Accounting for Changing Prices

Understand and account for changing prices.



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.


Constant Dollar Accounting

The real value of the dollar is determined by the goods or services for which it can be exchanged. This real value is commonly called purchasing power. As the economy experiences inflation(rising price-levels) or deflation(falling price-levels), the amount of goods or services for which a dollar can be exchanged changes; that is, the purchasing power of the dollar changes from one period to the next.

Constant dollar accounting restates financial statement items into dollars that have equal purchasing power. As one executive from Shell Oil Company explained, "Constant dollar accounting is a restatement of the traditional financial information into common unit of measurement." In other words, constant dollar accounting changes the unit of measurement; it does not, however, change the underlying accounting principles used to report historical cost amounts. Constant dollar accounting is cost based.

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:

Formula for Restating Historical Cost Dollars into Constant Purchasing Power Dollars

Amount to be restated x Index of current year
Index of base year
= 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:

Restatement of Historical Cost

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.

Monetary and Nonmonetary Items

In preparing constant dollar statements, it is essential to distinguish between monetary and nonmonetary items. Monetary items are contractual claims to receive or pay a fixed amount of cash. Monetary assets include cash, accounts and notes receivable, and investments that pay a fixed rate of interest and will be repaid at a fixed amount in the future. Monetary liabilities include accounts and notes payable, accruals such as wages and interest payable, and long-term obligations payable in a fixed sum.

All assets and liabilities not classified as monetary items are classified as nonmonetary for constant dollar accounting purposes. Nonmonetary items are items whose prices in terms of the monetary unit change in proportion to changes in the general price level. Examples of nonmonetary assets are inventories; property, plant, and equipment; and intangible assets. Most liabilities are monetary items, whereas capital stock equity is usually nonmonetary.

The following chart indicates some major monetary and nonmonetary items.

Illustration 3:

Major Monetary and Nonmonetary Items

Effects of Holding Monetary and Nonmonetary Items

Holders of monetary assets lose during a period of inflation because a given amount of money buys progressively fewer goods and services. Conversely, liabilities such as accounts payable and notes payable held during a period of inflation become less burdensome because they are payable in dollars of reduced general purchasing power. The gains or losses that result from holding monetary items during periods of price changes are often referred to as purchasing power gains and losses. As Northwestern National Life Insurance explained in its annual report, "If a company's equity is invested in monetary assets, the purchasing power of its equity is gradually eroded at a rate equal to inflation."

To illustrate the effects of holding monetary and nonmonetary items in a period of inflation, assume that Helio Company has the following balance sheet at the beginning of the year:

Illustration 4:

Balance Sheet (Beginning of Period)--Historical Cost

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:

Balance Sheet (End of Period) Historical Cost

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:

Balance Sheet (End of Period) Constant Dollar Basis?

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.

Constant Dollar Illustration

To illustrate the preparation of financial statements on a constant dollar basis, assume that Hartley Company starts business on December 31, 2000, by selling $190,000 of capital stock for cash. Land costing $80,000 is purchased immediately. During 2001, the company reports $190,000 of sales, cost of goods sold of $100,000, and operating expenses of $20,000. The income statement for Hartley Company on a historical cost basis is as follows:

Illustration 7:

Income Statement--Historical Cost Basis

The comparative balance sheets on a historical cost basis are as follows:

Illustration 8:

Balance Sheet Historical Cost Basis

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
December 31, 2001 200

Constant Dollar Income Statement

When a constant dollar income statement is prepared, revenues and expenses are restated to end-of-year dollars. The difference between restated revenues and expenses is reported as income (loss) before purchasing power gain (loss). The purchasing power gain (loss) is then added (deducted) to produce "constant dollar net income (loss)."

Revenues and expenses are usually assumed to occur evenly throughout the period. Therefore, the historical dollar amounts are multiplied by the restatement ratio, of which the numerator is the end-of-year index and the denominator is the average index. The constant dollar income statement for Hartley Company is provided below. (The explanations highlighted in color are not part of the formal statement; they are provided to help you understand how the statement is prepared.)

