000

ii. Averaging Method

- Under this method, opening stock and closing stock are reinstated at the average price.
The procedure is as follows:

 Restate both the opening and closing stock to average price.

 Compute the difference between the value of opening stock and closing stock on historical basis. This difference is made
up of two elements - volume change and price change.
 Compute the difference between opening and closing stock - both stated to average price - the difference is due to volume
change.

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 The difference between (b) and (c) above is the COSA.

(see example below).

Monetary working capital adjustment (MWCA)

- MWCA = Debtors - Creditors
- Does not include cash unless it is directly linked to movement in working capital
- MWCA represents the amount of additional (or reduced) finance needed for the monetary working capital as a result
of changes in the input prices of goods and services used and financed by the business.
- Monetary working capital includes the following elements:-

Monetary Assets
 Trade debtors
 Trade bills receivable
 Prepayments
 VAT recoverable
 Any part of the bank balance (or overdraft) arising from fluctuations in the level of stock, debtors, creditors, etc.
 Any part of the cash floats required to support day to day operations of the business.
 Certain stocks not subject to COSA e.g

- Seasonal purchases
- Dealing stocks
- Unique contracts

Monetary Liabilities
i. Trade creditors
ii. Trade bills payable
iii. Accruals and expense creditors
iv. VAT payable

NOTE:
(a) Creditors or debtors relating to fixed assets bought or sold under construction should be treated as part of borrowings
rather than MWC.
(b) Advance Corporation Tax, Mainstream Corporation Tax (MCT), and deferred tax should be treated as borrowings.

Gearing Adjustment
This is the gain due to the shareholders as a result of financing the assets through loans. The acquired assets increase in value
during periods of inflation while the amount of loan remains the same. Borrowings are usually fixed in monetary amount,
irrespective of changes in the prices in the various parts of operating capability. If prices rise, the value to the business of
assets exceed the borrowing that has financed them. The excess (less interest on the borrowings) accrues to the shareholders
and is realised as the assets are used or sold in the ordinary course of business.

Gearing Adjustment (GA)

= (DA + COSA + MWCA)* Borrowing (Average)

Borrowing + Shareholders Funds
(Average) (Average)

Borrowing comprises of all monetary liabilities less all monetary assets. In particular, convertible loan stock, debentures and
deferred taxation should be included in borrowing.

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CURRENT COST ACCOUNTING (CCA)

Merits of CCA (also called Current Cost Deprival Value Model)

1. It is relevant to the needs of users of financial statements in;

 Assessing the stability and sustainability of the business entity.

 Assessing the vulnerability of a business against take over predators.
 Evaluating the performance of management in maintaining and increasing the operating capacity of the business.
 Evaluating future performance.

2. CCA can be implemented easily by making adjustments to cost.

3. By excluding holding gains from profits CCA can be use to indicate whether or not a dividend should be paid.
4. Assets are valued not only at their current costs but after management has evaluated the opportunity cost of holding
them and the benefit of their future use to the business.

WEAKNESS OF CCA
IAS 15 has been criticize on a number of grounds;

(a) The inclusion of a monetary working capital adjustment and a gearing adjustment:
 Causes problems of definition particularly in relation to cash and overdrafts.
 Treats preference share capital like equity, although it is in reality nearer to borrowings in terms of sources of
finance. This is due to the need to show profit attributable to all shareholders, ordinary and preference as required
by the Companies Acts.
The guidance notes suggest that where a company has material amount of preference shares with fixed repayment
rights, it may wish to show in a note the effect of including preference share capital in net borrowings.
 Includes in borrowings such disparate items as taxation and debentures. While the latter might be expected to be
maintainable in a constant ratio to equity (excluding preference shares) the former will IAS 12 vary in relation to
taxable profit.

(b) It can be regarded that monetary working capital and gearing adjustments reflect some of the benefit of borrowing in
a period of inflation, by allowing for the netting off or adding back of that portion of the realized holding gain’s
financed by monetary liabilities.
However, there is still no indication given of the real effect, in general purchasing power terms, of inflation on the
investor’s stake.
(c) Profits are not comparable in real terms from year to year, nor from company to company within one year.
(d) Treatment of backlog depreciation: It is debited to current cost reserve (reducing the unrealized holding gain on fixed
assets). Would it be better to treat it as under-provision for depreciation in earlier years and it set against cumulative
retained current cost profits? Otherwise cumulative retained current cost profits? Otherwise cumulative retained
current cost profit will not represent the amount which can be distribute without depleting the operating capability.

Practical problems in operating current cost accounting

Amongst the practical problems encountered in operating current cost accounting are the
following:

Selection of a suitable index

It is not always easy to obtain an index which is perfectly suitable for measuring the movement in the current cost of a particular
type of asset. This need not be an insuperable problem because the company may be able to construct its own index or to
apply one which gives results which do not materially distort result.

