Introduction and Meaning of Accounting for Price Level Changes 1. Introduction of Accounting For Price Level Changes Conventional or historical cost accounting assumes that money has stable value. But in reality, value of money varies from time to time as a result of changes in the general level of prices. Prices of goods and services change over the time. t ime. The change in price as a result re sult of various economic and social forces brings about a change in the purchasing power o f money. Accounting is known as the language of business. The basic objective if accounting is to prepare financial statements in such a way that they give a true and fair view of business. Income statement should disclose the true profit or loss made by the business during a particular period where as balance sheet must show a true and fair view of the financial position of the business on a particular date. The recording of business transactions under the assumption that monetary unit is stable is called historical cost accounting (HCA). Under HCA, assets are recorded by the business at the price at which they are acquired and there will be no change c hange in their values even if the market values of such assets change. Likewise, liabilities are recorded at the amounts contracted for and such amounts are not revised to compensate for changes in the price level. Costs are recorded on historical basis where are revenues are recorded on current value basis. Under HCA, it is assumed that money has stable value. But in reality, the value of money varies from time to time. The historical accounting system does not consider the impact of price level change on financial statements. Therefore, accounting for price level changes has been emerged as new accounting system.
2. Meaning Of Accounting for Price Level Changes The general tendency in changes of o f prices of goods and services over a t ime is called price level. The rise in general price level is called c alled inflation. During the period of inflation, purchasing power of money declines. The fall in the general price level is called deflation. During the period of deflation, purchasing power of money increases. Price level change means increase or decrease in the purchasing power of money over a period of time. The accounting which considers price level changes is called accounting for price level changes. Accounting for price level changes is a system of maintaining accounts in which all items in financial statements are recorded at current values. This system of accounting ascertains profit or loss and presents financial position of the business on the basis of current prices. Accounting for price level changes is also called inflation accounting.
3. Objectives And Methods Of Accounting For Price Level Changes
Objectives Of Accounting For Price Level Changes
Historical cost accounting financial statements are prepared on the assumption that monetary unit is stable. But in reality, monetary unit is never stable and most of the countries have been facing high rates of inflation. Therefore, financial statements prepared under historical cost ac counting do not reflect current economic realities. They fail to give realistic and correct picture of the state if affairs of a concern. To overcome the limitation of historical cost accounting, there is a need to consider the effects of changes in value of money as a result of changes of price of goods and services. Following are the objectives of accounting for price level c hanges. * To show the true result of the operations i.e. real profit or loss. * To show the true financial position in curre nt values. * To show the realistic value of fixed assets in financial statement. * To provide sufficient depreciation to generate funds for the replacement of fixed assets. * To indicate the real capital em ployed. * To make distinction between holding gain or loss and operat ing gain or loss. * To make accounting records reliable for the various users.
Methods of Accounting for Price Level Changes
There are many methods of adjustments for the effects of changes in prices. The generally accepted methods of accounting for price level changes are as under: 1. Current purchasing power method or general purchasing power method(CPP or GPP) 2. Current cost accounting method(CCA method) 3. A hybrid method i.e. mixture of CPP and CCA method.
I.
Current Purchasing Power (CPP) Method
The introduction of current purchasing power (CPP) method is o ne of the greatest revolutions in the field of accounting. Under current purchasing power (CPP) met hod, any established and approved general price index is used to convert the values of various items in the balance sheet and profit and loss account. It involves the restatement of some or all of the items in the historical financial statement for changes in the general price level. For this purpose, approved price index is used t o convert the various
items of historical financial statement. This method helps to present financial statement in terms of units of equal purchasing power. Under this method, financial statements are prepared on the basis of historical cost and a supplementary statement is prepared showing historical items in terms of current value on the basis of general price index. Retail price index or wholesale price index is taken as an appropriate index for the conversion of historical cost items to show t he changes in value of money. This method takes into consideration the changes in the value of items as a result of general price level, but it does not account for changes in the value of individual items.
Characteristics Of CPP Method
1. A supplementary statement is prepared and annexed to historical financial statement. The supplementary statement includes re-statement of income statement and r e-stated balance sheet. 2. Any statement prepared under CPP m ethod is based on the historical statement. 3. Consumer price index or wholesale price index is used as conversion factor for re -stated of historical items. 4. All the items in financial statement are classified into monetary and non-monetary items. Nonmonetary items are adjusted, there is no need of any adjustment for the monetary items. 5. Net gain or loss account of monetary items is to be accounted in t he profit and loss account
Advantages Of Current Purchasing Power (CPP) Method
CPP method is useful for finding out real financial position of organization. Following are the advantages of CPP method. 1. CPP method adopts the same unit o f measurement by taking into account the price changes. 2. Under CPP method, historical accounts continue to be maintained. CPP statements are prepared on supplementary basis. 3. CPP method facilitates the calc ulation of gain or loss in purchasing power due to the holding of monetary items. 4. CPP method uses common purchasing power as measuring unit. So, the comparative study is easy. 5. CPP method provides reliable financial information for taking management decision to formulate plans and policies. 6. CPP method ensures keeping intact the purchasing power of capital contributed by shareholders. So, this method is of great importance from the point of view of the shareho lders.
Disadvantages Of Current Purchasing Power (CPP) Method
Following are the some major points for the criticism of CPP method: 1. CPP method considers only the changes in general purchasing power. It does not consider the changes in the value of individual items. 2. CPP method is based on statistical index number which can not be used in an individual firm. 3. It is very difficult to choose a suitable price index. 4. CPP method fails to remove all the defects of historical cost accounting system. 5. The use of general price index for CPP method is questioned. While general price index deals with consumer goods, business is interested in the price movement of producer goods.
II.
Current Costing Accounting(CCA) Approach
Current costing method is an alternative to current purchasing power (CPP) method. CCA approach was introduced in 1975 to overcome the difficulties of CPP method. Actually the CPP method applies the retail price index for finding out the conversion factors to restate the income state ment and balance sheet. So the CPP approach was criticized by the business world. Current costing accounting (CCA) approach recognizes the changes in the price of individual due to the change in general price level. This is the method which includes the process of preparing and interpreting financial statement in such a way t hat relevant change in the price is c onsidered significantly. In CCA method, the assets are valued in current cost basis. It does not consider the retail price index. This method considers the re placement value of the assets for its real ac counting records. The value of assets at which it is to be replaced in future is called the replacement value. Sometimes it is known as replacement cost accounting approach also. Under this method, e ach financial statement is to be restated in terms of the current value of such items.
Features Of Current Cost Accounting(CCA)
1. The fixed assets are recorded at replacement cost value in the balance sheet. 2. Inventories are shown at market value rather than market or cost price whichever less as in the historical system is. 3. Revaluation surplus are transferred to current cost accounting reserve but not distributed as dividend to shareholders. 4. Depreciation of fixed assets is to be calculated at replacement value. 5. Two types of profit i.e. profit from operation and profit from revaluation is calculated. 6. Liabilities are recorded in their o riginal value because there is no any change in monetary unit.
Objectives of Current Cost Accounting (CCA) Approach
1. To provide correct and reliable financial information based on the current replacement cost. 2. To calculate the profit without changing the historical profit. 3. To protect the business in the event of normal inflationary situation. 4. To keep level of capital in very balance position by making valuation of assets in proper value based on replacement value. 5. To provide realistic information to the management, investors, c reditors, government and to other interested parties. 6. To prepare the financial statement at the end of the year on the basis of current value of such item s.
