Hyperinflation - Great lecture notes for those students who is studying intermediate accounting PDF

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Hyperinflation and Current Cost Accounting (Batch May 2020) Page 1 of 10HYPERINFLATION AND CURRENT COST ACCOUNTINGAlternative to historical cost accounting As historical cost accounting has been criticized for providing information that is out of date and potentially understates asset values, curren...

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HYPERINFLATION AND CURRENT COST ACCOUNTING Alternative to historical cost accounting As historical cost accounting has been criticized for providing information that is out of date and potentially understates asset values, current value accounting has arisen as an alternative. This largely takes two forms:  Constant purchasing power (CPP), or  Current cost accounting (CCA). Constant purchasing power (CPP) Financial Reporting in Hyperinflationary Economy PAS 29, paragraph 8, provides that the financial statements of an entity that reports in the currency of a hyperinflationary economy, whether they are based on historical cost approach or a current cost approach, shall be stated in terms of the measuring unit current at financial reporting period. Presentation of the information required by the standard as supplement to unrestated financial statements is not permitted. The restatement of financial statements of an entity that reports in the currency of a hyperinflationary economy is accomplished by means of constant peso accounting. Constant peso accounting is the restatement of conventional or historical financial statements in terms of the current purchasing power of the peso through the use of index number. The other names are purchasing power or price level accounting PAS 29 Financial Reporting in Hyperinflationary Economies does not establish an absolute rate at which hyperinflation is deemed to arise. It is a matter of judgment when restatement of financial statements in accordance with PAS 29 becomes necessary. Hyperinflation is indicated by characteristics of the economic environment of a country which include, but are not limited to, the following: a. The general population prefers to keep its wealth in non-monetary assets or in a relatively st able foreign currency. Amounts of local currency held are immediately invested to maintain purchasing power. b. 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; c. 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; d. Interest rates, wages and prices are linked to a price index; and e. The cumulative inflation rate over three years is approaching, or exceeds, 100%.

Key features  Accounts figures are adjusted to show all figures in terms of money with the same purchasing power.  A general price index is used for this, applying a general level of inflation.  Figures in the statement of profit or loss and statement of financial position are adjusted by the CPP factor.  CPP factor = (Index at the reporting date ÷ Index at date of initial recognition) In converting the figures in the basic historical cost accounts into those in the CPP statement, a distinction is drawn between:  Monetary items  Non-monetary items Monetary items are those who amounts are fixed by contract or otherwise in terms of number of unites of currency, regardless of changes in general price levels. Holders of monetary assets lose general purchasing power during a period of inflation to the extent that any income from the assets does not adequately compensate for the loss in purchasing power. The converse applies to those having monetary liabilities. Monetary items are units of currency held and assets and liabilities to be received or paid in a fixed or determinable number of units of currency. The essential feature of a monetary item is a right to receive (or an obligation to deliver) a fixed or determinable number of units of currency. Examples include:  Pensions and other employee benefits to be paid in cash;  Provisions that are to be settled in cash;  Cash dividends that are recognized as a liability; and  A contract to receive (or delivery) a variable number of the entity’s own equity instruments or a variable amount of assets in which the fair value to be received (or delivered) equals a fixed or determinable number of units of currency. Non-monetary items include such assets as inventory and non-current assets. Retaining the historical cost concept requires that holders of non-monetary assets are assumed neither to gain nor to lose purchasing power by reason only of changes in the purchasing power of the unit of currency. The owners of a company’s equity capital have the residual claim on its net monetary and non-monetary assets. The equity interest is therefore neither a monetary nor a non-monetary item. All other assets and liabilities are non-monetary. The essential feature of a non-monetary item is the absence of a right to receive (or an obligation to deliver) a fixed or determinable number of units of currency. Examples include:  Amount prepaid for goods and services (e.g. prepaid rent)  Goodwill  Intangible assets  Inventories  Property, plant and equipment Provisions that are to be settled by the delivery of a non-monetary asset 

The following are a list of statement of financial position items, identify the proper classification as monetary or nonmonetary items: Monetary Nonmonetary 1. Cash/Demand deposits/Time deposits/ Foreign Currency X 2. Investment in equity securities including FA-PL and FA-OCI X 3. Investment in bonds – HTM (Amortized cost) X