Illustration 10:

Hartley Company Income Statement Constant Dollar Basis

Restatement of the items in Illustration 10 is explained as follows:

Sales. Because sales were spread evenly over the year, the average index is used in the computation to restate sales to end-of-year dollars.

Cost of Goods Sold. The cost of goods sold of $100,000 consists of two amounts, purchases of $135,000 less ending inventory of $35,000. Because the costs of purchases and ending inventories were spread evenly over the year, the average index is used in the computation to restate cost of goods sold to end-of-year dollars.

Operating Expenses. Because operating expenses were spread evenly over the year, the average index is used in the computation to restate operating expenses to end-of-year dollars.

Purchasing Power Loss. Computation of the purchasing power gain (loss) on monetary items requires a reconciliation of the beginning and ending balances of each monetary item for the period. A restatement ratio is then applied to the beginning balance and each reconciling amount. Hartley Company has only one monetary item, cash. Because prices are rising, it will experience a purchasing power loss for 2001. The computation of the loss is shown in Illustration 11.

Illustration 11:

Computation of Purchasing Power Loss

  2001Historical x RestatementRatio = Restated to 12/31/01Dollars
Cash:          
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         263,750
Ending balances $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.

Constant Dollar Balance Sheet

When a constant dollar balance sheet is prepared, all monetary items are stated in end-of-year dollars and therefore do not need adjustment. Nonmonetary items, however, must be restated to end-of-year dollars. The constant dollar balance sheet for Hartley Company is provided below. (The explanations highlighted in color are not part of the formal statement; they are provided to help you understand how the statement is prepared.)

Illustration 12:

Balance Sheet Constant Dollar Basis

Restatement of the items in Illustration 12 is explained as follows:

Cash. Cash is a monetary item; therefore, no restatement is necessary.

Inventory. Inventory is a nonmonetary item and therefore it must be restated. Because inventory was purchased evenly throughout the year, the $35,000 must be multiplied by the ratio of the ending index, 200, to the index at the time the inventory was purchased, which was the average for the year of 160.

Land. Land is a nonmonetary item; therefore, it must be restated. Because land was purchased at the end of the preceding year, the $80,000 must be multiplied by the ratio of the ending index to the index at the time the land was purchased, which was 100.

Capital Stock. Capital stock is a nonmonetary item; therefore, restatement is necessary. Because capital stock was issued at the end of the preceding year, the $190,000 must be multiplied by the ratio of the ending index, 200, to the index at the time the capital stock was issued, which was 100.

Retained Earnings. Since no balance existed in retained earnings at the beginning of the year, the retained earnings in constant dollars includes only the constant dollar net loss for the current period of $31,250. Thus, Hartley Company on a constant dollar basis reports a negative retained earnings after its first year of operations.

Advantages and Disadvantages of Constant Dollar Accounting

Constant dollar financial statements have been discussed widely within both the accounting profession and the business and financial community. They are lauded by many as a means of 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.


Current Cost Accounting

The price of a specific item may be affected not only by general inflation, but also by individual market forces. For example, in a recent 6-year period, certain items changed more or less than the general price level. To illustrate, during this period of time, the cost of a local telephone call 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.

Current Cost Adjustments

When current cost statements are prepared, it is also necessary to distinguish between monetary and nonmonetary items. Monetary items are stated at their current cost in the historical cost financial statements. As a result, no adjustment is necessary to items such as cash, accounts receivable, notes payable, or accounts payable when preparing a current cost balance sheet. A purchasing power gain or loss on the monetary items is not computed under current cost accounting because the measuring unit, the dollar, is not considered to have changed from one period to the next.

Conversely, nonmonetary items as a rule must be adjusted at year-end. The current cost of nonmonetary items tends to change over time. For example, land held over a period of time will usually experience some type of price change. The same is true of other nonmonetary items such as inventory; property, plant, and equipment; and intangible assets.

