Unit 4 Accounting for Price Level Changes

Introduction of Accounting for Price Level ChangesConventional 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. The change in price as a result of various economic and social forces brings about a change in the purchasing power of 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 theprice at which they are acquired and there will be no change 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.Meaning Of Accounting for Price Level ChangesThe general tendency in changes of prices of goods and services over a time is called price level. The rise in general price level is called 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.Objectives of Accounting for Price Level ChangesHistorical 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 accounting 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 changes.

* To show the true result of the operations i.e. real profit or loss.* To show the true financial position in current 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 employed.* To make distinction between holding gain or loss and operating gain or loss.* To make accounting records reliable for the various users.

Methods of Accounting for Price Level ChangesThere 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:

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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.1. Current Purchasing Power (CPP) Method:The introduction of current purchasing power (CPP) method is one of the greatest revolutions in the field of accounting. Under current purchasing power (CPP) method, 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 to 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 the 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 Method1. A supplementary statement is prepared and annexed to historical financial statement. The supplementary statement includes re-statement of income statement and re-stated balance sheet.2. Any statement prepared under CPP method 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. Non-monetary 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 the 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 of 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 calculation 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 shareholders.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 cannot be used in an individual firm.

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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.Steps of Current Purchasing Power (CPP) MethodUnder current purchasing power (CPP) method, financial statements prepared under historical cost accounting are re-stated by using an approved price index. The following steps should be followed to prepare financial statements under CPP method of accounting for price level changes.1. Calculation of Conversion FactorCPP method involves the re-statement of historical figures at current purchasing power. For this purpose, historical figures must be multiplied by conversion factors. The formula for the calculation of conversion factor is:

Conversion factor = Price Index at the date of Conversion/Price Index at the date of item arose

Conversion factor at the beginning = Price Index at the end/Price Index at the beginning

Conversion factor at an average = Price Index at the end/Average Price Index Conversion factor at the end = Price Index at the end/Price Index at the end Average Price Index= Price Index at beginning + Price Index at the end/2 CPP Value = Historical value X Conversion factor

Notes:* For the items taken from the beginning period (e.g. assets, liabilities, taken from the operating balance sheet), beginning conversion factor is used.* For the items which occur throughout the year like sales, purchases, operating expenses etc., average conversion factor is used.* For the items which occur at the end of the year like tax, dividend etc. ending conversion is used.2. Distinction between Monetary and Non-monetary AccountsCPP method classifies all assets and liabilities into two groups i.e. monetary items and non-monetary items.Monetary Items: Monetary items are assets and liabilities, the amounts of which are receivable or payable only at current monetary value. Monetary assets include cash, bank, bills receivables, debtors, prepaid expenses, account receivables, investment in bond or debentures, accrued income etc. Monetary liabilities include creditors, account payable, bills payable, outstanding expenses, notes payable, dividend payable, tax payable, bonds or debentures, loan, advance income, preference share capital etc.Non-monetary Items: Those items which cannot be stated in ficed monetary value are called non-monetary items. Such items denote assets and liabilities that do not represent specific monetary claims. Non-monetary accounts include land, building, machinery, vehicles, furniture, inventory, equity share capital, irredeemable preference share capital, accumulated depreciation etc. Non-monetary items do not carry a fixed value like monetary items. Therefore, under CPP method, all such items are to be restated to represent current general purchasing power.3. Gain or Loss on Monetary itemsMonetary items are receivable or payable in fixed amount irrespective of changes in purchasing power of money. The change in purchasing power of money has an effect on monetary assets and monetary liabilities, Therefore, the holding of such items results gain or loss in terms of real purchasing power. Such gain or loss is termed as general price level gain or loss. During the period of inflation, holding of monetary assets results in loss and holding of monetary liabilities result in gain. Such gain or loss must be taken into accounts when income statement is prepared under CPPmethod to arrive at the overall profit or loss.

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4. Valuation Of Cost Of Sales And InventoriesCost of sales and inventory value vary according to cost flow assumptions i.e. first-in-first-out (FIFO) or last-in-first-out (LIFO). Under FIFO, cost of sales comprises the entire opening stock and current purchases less closing stock. And closing is entirely from current purchase. Under LIFO method, cost of sales comprises current purchase only. However, if the current purchase are less than cost of sales, a part of opening inventory may also become a part of cost of sales. And closing stock comprises purchases made in previous year.5. Ascertainment Of ProfitUnder current purchasing power method, profit can be determined in two ways. They are:i. Re-statement Of Income Method: Under this method, historical income statement is re-stated in CPP terms. Following conversion factors are used to restate the figures of historical cost statement.* Sales and operating expenses are converted at the average rate application for the year.* Cost of sales is converted as per cost flow assumption i.e. FIFO and LIFO.* Depreciation is converted on the basis of indices prevailing on the dates when assets were purchased.* Taxes and dividend paid are converted on the indices that were prevalent on the dates when they are paid.* Gain or loss on monetary items should be shown as separate item to arrive at the overall profit or loss.ii. Net Change Method: This method is based on the normal accounting principle that profit is change in equity during an accounting period. In order to determine profit, following steps are taken.* Opening balance sheet prepared on historical cost accounting method is converted in CPP forms at the end of the year. Monetary and non-monetary items are re-stated by using proper conversion factors. Equity share capital is also converted. The difference in the balance sheet is taken as reserve. Alternatively, the equity share capital may not be converted and the difference in balance sheet be taken as equity.* Closing balance sheet prepared under historical costing is also converted. Only non-monetary items are re-stated. The difference in balance sheet is taken as reserve after converting equity capital. Alternatively, the equity capital may not be restated in CPP terms and balance be taken as equity.* Profit is equivalent to net change in reserve where equity capital has also been converted or net change in equity where equity capital has not been re-stated.6. Restated Balance SheetThe historical balance sheet is prepared as per the historical income statement, so it can not represent the revised or changed value of assets and liabilities. Under the price level change, the historical balance sheet should be revised to reflect the true picture of financial position of any organization. Inside the historical balance sheet, both monetary and non-monetary items are listed. So, the monetary and non monetary items should be separated first of all. It is not necessary to change the monetary item into CPP value because such items are already utilized while calculating the holding gain or loss. Only the non monetary items are to be adjusted to the CPP value by multiplying appropriate conversion factors.Meaning of Current Costing Accounting (CCA) ApproachCurrent 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 statement 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 that relevant