4. Investment in bonds – TS (FA-PL) and AFS (FA-OCI) Hyperinflation and Current Cost Accounting (Batch May 2020)

X Page 1 of 10

5. Accounts and notes receivable X 6. Allowance for doubtful accounts and notes X 7. Inventories X 8. Advances to employees X 9. Prepaid insurance, taxes, advertising, rent X 10. Prepaid interest X 11. Receivables under finance lease X 12. Long term receivables X 13. Special deposit which are recoverable/Refundable Deposits X 14. Pension, sinking and other fund- Consisting of equity securities X 15. Pension, sinking and other fund- Held to maturity bonds X 16. Advances to unconsolidated subsidiary X 17. Equity in unconsolidated subsidiary X 18. Deferred life insurance policy acquisition X 19. Deferred property and casualty insurance policy acquisition X 20. Property, plant and equipment X 21. Accumulated depreciation X 22. Cash surrender value X 23. Advances to suppliers X 24. Discount on bonds payable X 25. Intangible assets X 26. Goodwill X 27. Accounts and notes payable X 28. Accrued expenses X 29. Cash dividends payable X 30. Liability for refundable deposits X 31. Advances from customers X 32. Accrued losses on firm purchase commitments X 33. Bond payable X 34. Obligation under finance lease X 35. Pensions and other benefits to be paid in cash X 36. Estimated warranty liability X 37. Mortgage payable X 38. Taxes payable X 39. Deferred tax liability** X 40. Deferred investment tax credit X 41. Provisions that are to be settled in cash X 42. Deferred revenue X 43. Noncontrolling interest X 44. Preference share capital X 45. Ordinary share capital X 46. Share premium X 47. Retained earnings  is a residual and should not be classified as neither monetary nor non- monetary

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Procedures for restatement: 1. The restatement is made by applying a general price index 2. The items in the financial statements are classified into monetary and nonmonetary. 3. Monetary items are not restated because they are already expressed in terms of the monetary unit current at financial reporting period. 4. Nonmonetary items are restated by applying the general price index from the date of acquisition to the financial reporting period. Some nonmonetary items are carried at amount current at financial reporting period, such as net realizable value and market value. Thus, inventory carried at net realizable value and trading and available for sale securities carried at fair value are no longer restated. 5. Some nonmonetary items are carried at amount current at date other than acquisition date; for example, property, plant and equipment are revalued. In such case, the carrying amounts are restated from the date of revaluation. 6. All items in the statement of comprehensive income are restated by applying the change in the general price index from the dates when the items of income and expenses were initially recorded. However, for practical purposes, the average index may be used. 7. The purchasing power gain or loss is computed. This pertains only to monetary items. The gain or loss on purchasing power is included in profit or loss and separately disclosed. 8. The restated amount of a nonmonetary item is reduced when it exceeds the recoverable amount. Hence, restated amounts property, plant and equipment, goodwill, patent, and trademark are reduced to recoverable amount. Restated amount of inventory is reduced to net realizable value. 9. Any revaluation surplus recognized previously is eliminated. 10. Retained earnings would be the balancing figure in the restated statement of financial position. 11. When comparative statements are prepared, the monetary items of the preceding year are expressed in terms of the index number at the end of the current year. (For comparative purposes only – monetary items price index TY / LY)

Computation of Gain or Loss on Purchasing Power: What items are restated?

Formula for restatement

Only nonmonetary items are restated when preparing constant peso statements. Monetary items are not restated anymore because they are automatically stated in terms of current purchasing power of the peso. The objected of constant peso accounting is to report elements of the financial statements in terms of pesos that have the same purchasing power. Index number on financial reporting period x Historical cost Index number on acquisition date

Monetary assets, beginning, restated Less: Monetary liabilities, beginning, restated Net monetary assets/(liabilities), beginning restated Add: Increase in net monetary assets, restated (ex. Sales) Total Less: Decrease in net monetary assets, restated (ex. Purchases, interest expense, income tax, dividends declared and Selling and Administrative expenses) Net monetary assets/(liabilities), end, restated

Situation Inflation (increase/rising prices) Deflation (decrease/falling prices)

Monetary Asset Loss on purchasing power Gain on purchasing power

xxx (xxx) xxx/(xxx) Xxx Xxx (xxx) xxx/(xxx)

