39 Problems Created by Changing Price level, Approaches to Price Level

Sanjeet Sharma

epgp books

 

 

LEARNING OBJECTIVES:

 

This module helps to understand the concept of Accounting for Price-Levels Changes. After studying this module the students may able to

  • Understand the need and importance of Accounting for Price-Levels Changes.
  • Explain methods/Techniques of Price Level /Inflation Accounting.
  • Discuss the limitations of Accounting for Price-Levels Changes.

Introduction

 

Prices of goods and services keep on changing over a period of time. Prices are affected by various factors such as economic, political or social. Changes in the price levels can be divided in two types of economic situations, inflation and deflation.

  • Inflation is a period of rise in general price level whereas
  • deflation is a period of fall in general price level.

 

Accounting is known as the language of business. It is necessary for every business concern to present true and fair view of the operating and financial position of the concern. It helps the various stakeholders such as shareholders, investors, creditors and others to study and to take various important decisions relating to business. Changes in the price levels results in inaccurate presentation of financial statements. The accounting which is based on conventional method is known as historical cost method. The financial statements are prepared on the basis of historical costs on the assumption that the rupee has static value. But the assumption is not valid because the value of the money i.e. the purchasing power of the rupee keeps on changing. After the Second World War the prices started rising continuously. It made nonsense to present the financial statements on historical cost basis. So, historical cost method has now become irrelevant. In order to get rid of the problems related with historical costing, Accounting for Changing Price-Level has been recommended.

 

HISTORICAL COST

 

Historical cost is original cost incurred at the time of a transaction takes place. There is difference original cost, replacement cost and current cost, or inflation-adjusted cost. For example, land purchased in 2010 at cost of 100000. Even it is still in the ownership of the buyer it will be presented on the buyer’s balance sheet at its cost or historical cost of 100000. It may be possible that its

 

  • current cost,
  • replacement cost, and
  • inflation-adjusted cost are more then original cost.
  • Assumption: Historical accounting is based on assumption that monetary unit remains stable.
  • Recording of Assets: Assets are recorded at their actual cost.
  • Recording of Liabilities: Liabilities are recorded at the amounts at which these are incurred.

 

ACCOUNTING FOR PRICE-LEVELS CHANGES

 

Historical accounting is based on assumption that monetary unit remains stable. This assumption does not remain valid in present changing business world. In the reality the value of assets and liabilities of an enterprise is affected by the changes in the purchasing power of money. For example decline in purchasing power of money results in overstatement of profit and understated of asset. Thus, the traditional method based on historical costing fails to provide the accurate business results under situations of changing prices. So, in present scenario historical cost  method has become irrelevant. In order to get rid of the problems related with historical costing, Accounting for Changing Price-Level Changes has been recommended. The accounting for price-level changes is a technique

  • in which transactions of business are recorded at current values and
  • it makes an attempt to neutralize the impact of changing price levels on the transaction of business.
  • Accounting for price level changes is also known as inflation accounting.

It is also cleared with the figure given below:

NEED OF ACCOUNTING FOR PRICE-LEVELS CHANGES

 

The following are problems that generated the need of the Accounting for Price-Levels Changes 1 Historical cost fails to present the true and fair view: The main objective of maintaining accounts is to prepare income and financial statements to present the financial position of the business entities in front of interested parties. In case of price level changes the historical cost fail to present true and fair view of the business financial performance and financial health.

  1. Non-recognition of Gains or Losses: In the times of changing price levels the traditional accounting based on Historical Cost convention does not recognize the gains arising due to increasing prices at time of inflation or losses arising due to decreasing prices at times of deflation.
  1. 3. Distorted picture of operation: The accounting records are maintained on historical cost basis, the profit and loss account, in case of changing price levels, will present a distorted picture of business operation.
  2. Irrelevant Comparison; Financial statements based on conventional method of accounting disclosed in the balance sheet become incomparable over a number of years. In times of constantly changing price levels any attempt made for comparative analysis would not be useful.
  1. Problem of under capitalization: In times of rising prices, the depreciation provisions created on the basis of historical cost becomes inadequate at the time of replacement of assets. Due to this the business may operate under capitalized.
  2. Erosion of real capital: The erosion of real capital takes place in times of inflation due to rise in price-levels, as
  • depreciation on fixed assets is charged at inadequate rate and
  • consumption of inventory to revenue earnings is charged at inadequate rate

in the traditional method of accounting.

