Definitions:

Monetary assets: Those assets whose amount is fixed by contract or otherwise as to the number of dollars to be received, regardless of changes in the general price level.

(Examples: cash, accounts receivable)

Non-monetary assets: All other assets; or those assets whose amount is not fixed by contract or otherwise as to the number of dollars to be received, regardless of changes in the general price level.

(Examples: inventory, land, equipment)

Monetary liabilities: Those liabilities whose liquidation will require a fixed number of dollars, regardless of changes in the general price level.

(Most liabilities are monetary in nature; examples: accounts payable, bonds payable, notes payable)

Non-monetary liabilities: All other liabilities; or those liabilities whose liquidation will not require a fixed number of dollars, regardless of changes in the general price level.

(Very few non-monetary liabilities; usually items such as unearned revenues whose liquidation will require the performance of a service or the delivery of some asset, such as inventory, as opposed to using cash or some other monetary asset.)

All stockholder equity accounts are non-monetary with the possible exception of preferred stock having a fixed liquidation value.

Holding monetary assets and/or monetary liabilities during periods of changing prices creates purchasing power losses or gains. (Purchasing power refers to the ability to buy goods and services with a given amount of money)

If monetary assets are held during a period of general price level increases, a purchasing power loss is incurred.

If monetary liabilities are held during a period of general price level increases, a purchasing power gain is incurred.

Purchasing power gains and losses are not recognized in traditional financial reporting (the historical cost model)

Purchasing power gains and losses only occur if a company holds monetary items during a period of changing  prices.

Historical cost/constant dollar reporting is not considered a departure from historical cost; rather, it is simply an adjustment of the historical costs to dollars of constant purchasing power.

Procedures for Adjusting to Constant dollars--General Outline

Assume we are converting to end-of-the-year constant dollars: Conversion factor needed for each item on the financial statements:

 Conversion factor = Price index at end of year divided by price index in effect when the account was created

For balance sheet accounts:

Monetary assets: Year-end index/ Year-end index

Monmonetary assets: Year-end index/ index in effect when asset was acquired

Same for liabilities and Owners equity accounts

For income statement accounts:

for most items: Year-end index/ Average index for the year

Some items, such as depreciation, will need to modify the conversion factor = Year-end index/ index in effect when the asset was acquired

Steps in calculating purchasing power gains and/or losses on monetary items:

Step one: reconcile the beginning and ending monetary assets and monetary liabilities.

Step two: Adjust beginning monetary item to constant dollars

Step three: Adjust each reconciling item to constant dollars

Step four: Total adjusted items in step two and step three

Step five: Adjust ending monetary item to constant dollars (if adjusting to end of year dollars, ending monetary item is already in constant dollars)

Step six: subtract results in step five from the total in step four

The result of step six is the amount of purchasing power gain on loss on the monetary item. Will need to carry out this process for both monetary assets and monetary liabilities.

Purchasing power gain or loss for the period is reported as a separate line item below net income on the price level adjusted income statement. The PPG or PPL is not considered to be part of net income for the period.