Monetary Liability Gain on purchasing power Loss on purchasing power

Advantages and disadvantages of CPP accounts Page 3 of 10

Advantages  CPP accounting is both simple and objective. It relies on a standard index.  It adjusts for changes in the unit measurement and therefore is a true system of inflation accounting.  It measures the impact on the company in terms of shareholders’ purchasing power. Disadvantages  It fails to capture economic substance when specific and general price movements diverge.  The unfamiliarity of information stated in terms of current purchasing power units  CPP does not show the current values to the business of assets and liabilities.  The general price index used is not necessarily appropriate for all assets in all businesses  The physical capital of the business is not maintained. Current cost accounting (CCA) Current cost accounting – is the restatement of historical cost in terms of current replacement cost. Current replacement cost is the estimated cost to acquire a similar asset at current purchase price. Current cost accounting may also be called “Current Value Accounting”. The key features of CCA are as follows  It is based on deprival values or value to the business.  Inventory and non-current assets are valued at deprival value.  Monetary assets (cash, receivables, payables, loans) are not adjusted.  An additional charge to the statement of profit or loss reflects the deprival value of inventory within cost of sales.  An additional charge in the statement of profit or loss reflects deprival value of non-current assets (depreciation) Essence of current cost accounting  Recognition of gain or loss in holding  Replacement cost > historical cost = holding gain  Replacement cost < historical cost = holding loss Classification  Holding gain or holding loss may be classified as realized or unrealized.  If the asset is still unsold or unused – unrealized gain or loss If the asset is already sold or used – realized gain or loss  Current cost (or replacement cost) accounting is not a single system of accounting – there are several variants. We will concentrate on general principles, in particular those relating to inventory and non-current assets.  The current cost statement of profit or loss is charged with the value to the business of assets consumed during the period. In particular, the charges for consuming inventory (cost of sales) and non-current assets (depreciation) are based on current rather historical values.  The current cost statement of financial position reflects the current value of inventory and non-current assets. Current Cost Accounting( Gain = CC > HC)/ (Loss = CC < HC) Nondepreciable asset Depreciable asset Inventory Unrealized holding Current cost this year VS Current Net Current cost VS Carrying value of Ending inventory at current gain or loss cost last year. depreciable asset cost VS Ending inventory at Historical cost (unsold) Realized holding Current cost at the time of sale VS Depreciation based on average cost Cost of sales based on Current cost last year. VS Depreciation based on historical average cost VS Cost of gain or loss cost sales based on historical cost Preparation of current cost Statement of comprehensive income 1. Sales – not restated ( current selling prices are made throughout the period) 2. Cost of sales – current cost of units sold at the time of sale ( Cost of sales is equal to the average cost multiplied by the units sold during the period). 3. Operating expenses – at current cost ( already stated) 4. Depreciation – average current cost of PPE 5. Income tax – already at current cost basis. (it is computed on the basis of the income under historical cost) 6. Realized holding gain or loss = Current cost – Historical cost of assets sold or used during the period. Preparation of current cost statement of financial position 1. Cash and receivables – not restated 2. Inventory – stated at current cost at end of the year 3. PPE – Land is stated at current cost. Depreciable asset at current cost minus accumulated depreciation based on current cost) 4. Payables – Not restated 5. Share capital and share premium – Not restated 6. Retained earnings – the balance of retained earnings is obtained from the current cost statement of retained earnings: Current cost retained earnings – beginning Add: Current cost net income Minus: Dividends declared or paid Current cost retained earnings – ending

xxx xxx (xxx) xxx

Advantages and disadvantages of CPP accounts Advantages  The most important advantage of CCA is its relevance to users.  Users will be able to assess the current state or recent performance of the business.  Physical capital is maintained.  Assets are stated at their value to the business. Disadvantages:  Possibly greater subjectively and lower reliability than historical cost.  Lack of familiarity  Complexity. CCA only adjusts values for non-monetary assets not all assets/liabilities  Page 4 of 10

REVIEW QUESTIONS 1.

2.

Indicate whether monetary and nonmonetary: Monetary Cash in bank √ Accounts receivable √ Allowance for doubtful accounts √ Advances to employees √ Advances to suppliers Inventory Financial asset at fair value Financial asset at amortized cost Prepaid expense Patent

Non-Monetary

, √ √ √ √ √ √

Accounts payable Accrued expenses Unearned revenue Advances from customers Estimated warranty liability Bonds payable Finance lease liability Deferred tax liability Share capital Retained earnings

Monetary √ √

Non-Monetary

√ √ √ √ √ √ √

ABC Company operates in a hyperinflationary economy and provides the following statement of financial position on December 31, 20x20: Property, plant and equipment P900,000 Inventory 2,700,000 Cash 350,000 Noncurrent liabilities 500,000 Current liabilities 700,000 Share capital issued December 31, 20x16 400,000 Retained earnings 2,350,000 The price index numbers on December 31 of each year are 20x16 – 100, 20x17 – 130, 20x18 – 150, 20x19 – 240, and 20x20 – 300. The property, plant and equipment were purchased on December 31, 20x18. The non-current liabilities were loans raised on December 31, 20x18. What is the balance of retained earnings on December 31, 20x20 after adjusting for hyperinflation? A. P2,350,000 B. P2,750,000 C. P3,550,000

Property, plant and equipment Inventory Cash

Noncurrent liabilities Current liabilities Share capita Retained earnings

900,000 2,700,000 350,000

300 300 300

150 270 300

1,800,000 3,000,000 350,000 5,150,000

500,000 700,000 400,000

300 300 300

300 300 100

500,000 700,000 1,200,000 2,750,000 5,150,000

D. P2,625,000

Balancing figure

Use the following information for the next two (2) questions: DEF Company operating in a hyperinflationary economy provided the following data: Before restatement Liabilities P2,000,000 Share capital 5,000,000 Revaluation surplus 1,000,000 Retained earnings 1,500,000 Total liabilities and equity P9,500,000 3.

4.

What amount should be reported as retained earnings? B. P5,000,000 A. P3,500,000

C. P1,000,000

D. P0

What amount should be reported as revaluation surplus? A. P1,000,000 B. P2,500,000

C. P6,000,000

D. P0

Liabilities Share capital Retained earnings

5.

After restatement P2,500,000 8,500,000 ? ? P16,000,000

2,500,000 8,500,000 5,000,000 16,000,000

Balancing figure

GHI Company provided the following information during 20x20: Inventory – January 1 Purchases Inventory – December 31

P1,650,000 4,000,000 2,500,000

The relevant index numbers are 120 on January 1, 20x20, 280 on December 31, 20x20, and the average index number for 20x19 is 110. What is the cost of goods sold in a hyperinflationary income statement for 20x20? A. P6,300,000 B. P7,300,000 C. P3,150,000

D. P4,410,000

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