 

HISTORICAL COST: Historical cost is original cost incurred at the time of a transaction.

 

ACCOUNTING FOR PRICE-LEVELS CHANGES: The accounting for price-level changes is an accounting technique in which business transaction are recorded at current values and it makes an attempt to neutralize the impact of changing price levels on the transaction of business. Accounting for price level changes is also known as inflation accounting

 

NEED OF ACCOUNTING FOR PRICE-LEVELS CHANGES

  • Historical cost fails to present the true and fair view
  • Erosion of real capital
  • Distorted picture of operation
  • Irrelevant Comparison
  • Problem of under capitalization
  • Non-recognition of Gains or Losses

METHODS/TECHNIQUES OF PRICE LEVEL /INFLATION ACCOUNTING

 

There are number of methods related with inflation accounting. Some of the important methods among these are:

(i) Current Purchasing Power Method (CPP);

(ii) Replacement Cost Accounting Method (RCA);

(iii) Current Value Accounting Method (CVA), and

(iv) Current Cost Accounting Method (CCA).

Current purchasing power method or CPP method is used for purpose of adjusting financial statement during inflationary period. According to this method the business keeps its accounts on the basis of conventional historical cost system. However, it further requires preparation of supplementary statement at the end of accounting period. This supplementary statement shows all the items of the financial statement in terms of the purchasing power of currency or value of rupee as at the end of the period.

 

Features of current purchasing power method

The Main features of current purchasing power method are:

  1. Preparation of financial statements on the basis of historical costs: According to this method the income statement i.e. profit and loss account and statement of financial position i.e. balance sheet are prepared on the basis of historical costs. Further, this method requires that final accounts of a business should be attached by a supplementary statement. This statement must show changes that have taken place in the financial items of the business due changes in the purchasing power of money or value of money.
  1. Conversion Technique: According to this method historical figures presented in financial statements must be converted in to current figures by considering the current purchasing power of money. The conversion of figures which are given in the basic financial statements into the figures in the supplementary statement should be by taking following steps
  • Use of General Price Index: The conversion of figures is done by using a General Price Index. For this purpose the Consumer Price Index or the Wholesale Price Index published by Reserve Bank of India can be taken.
  • Conversion formula: The items of financial statement are converted with the use of following formula

CA = CPIPPI X  HA

 

Where

CPP = Current purchasing power;

CPI = Current General Price Index;

PPI = Previous Price Index at the date of existing figure;

CA =Converted Amount

HA = Historical Amount

 

  1. Classification of Accounts: For the propose of converting historical figure in to current purchasing power of money the financial accounts can be classified into two major categories namely,
  • Monetary Accounts
  • Non-monetary Accounts

 

Monetary Accounts

 

Monetary Accounts represents such assets and liabilities or balance sheet items which are not subject to reassessment because the values of these items do not change with a change in purchasing power of money. The examples of such items are

  • cash,
  • bills receivable/payable,
  • debtors/creditors,
  • Outstanding incomes/expenditures, etc.
  • (b) Non-monetary accounts

Non-monetary accounts include such items of balance sheet which are subject to reassessment because the values these is affected by the change in the purchasing power of money. The examples of such items are Such as

  • stock,
  • plant,
  • building,
  • Furniture, etc.

It is important to note that only the non-monetary accounts or items are adjusted to the current purchasing power of money and are restated in the supplementary statement.

 

Limitations of CPP Method: Current purchasing power method suffers from following limitations:

 

  1. Use of single average index number In Current purchasing power method general price index is used and this index numbers cannot be used with precision to individual financial item of the balance sheet.
  1. Selection of particular index number: In Current purchasing power method it is a difficult job to select a particular index number because different price index numbers are needed in different price situations.
  1. Costly and time consuming process: Current purchasing power method requires preparation of adjusted financial statement which is a costly and time consuming process.
  1. Not provide true picture about the financial state: Current purchasing power method monetary accounts are excluded while preparing adjusted financial statement. The exclusion of these accounts cannot give true picture of a business concern.
  1. Not suitable for the purpose of taxation: Current purchasing power method is not suitable for the purpose of taxation as it is not acceptable by Income Tax Act 1961.