When a nonmonetary item is restated, a holding gain or loss arises and must be reported on the financial statements. A holding gain (loss) is an increase or decrease in an item's value while it is held by the company. For example, if the current cost of land is $20,000 on January 1, 2001, and $32,000 on December 31, 2001, the company has a holding gain on this land of $12,000, computed as follows:

Illustration 13:

Computation of Holding Gain

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:

Income Statement Historical Cost Basis

The comparative balance sheets on a historical cost basis are as follows:

Illustration 15:

Comparative Balance Sheets Historical Cost Basis

The relevant current cost amounts for the income statement and balance sheet items for 2001 are as follows:

Illustration 16:

Relevant Current Cost Amounts

Current Cost Income Statement

In a current cost income statement, two income numbers are reported. The first, current cost income from operations, is sales revenues less the current cost of goods sold less operating expenses or to less the current cost of goods sold and operating expenses. This amount is the income a company has earned after providing for the replacement of assets used in operations.

The second income number, current cost net income, measures the total income of a company from one period to the next. Thus, holding gains (losses) are added (deducted) to current cost income from operations to arrive at this number. The current cost income statement for Sensor, Inc. is provided below. (The explanations highlighted in color are not part of the formal statement; they are provided to help you understand how the statement is prepared.)

Illustration 17:

Income Statement Current Cost Basis

The preceding items are explained below.

Sales and Operating Expenses. Sales and operating expenses are already stated at their current cost amounts on historical cost statements; therefore, no adjustment is needed for these items.

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:

Computation of Holding Gain

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.

Current Cost Balance Sheet

The preparation of a current cost balance sheet is relatively straightforward. Monetary items are not adjusted because they are already stated at current cost. Similarly, capital stock equity is not adjusted because its balance represents the current cost of capital stock. All other nonmonetary items must be adjusted to current costs. The current cost balance sheet for Sensor, Inc. is shown in Illustration 19. (The explanations highlighted in color are not part of the formal statement; they are provided to help you understand how the statement is prepared.)

Illustration 19:

Balance Sheet Current Cost Basis

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.

Advantages and Disadvantages of Current Cost

A distinct advantage that current cost has over both historical cost and constant dollar accounting is that the specific changes (up and down) in individual items are considered. While the general level of prices may be increasing, prices of specific items may be decreasing. Such items as calculators, tennis balls, watches, microwave ovens, and television sets, for example, have decreased in price, whereas the general level of prices has increased. Constant dollar accounting using a general price index does not make an allowance for these changes in prices as effectively as a current cost system does.

The major arguments for the use of a current cost approach are:

Current cost provides a better measure of efficiency. If depreciation is based on current costs, not historical costs, a better measure of operating efficiencies is obtained. For example, assume that you are a new manager in an operation that includes a number of assets purchased recently at current prices, and your performance is compared with that of someone in a similar job elsewhere who is using similar assets that were purchased 5 years ago when the price was substantially lower. You probably would contend that the 5-year-old assets should be revalued because the other manager will show a lower depreciation charge and higher net income than you will.
Current cost is an approximation of the service potential of the asset. It is difficult if not impossible to determine the present discounted values of specific cash flows that will occur from the use of certain assets; but current cost frequently is a reasonable approximation of this value. As the current cost increases, the implication is that the enterprise has a holding gain (an increase from one period to another in the current cost of that item) because the aggregate value of the asset's service potential has increased.
Current cost provides for the maintenance of physical capital. Assume that an asset is purchased for one dollar, sold for two dollars, and replaced for two dollars. How much income should be reported and how much tax should be paid'? Under traditional accounting procedures, one dollar of income would be earned (which is subject to tax and a claim for dividend distribution). If current cost is used, however, no income exists to be taxed and claims for dividend distribution would probably be fewer.
Current cost provides an assessment of future cash flows. Information on current cost margins may be useful for assessing future cash flows when the selling price of a product is closely related to its current cost. In addition, reporting holding gains (losses) may help in assessing future cash flows.

The major arguments against current cost adjustments are:

The use of current cost is subjective because it is difficult to determine the exact current cost of all items at any point in time. A good second-hand market for all types of assets does not exist. In most cases, the asset is not replaced with an identical asset; it is replaced with a better one, a faster one, an improved one, an altogether different one, or it is not replaced at all.
The maintenance of physical capital is not the accountant's function. It is generally conceded that it is management's function to ensure that capital is not impaired.
Current cost is not always an approximation of the fair market value. An asset's value is a function of the future cash flows generated by it. Current cost, however, does not necessarily measure an increase in the service potential of that asset.