Overseas assets
It is often difficult to obtain a suitable index for use with overseas assets. Once again a proxy is often possible.

Valuation of specialist plant and buildings

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It is often difficult to obtain a suitable market value for specialist items, but indices may be constructed as an alternative.

d) There may be no intention to replace an asset, possibly due to a change in the nature of the business
In such a case the current cost of the existing asset was not given a relevant adjustments. Where a company is trying
to maintain its operating capacity in a different area it should use a suitable index base on a possible replacement in
the new field of activitiy.
e) There may be no modern equivalent asset due to the advance of technology
In such a case it is necessary to calculate what proportion of the cost of a new asset is required in order to maintain
the volume of output and determine the current cost of the old equivalent therefrom. That part of the charge which
gives added output or cost advantages should be disregarded.
f) It may be difficult to audit some of the adjustments
In practice it is generally no more difficult to verify these areas than other subjective aspects of accounting.

In addition to the above penalties, any person guilty of insider trading is liable to pay
Compensation to any person who in the transaction for the purchase or sale of securities, entered into with the insider, or with
a person acting on his behalf, suffers loss, by reason of the difference between the price at which securities were transacted
and the price at which they would have likely have transacted if the offence had not been committed. In the event the harm
is done on the market as a whole, or those harmed cannot be reasonably and practicably determined, the payment shall be
made to the Compensation Fund of the CMA. The amount of compensation to be paid is the amount of loss sustained by
the person claiming compensation.

2.9 SUMMARY
The history of the development of a system of accounting for price level changes is important to an understanding of why
most companies still report financial results using historic cost accounting principles. Therefore, it is highly recommended
that you need chapters 4,5,6 and 7 of Lewis/Pendrill -before you attempt the reinforcing questions that follow.

In general, HCA it preferred because of the following reasons:

 It’s simplicity relative to inflation-adjusted systems makes it faster and cheaper to use
 It is widely understood as a basis for accounting, even among non-accountants. The same cannot be said for much of the
inflation accounting that has been proposed.
 It is more objective than inflation-adjusted accounting, since most inflation-adjusted statements make debatable changes
to the Historical Cost accounts.
 The tax authorities in most countries, Kenya included, has historically continued to make assessments on the historical
cost profits.
 It is a tried and tested system, requiring no major, radical shifts in our traditional understanding of the theory and practice
of accounting.
 The relative simplicity and objectivity make it more valuable for purposes of comparison than statements prepared on
other bases.

REQUIREMENTS OF IAS 29 Financial Reporting in Hyperinflationary Economies

The objective of IAS 29 is to establish specific standards for enterprises reporting in the currency of a hyperinflationary
economy, so that the financial information provided is meaningful.

Restatement of Financial Statements

The basic principle in IAS 29 is that the financial statements of an entity that reports in the currency of a hyperinflationary
economy should be stated in terms of the measuring unit current at the balance sheet date. Comparative figures for prior
period(s) should be restated into the same current measuring unit. Restatements are made by applying a general price index.
Items such as monetary items that are already stated at the measuring unit at the balance sheet date are not restated. Other
items are restated based on the change in the general price index between the date those items were acquired or incurred and
the balance sheet date.

A gain or loss on the net monetary position is included in net income. It should be disclosed separately.

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The Standard does not establish an absolute rate at which hyperinflation is deemed to arise - but allows judgement as to when
restatement of financial statements becomes necessary. Characteristics of the economic environment of a country which
indicate the existence of hyperinflation include:

the general population prefers to keep its wealth in non-monetary assets or in a relatively stable foreign currency.
Amounts of local currency held are immediately invested to maintain purchasing power;
the general population regards monetary amounts not in terms of the local currency but in terms of a relatively stable
foreign currency. Prices may be quoted in that currency;
sales and purchases on credit take place at prices that compensate for the expected loss of purchasing power during
the credit period, even if the period is short; and
the cumulative inflation rate over three years approaches, or exceeds, 100%.

IAS 29 describes characteristics that may indicate that an economy is hyperinflationary. However, it concludes that it is a
matter of judgement when restatement of financial statements becomes necessary.

When an economy ceases to be hyperinflationary and an enterprise discontinues the preparation and presentation of financial
statements in accordance with IAS 29, it should treat the amounts expressed in the measuring unit current at the end of the
previous reporting period as the basis for the carrying amounts in its subsequent financial statements.

Disclosure

Gain or loss on monetary items

The fact that financial statements and other prior period data have been restated for changes in the general
purchasing power of the reporting currency
Whether the financial statements are based on an historical cost or current cost approach
Identity and level of the price index at the balance sheet date and moves during the current and previous reporting
period