REPLACEMENT COST ACCOUNTING METHOD

 

With the purpose to overcome the limitations of current purchasing power method Replacement Cost Accounting (RCA) method had been developed. The main limitation of CPP method is that it is based on General Price Index and does not take in to account the individual price index related with specific assets. Replacement Cost Accounting (RCA) method is not based on General Price Index and takes in to account the individual price index which is directly related with particular assets. It has also received great attention as it play important role in solving problems related with financial reporting that arise due to rapidly growing prices.

 

Features of the Replacement Cost Accounting Method

Features of the Replacement Cost Accounting Method are given as below

  1. Create sufficient provision for replacement

Replacement Cost Accounting (RCA) method create sufficient provision to meet the requirements of the replacement fixed asset.

  1. Use of Replacement Cost:

In Replacement Cost Accounting (RCA) method the charges to profit and loss account are governed by the replacement cost. In it the amount of expense should be reported equal to the amount of rupees needed at the time of expenses incurred to replace the resources used. Example: For example, if a firm

  • Sold product „X‟ on 30 April, 2015 for Rs. 10,000.
  • Product „x‟ was purchase by the firm on January 20, 2010, for Rs. 5,000.
  • At the time of sale, the cost to replace the product „X‟ is Rs. 7000.
  • Under replacement cost accounting system, it will treated as below in income statement as sales Rs. 10,000 less cost of goods sold Rs. 7,000.
  1. Matching: The reason behind taking expenses in terms of replacement cost is that any income that shown in the profit and loss account is matched with the current cost of the resources which were used to earn that revenue.
  1. Reporting in balance sheet:

In Replacement Cost Accounting (RCA) method all of the non-monetary items are reported in the balance sheet at replacement cost.

  1. Use of directly relevant indices: Replacement Cost Accounting method use indices which are directly relevant to particular financial item rather than General Price Index.

Demerits of Replacement Cost Accounting (RCA):

Main demerits of Replacement Cost Accounting (RCA) are given below:

  • Difficult: Replacement Cost Accounting method requires using a number of price indices for the purpose of converting the financial items in the statements and selection of relevant price index to be used in a particular case is a difficult task.
  • Subjectivity: Replacement Cost accounting method involves an element of subjectivity.

 

DIFFERENCE BETWEEN RCA AND CPP The main difference between RCA and CPP is.

  • Replacement Cost Accounting method requires to use such indices which are directly relevant to particular financial item.
  • General Price Index as used in current purchasing power method.

Merits: current value accounting shows economic reality by using current values to financial items in the financial statements.

 

Demerits of Current value accounting:

Current value accounting method has following demerits:

 

·         Difficult task: current value accounting requires current values of items of the balance sheet and the determination of relevant current value is a difficult task.

 

·         Subjectivity: current value accounting involves an element of subjectivity.

 

CURRENT COST ACCOUNTING METHOD

 

To consider and recommend the accounting for price level changes, the British Government had appointed a committee in 1973. The chairman of the committee was Mr. Francis C.P. Sandilands. The committee is known as Sandiland committee. This committee presented its report on 25th June, 1975 and recommended the Current Cost Accounting (CCA) technique for financial reporting in place of CPP or RCA techniques for price level changes. The Committee considered CCA as a comprehensive technique of accounting for inflation. The CCA method matches current revenues with the current cost of the resources which are consumed in earning them. The Current Cost Accounting (CCA) method is also termed as Specific Price Level approach.

 

Basic principles of Current Cost Accounting techniques

The basic principles of Current Cost Accounting techniques are:

 

1.      Unit of measurement: Current Cost Accounting techniques takes the assumption of that money is the unit of measurement in accounting.

 

2.      Values of Assets and liabilities: In Current Cost Accounting techniques assets and liabilities are shown in the balance sheet at their current values and not on historical Costs.

 

3.      Depreciation of fixed assets: In this method the depreciation of fixed assets calculated on their current value not on original cost.

