What it means
Ordinary accounts mix units without saying so. A balance sheet can show land bought twenty years ago next to cash received last week, add them together and present the total as though both numbers were measured on the same scale.
The restatement divides everything into two families. Non-monetary items such as property, plant and inventory are scaled up by the change in the price index since purchase, while monetary items such as cash, receivables and loans are already stated in current money and are left alone.
That split creates the distinctive figure in this method: the purchasing power gain or loss on net monetary items. Holding cash during inflation loses value, while owing money gains value, and constant dollar accounting reports that effect explicitly rather than letting it hide.
Depreciation is where the difference bites hardest in practice. Charging depreciation on an original cost from a decade ago understates the real cost of using the asset and flatters profit, which can lead a company to pay dividends out of capital it will need to replace the machine.
It is worth separating this from current cost accounting, which is a different repair to the same problem. Constant dollar accounting adjusts for general inflation using one index, while current cost accounting replaces historical figures with the specific replacement cost of each asset.
In practice
Real-world examples.
Example
A subsidiary operating in a country with 60% annual inflation restates its accounts before they are consolidated into the parent's group figures. Without the restatement, the subsidiary's property would appear at a small fraction of its real value alongside the parent's assets.
Example
A heavy engineering firm discovers that depreciation on restated asset values exceeds its reported profit. The board halves the dividend, having realised that the historical cost accounts were showing a profit the business could not actually afford to distribute.
Example
A lender reviewing a borrower's covenant compliance asks for constant dollar figures alongside the statutory accounts. The restated gearing ratio looks considerably better, because the borrower's fixed assets have been scaled up while its loan balance has not.
Formula
Calculation
Restated amount = historical cost x (current price index / price index when the item was recorded)
A company bought a machine for $600,000 when the general price index stood at 120. The index is now 180, so the restated cost is $600,000 x (180 / 120) = $900,000.
The machine is depreciated on a straight line basis over ten years. On historical cost that is $600,000 / 10 = $60,000 a year; restated it is $900,000 / 10 = $90,000 a year. After four years, accumulated restated depreciation is 4 x $90,000 = $360,000 and the restated net book value is $900,000 - $360,000 = $540,000, against a historical net book value of $600,000 - $240,000 = $360,000.
The second half of the exercise covers monetary items. If the company owed $200,000 more than it held in cash and receivables throughout a year in which the index rose from 180 to 198, a rise of 10%, it records a purchasing power gain of $200,000 x 10% = $20,000, because those debts are repaid in money worth less than the money borrowed.Case study
Seen in the real world.
This is an illustrative and entirely fictional example. Solenne Textiles, an invented mill operating in a high inflation economy, reported record profits for three consecutive years while its cash balance shrank and its machines aged.
Its auditors insisted on restated statements. Depreciation calculated on restated asset costs came to $4,500,000 against the $2,000,000 charged in the historical accounts, and the difference of $2,500,000 was enough to turn the reported profit into a real loss. The restatement also revealed a purchasing power gain on the fictional company's large bank loan, which had been quietly subsidising the reported result.
Management responded by indexing its selling prices monthly rather than annually and by holding a smaller working cash balance. The accounts had not changed the business, but they had finally described it in a single unit of measurement.
Watch out
Common mistakes.
- Restating monetary items such as cash and loans, when those are already expressed in current purchasing power and should be left untouched.
- Confusing constant dollar accounting with current cost accounting, which uses each asset's own replacement cost rather than a single general index.
- Treating the purchasing power gain on borrowings as ordinary trading profit, when it is a monetary effect and does not represent cash generated by the business.
Questions
People also ask.
When is this method actually required?
It is applied in hyperinflationary economies under international accounting rules, and is otherwise used as supplementary information rather than as the main statements.
Does restating the accounts change the tax bill?
Generally no, because tax authorities in most countries assess tax on historical cost figures, so the restated statements serve management and investors rather than the tax return.
Which index should be used for the restatement?
A general price index for the country concerned, most often the consumer price index, applied consistently to every non-monetary item in the accounts.
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