Accounting for price level change

Introduction
Price-Level
changes are changes in the prevailing exchange ratio between money and goods or
services.
Whenever a
rise in the general level of prices, for goods and services occurs, the general
purchasing power of the Naira decline – this is inflation. In contrast,
deflation is an increase in the Naira general purchasing power as the general
price level decline.
Price indexes
Price indexes
measure price – level changes. A price indexes represents a series of
measurements stated as percentages indicating the relationship between; 
(a)        The weight average price of a sample of
goods and services at various point in time and

(b)        The weighted average price of a similar
sample of goods and services at a common or base date.
For example,
assume we wish to construct a price index for single commodity that was priced
at
N1.60 in
December 19X2,
N2,00 in December 19X3 as our base date and N3,00 in December 19X4. Our price index expresses the price of this
commodity in December of 19X2, 19X3 and 19X4 as a percentage of its price in
December 19X3 as follows: 

The percentage
relationship of the base date is always 100%. The price index for each date is
as follows (the percentage sign is understood and not shown with index number).
            December 19 x 2                80
            December 19 x 3                100
            December 19 x 4                150
Conversion factors
With index
numbers, amounts stated in terms of Naira of general purchasing power at a
particular time may be rested in terms of Naira of different purchasing power
at another time.
We simply
multiply the amount to be rested by the following conversion factor.

 

Example:
Suppose we
acquire a parcel of land for
N5,000 in December 19X3 when the general price index was 100. Suppose
also that the general price for the various times were as follows:
            December 19X2                 80
            December 19X3                 100
            December 19X4                 150
            Average for 19X4   124
We restate the
cost of the land in terms of December 19 x 4 by multiplying the
N5,000 by the conversion factor 150/100 (December 19
x 4 index/December 19 x 3). The resulting measure is
N 7,500 – the cost of the land stated in naira of 19
x 4 general purchasing power.
The conversion
process works in the other direction as well. The cost of the land in terms of
December 19 x 2 naira is
N 5,000 x 80/100 = N 4,000. The amounts N 7.500 and N 4,000 each represent the cost of the land, but the cost is expressed in
a different unit measure in each case.
Usually, the
amounts in “Old Naira” or “historical cost” are converted to current naira because
the later figure is more relevant to the overall economic situation.
Adjustment Procedures:
Basically,
constant naira adjustments cause all items in the financial statement to be
stated in naira with a common purchasing power content. Conversion factors are
used to make the adjustment.
At all times
attempt should be made to state the converted data in terms of the naira’s
purchasing power at the latest balance sheet date.
Balance sheet conversion
Before a
balance sheet conversion, we must separate monetary assets and liabilities from
non-monetary items.
(a)      Monetary
Assets: –
These include cash and other assets such as receivables.
Receivables represent the right to receive a fixed number of naira in future,
regardless of price-level changes. Most liabilities are monetary. Monetary
items are those normally carried in the accounts at current cash values.
Monetary items are worth their face value.
Consequently,
monetary items held at the balance sheet date do not need to be restated. They are
automatically stated in current naira. Monetary assets held during the period
of inflation lose purchasing power, whereas holding monetary liabilities leads
to gain in purchasing power.
On of the
principle objectives of adjustment restatement is to measure this net gain or
loss from holding monetary items.
(b)      Non-Monetary
Items: –
The remaining items in the balance sheet are classified as
non-monetary. They include inventor, plant and machinery and capital stock.
Non-monetary items are restated in terms of the currency equivalent of the
purchasing power at the time of acquisition.
Holding
monetary items during the period of rising prices (inflation) create purchasing
power gains and losses on these items.
Example
Suppose you
hold
N 1,000 cash
during a period when the general price level increase from 100 to 150.
Obviously, at the end of the period, your
N1,000 will buy fewer goods and services than it would at the beginning
of the period. The decrease in your ability to buy goods and services as a
result of inflation is a purchasing power loss on cash.
            The amount of loss = N 500; that is
                             150 – 100 = 50%
                              50% of N 1,000 = N 500.
Example
Assume you
also had payable of
N 800 outstanding during the time the general price index increased from
100 – 50. As a result of inflation, you owe at the beginning of the period.
The decrease
in the general purchasing power of the naira with which you will settle the
liability represents a purchasing power gain on the note.
The amount of
gain =
N 400
determined as follows:
                                         150 – 100 =
50%
                                          50% of N 800       = N 400
Example
Let us
consider a simple balance sheet conversion by looking at Rainbow Co. Ltd.
organized on January 1, 19 x 4 when the general price index was 100. It’s
opening balance sheet was follows:

Assume no
further transactions occurred during 19×4, in conventional terms, index
increased to 150
Rainbow
Co.Ltd’s balance sheet at the end of 19×4, in conventional terms, would be the
same as the one shown above.
The price
level adjusted Balance Sheet at December 31, 19×4, would be as follows
(conversion computation in parenthesis).

Advantages of adjusted data:
Some of the benefits
of adjusting for changes in the general purchasing power of the naira are:
1.         Better comparison of financial data
through time
2.         Improved additivity of financial data
and;
3.         Increased disclosure of information
through calculation of purchasing power gains and losses on monetary items.
Comparability of data through time:
To illustrate
the advantage of adjusted data, assume that the average price level indexes and
XYZ. Company’s Sale revenue for 1992
– 1994 are shown below

A study of the
unadjusted sales figure above indicates a healthy increase in sale. However, if
we convert the naira stated in the average price level index for 1992, 1993 and
1994 to that of the end (the latest balance sheet date), we discover the
following sales levels:
Average
price Level Index
Unadjusted
Sale
Conversion
Factor
Restated
sales
1,992
75
N 1,000,000
150/75
N 2,000,000
1,993
90
N 1,000,000
150/90
N 1,950,000
1,994
125
N 1,380,000
150/125
N 1,656,000
Adjusting the
data to a common naira indicates a decrease in sales activity rather than an
increase. We can easily imagine the erroneous operating decisions that could
result from similar data distortions.
Example                  
Additivity data
The basic
mathematical law of additivity asserts that only units can be added or
subtracted.  Supporters of general price
level adjustments claim that addition and subtraction of naira of different
purchasing power violate the law of additivity.
Assume XYZ company (from previous
illustration) purchased a building in 1991 for
N 5,400,000 –when the price –level index was 60 and the building is depreciated
N 270,000 per
year.
XYZ Company’s other for 1994 totalling N 900,000 were incurred and paid uniformly throughout the year. The
conventional Profit and Loss Account for 19×4 and the data restated in terms of
the 19×4 year and naira appear as follows:

Note
(a)      In the restated P & L A/c, all items
are stated in naira of common general purchasing power.
(b)      The restated amounts are decided different
from unadjusted amount
Conclusion
Thee
importance accounting for price-level changes be over emphasized, Price level
changes reflect changes in the prevailing exchange ratio between money and
goods or services as a result of inflation or deflation.
Price Level
changes are measured by price indexes. Price indexes are based on the use of
index numbers and conversion factors.
In balance
sheet conversion, the monetary assets and liabilities are separated from non-monetary
items.
The advantages
of adjusted data include better comparison of financial data through time and
improved additivity of financial data.

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