 

4.      Value of inventory: In this method inventory is not valued on the basis of market price or market price which ever less. The inventory consumed should be valued at their replacement cost.

 

5.      Cost of goods sold: In this method Cost of goods sold is valued on the basis of price prevailing at the date of consumption and not at the date purchase.

 

6.      Revaluation Reserve Account: Surpluses arising due to revaluation of fixed assets should be transferred to Revaluation Reserve Account. Amount in Revaluation Reserve Account is not available for distribution as dividend.

 

7.      Annual accounts: Under CCA method, a company‟s annual accounts will include:

(i)     Profit and Loss account;

(ii)     Appropriate account

(iii)    Statement of the changes in the net equity

 

METHODS/TECHNIQUES OF PRICE LEVEL /INFLATION ACCOUNTING

  •  Current Purchasing Power Method (CPP);
  •  Replacement Cost Accounting Method (RCA);
  •  Current Value Accounting Method (CVA), and
  •  Current Cost Accounting Method (CCA).

 

CURRENT PURCHASING POWER METHOD: Current purchasing power method or CPP method is used for adjusting financial statement during inflationary period. According to this method the business keeps its accounts on the basis of conventional historical cost system. However, it further requires preparation of supplementary statement at the end of accounting period.

 

REPLACEMENT COST ACCOUNTING METHOD: The main limitation of CPP method is that it is based on General Price Index and does not take in to account the individual price index related with specific assets. Replacement Cost Accounting (RCA) method is not based on General Price Index and takes in to account the individual price index which is directly related with particular assets.

 

CURRENT VALUE ACCOUNTING METHOD: Current-value or fair value accounting has been developed for the purpose of substituting historical cost accounting. Under this method items in the balance sheet are shown at their current values.

 

CURRENT COST ACCOUNTING METHOD: The CCA method matches current revenues with the current cost of the resources which are consumed in earning them

Advantages of Account for Price-level Charges

 

Accounting for Changing Price-Level is solution of many of the problems. Some of the important advantages of Accounting for Changing Price-Level are explained as under:

  1. More realistic and accurate picture of profitability

The traditional method of accounting does not reveal real profits at times of inflation or deflation. Accounting for Changing Price-Level present more realistic view of profitability as under this system current revenues are matched with current costs.

 

2.   Better projections: Accounting for changing price levels provide the business with better projections that can be made for analysing proposals related with

 

·         Replacements of assets

·         New capital expenditures etc,

 

3.      Make accounting profits and economic profits same: In inflationary accounting depreciation charged on current values of assets and it enables a firm to show accounting profits more close to economic profits.

 

4.    More realistic and true and fair view of the financial position Statement of financial position or balance Sheet provides true and fair view of the financial position of in inflationary accounting because the assets are shown at

 

·         current values and

·         not on distorted values as in historical accounting.

 

5.     Correct calculation of the returns on capital: Accounting for Changing Price-Level current costs are used for calculation of the percentage of returns on capital. Thus return on capital calculated under this method will be more meaningful to the users.

 

6.   Helpful in pricing decisions: In accounting for Changing Price-Level Current costs are used for pricing decisions of a product. This provides more realistic price.

 

7.  Solve problem of inadequacy of fund: In current cost accounting, the problem of inadequacy of fund does not arise as the

 

·         provision for depreciation on fixed assets is calculated on the basis of current costs and

·         the value of stock of inventory for replacement are made on the basis of current costs Thus, the amount so far reserved will be equal to the funds required for the purpose of replacement.

 

8.   Depicts the true and fair view of the financial position: The problems of non reporting of “True and Fair View” will be solved, as it depicts the true and fair view of the financial position of a concern as current values of the items are considered in the preparation of balance sheet.

9.   Enables to maintain real capital: Inflationary accounting enables a company to maintain its real capital. This system avoids payment of dividends and taxes out of capital.

 

10.  Meaningful comparison

 

Accounting for changing price level changes makes possible the comparative study of the enterprises set up at different periods.

 

11.   Proper information for decision making: Accounting for changing price level changes provide accurate financial information to the various interested parties. Stakeholders such as investors, employees and the public at large are not misled by inflated book profits because inflation accounting shows more realistic profits.