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.

PROFESSION'S POSITION ON CHANGING PRICE INFORMATION

In September 1979, the FASB, in response to a perceived need for information on the effects of changing prices on financial statements, required large publicly held companies to disclose certain price-level adjusted financial information. The required price-level adjusted information was provided on an experimental basis and consisted of restated information from the primary financial statements to reflect changes in (1) general price levels (constant dollar data) and (2) specific price levels (current cost data).

An FASB survey of financial statement users, preparers, and auditors revealed that both the number of users and the extent of use of the data were limited. Many respondents commented that the price-level adjusted data did not appear to have been used by the institutional investment community, bankers, or investors in general. Therefore, partly as a result of nonuse and partly as a result of prevailing low inflation rates, the accounting profession in 1987 was persuaded to cease requiring the disclosure of supplementary information on the effects of changing prices. Companies now are only encouraged to disclose price-level adjusted information and are not discouraged from experimenting with different forms of disclosure. Many companies include a discussion of inflation in the Management's Discussion and Analysis section of the annual report.


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. Companies are now encouraged to disclose price-level-adjusted information and are not discouraged from experimenting with different forms of disclosure. Many companies include a discussion of inflation in the Management's Discussion and Analysis Section of the annual report.



Exercises

Exercise 1

(Constant Dollar Income Statement) B. Jenner, Inc. had the following income statement data for 2001:

Sales $250,000
Cost of goods sold 168,000
Gross profit 82,000
Operating expenses 34,000
Net income $ 48,000

The following price levels were observed during the year:

  Price Index
December 31, 2001 150
2001 average 125
December 31, 2000 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 December 13, 2000
Cash $ 78,000 $ 57,000
Inventory 40,000 25,000
Sales 230,000 200,000
Cost of goods sold 150,000 132,000
Operating expenses 44,000 30,000

The following price level indexes were observed during the year:

  Price Index
December 31, 2001 140
2001 average 125
December 31, 2000 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   Cost of goods sold 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.

  1. Constant dollar income statement for the year ended December 31, 2001.
  2. Constant dollar balance sheet on December 31, 2001.

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

  1. Determine current cost income from operations.
  2. Determine current cost net income.

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
Average for the year 150
December 31, 2001 175

Instructions

(Round all computations to the nearest dollar.)

  1. What is the amount of purchasing power gain or loss from holding the January 1 balance of net monetary items throughout the year?
  2. What is the amount of purchasing power gain or loss from holding net monetary items?
  3. Explain why the company had a purchasing power gain or loss.

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.

Grupo Rana Enterprises BALANCE SHEET December 31, 2001

Cash $25,000   Accounts payable $ 9,000
Inventory 42,000   Capital stock 50,000
Land 16,000   Retained earnings 24,000
  $83,000     $83,000

The following additional information is presented:

Cost of goods sold on a historical cost basis is $54,000; on a current cost basis $58,000.
No dividends were paid in the first year of operations.
Ending inventory on a current cost basis is $46,000; land on a current cost basis is $22,000 at the end of the year.
Operating expenses for the first year were $25,000.

Instructions

  1. Prepare an income statement for the current year on a (1) historical cost basis and a (2) current cost basis.
  2. Prepare a balance sheet for the current year on a current cost basis.
  3. 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.

Determine the following:

Income before purchasing power gain or loss on a constant dollar income statement for 2001.
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

  1. On what basis can it be contended that Lewis's conventional statements should be restated for changes in the general price level?
  2. Distinguish between financial statements restated for general price-level changes and current value financial statements.
  3. Distinguish between monetary and nonmonetary assets and liabilities as the terms are used in constant dollar accounting. Give examples of each.
  4. Outline the procedures Lewis should follow in preparing the proposed supplementary statements.
  5. Indicate the major similarities and differences between the proposed supplementary statements and the corresponding conventional statements.
  6. 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)