Page 45 - DCOM409_CONTEMPORARY_ACCOUNTING

Contemporary Accounting

Notes You are required to value the machinery on January 1, 2008 and December 31, 2008, both
according to historical cost accounting system and current cost accounting system, charging
depreciation on straight-line basis. Also, find the amount that needs to be adjusted for
depreciation in year 2008.
Hint: (1) WDV on 1.1.2008 (2) WDV on 31.12.2008

Historical Cost - 70000 Historical Cost - 60000
Current Cost - 112000 Current Cost - 105000

2.4.3 Hybrid Method

This method is a compromise between the Current Purchasing Power and Current Cost
Accounting methods. Under this method, fixed assets and inventories are valued at specific
indices—Current Cost Accounting. In addition to this, purchasing power gains and losses in
respect of monetary items are also considered, which otherwise are ignored in Current Cost
Accounting. Those who advocate this method argue that by combining the two methods, the
advantages of both the methods can be obtained. But the critics of this method state that its
acceptance may prove difficult because of theoretical objections. In addition, the method may be
a victim of the disadvantages of both the methods.
Self Assessment

Fill in the blanks:
9. …………..= Price index at the date of conversion / Price index at the date the item arose.
10. …………items are those items that are fixed by contract or otherwise remain fixed
irrespective of any change in the general price level.
11. According to the………….method, inventories first purchased are taken to be first issued
to production or sold to customers.
12. Under ………….method, fixed assets and inventories are valued at specific indices.

2.5 Utility and Applications

The effects of inflation upon a business can briefly be described as distorting its profit performance
and valuations of its capital. This, in turn, affects the judgements and decisions of its management,
shareholders, investors and the government.
The immediate operating effect of inflation is upon the cash flow of the business entity. That is
the ability of the inflowing cash to acquire the depreciated fixed asset in real terms. Assets
recorded at historical cost will have a lower real value as the purchasing power of money falls
with inflation. On the other hand, liabilities such as loans are recorded in the financial statements
at historical cost and that is the amount to be repaid despite the fact that the rupees we repay will
have a lower real value than the rupees that were borrowed.

Inflation will also affect the profits of the business. Revenues will be at current prices as they are
the price paid today. Costs will be based on historical costs. In real terms, there is no comparison
between the both, and the net effect will be overstatement of profits. Depreciation will be based
on the historical cost, possibly years ago, and will be understated.
To examine the issue in greater details an attempt is now made to study the distortions that
inflation causes in the financial statements based on historical costs and how such distortions
affect the quality of information that is available to the users.

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