 

12.    Improve its social image: The financial statements prepared on the basis of price level accounting also improve social image of the business.

 

13.    Replacement the assets: It helps the enterprise to replace the assets when required with more ease as depreciation is charged on current value of the asset.

 

14.  Realistic price for its shares: Accounting for changing price level changes provides realistic price for shares.

 

Disadvantages of Price Level Accounting

Following inherent disadvantages of the price level accounting

1.  Not sufficient to measure the changes in prices

 

In price level accounting the financial statements prepared under conventional accounting system is adjusted based on single price index. The single index can not be sufficient to measure the changes in prices in all financial items.

 

2.     Personal preferences In Price Level Accounting the adjusted measures are based on assumptions and these assumptions are dependent on personal preferences.

 

3.  Not suitable for income tax purposes

 

The statements prepared after adjusting values recorded in terms of historical cost concept are not accepted by the tax authorities. Depreciation charged on current values of fixed assets is not acceptable under the Income Tax Act, 1961.

 

4: Never ending process: In present scenario economies are characterized by constantly upward rising prices. So, the problem of adjusting of accounts to these price changes becomes a constant feature for the present accounting world. Thus, it will become a never ending problem and remaining unresolved for ever.

 

5. Many calculations and complications: Price level accounting involves many calculations and these calculations make financial statements complicated and confusing. Thus, Inflating accounting is a

 

·         complicated,

·         confusing,

·         time consuming process

 

6.  Based on adoption of proper conversion method Price level accounting depends heavily on the selection of proper conversion method. Normally people may convert the items on the basis most suited to them. This results in failure of Price level accounting.

 

 

·         More realistic and accurate picture of profitability

·         Better projections

·         Make accounting profits and economic profits same

·         More realistic and true and fair view of the financial position

·         Correct calculation of the returns on capital

  • Helpful in pricing decisions
  • Solve problem of inadequacy of fund
  • Depicts the true and fair view of the financial position
  • Enables to maintain real capital
  • Realistic price for its shares
  • Proper information for decision making
  • Improve its social image
  • Realistic price for the shares of a company
  • Replace the assets
  • Meaningful comparison
  • Not sufficient to measure the changes in prices in general
  • Personal preferences
  • Not suitable for income tax purposes
  • Never ending process
  • Many calculations and complications
  • Based on adoption of proper conversion method

 

SUMMARY

 

Accounting is known as the language of business. It is necessary for every business concern to present true and fair view of the operating and financial position of the concern. Changing Price-Level made nonsense to present the financial statements on historical cost basis. For the solution of problems related with historical costing, Accounting for Changing Price-Level has been suggested.

you can view video on Problems Created by Changing Price level, Approaches to Price Level

Few suggested reading to learn more:

 

  • Bhattacharya, SISIR Kumar and Sujit Kumar Roy, Management Accounting, S. Chand & Company Ltd.
  • HIngorani, N.L. and A.R. Ramanathan, “Management Accounting”  Sultan Chand & Sons.
  • Sahaf, M.A.,  “Management  Accounting  Principles  and  Practice”  Ashish  Publishing House.
  • Sharma, R.K. and Shashi K. Gupta, “Management Accounting” Kalyani Publishers.

 

Points to Ponder:

 

  1. Historical cost is original cost incurred at the time of a transaction.
  2. The accounting for price-level changes is an accounting technique in which business transaction are recorded at current values and it makes an attempt to neutralize the impact of changing price levels on the transaction of business.
  3. Accounting for price level changes is also known as inflation accounting
  4. Current purchasing power method or CPP method is used for adjusting financial statement during inflationary period.
  5. According to this method the business keeps its accounts on the basis of conventional historical cost system. However, it further requires preparation of supplementary statement at the end of accounting period
  6. The CCA method matches current revenues with the current cost of the resources which are consumed in earning them.
  7. Current-value or fair value accounting has been developed for the purpose of substituting historical cost accounting. Under this method items in the balance sheet are shown at their current values.
  8. The main limitation of CPP method is that it is based on General Price Index and does not take in to account the individual price index related with specific assets.
  9. Replacement Cost Accounting (RCA) method is not based on General Price Index and takes in to account the individual price index which is directly related with particular assets.