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change in the price is considered significantly. In CCA method, the assets are valued in current cost basis. It does not consider the retail price index. This method considers the replacement value of the assets for its real accounting 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, each 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 profits from revaluation are calculated.6. Liabilities are recorded in their original value because there is no any change in monetary unit.Objectives of Current Cost Accounting (CCA) Approach1. 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, creditors, 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 items.USA and Price-level AccountingThe Financial Accounting Standards Board was established U.S.A. in 1972. The FSAB has issued a number of statements of accounting standards dealing primarily with specific problems. In October 1979, it issued a statement No. 33 entitled ‘Financial Reporting and Changing Prices’ popularly known as Financial Accounting Standard 33 (FAS-33). The standard requires companies to compute inflationary effect on profits in two different ways: (i) constant dollar method, and (ii) current cost accounting method.The first method adjusts inventory costs and depreciation for changes in the consumer price index since the related assets were purchased. The second method adjusts these key items for price changes of specific assets that a company usually holds. However, this information has to be given only as supplementary information.At the time of issue of FAS: 33 it was mentioned that the FASB will undertake a comprehensive review of this statement not later than five years after its publication.Consequently the Board issued an Exposure Draft in December 1984, which relates to current cost/constant purchasing power disclosure together with all pronouncements relating to FAS-33 made from time to time.However in October 1985, the FASB at its meeting decided that the present changing price disclosures required by FAS-33 should be retained for the time being and the Exposure Draft issued in December 1984, as referred above, will not be issued as a final statement.India and Price Level AccountingThe problem of price level changes and its impact on the financial statements has assumed considerable importance in the last few decades. As a matter of the fact the very need for method of accounting to take cognisance of changing prices has been often questioned. The choice of an appropriate method has been widely debated. Keeping in view these facts, the Institute of Chartered Accountants of India issued in September 1982 a Guidance Note

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on Accounting for Changing Prices in the hope that it will stimulate thought and encourage a wider use of the method of accounting for price level changes.The most relevant aspects of the Guidance Note are as follows:(i) The adoption of a system of accounting for changing prices would require a considerable amount of time, money and specialised skills. Also the various techniques are still in the process of development. However, in view of the importance of the subject, it is recommended that enterprises, particularly the large enterprises, may develop the necessary systems to prepare and present this information.(ii) Out of the various methods of accounting for changing prices, the Current Cost Accounting Method seems to be most appropriate in the context of the economic environment in India. The periodic revaluations of fixed assets and the adoption of LIFO formula for inventory valuation are partial responses to the problem of accounting for changing prices. Current Purchasing Power Accounting, though simple to apply, does not ensure the maintenance of the operating capability of an enterprise. Current cost accounting, on the other hand, is a rational and comprehensive system of accounting for changing prices, as it considers the specific effects of prices on individual enterprises and thus ensures that profits are reported only after maintaining the operating capability. However, the introduction of a full-fledged system of Current Cost Accounting on a wider scale in India will inevitably take some time. During this transitional phase, periodic revaluations of fixed assets along with the adoption of UFO formula for inventory valuation would reflect the impact of changing prices substantially in the case of manufacturing and trading enterprises.(iii) Adequate data base has presently not been developed in India for accounting for changing prices. Every enterprise, therefore, may have to select the price indices depending on its own circumstances. The detailed price indices published in its monthly bulletins by the Government of India can be adopted in a number of cases. There is no doubt that further steps will have to be taken for the timely publication of statistical information required by various industries for the implementation of accounting for changing prices.(iv) Considering the importance of the information regarding the impact of changing prices it is recommended that while the primary financial statements should continue to be prepared and presented on the historical cost basis, supplementary information reflecting the effects of changing prices may also be provided in the financial statements on a voluntary basis, at least by large enterprises.Since the presentation of statements adjusted for the impact of changing prices is voluntary, the enterprises may or may not get this information audited. However, the audit of such statements would enhance their credibility.(v) Apart from its utility in external reporting, accounting for changing prices may also provide useful information for internal management purposes. Accounting information system is designed primarily to provide relevant information to various levels of management with a view to assist in managerial decision making, control and evaluation. However, in periods of rapid and violent fluctuations in prices, the information provided by historical cost-based accounting system may need to be supplemented by information regarding the impact of changing prices. The areas in which such information may be of prime importance to management include investment decisions and allocation of resources, divisional and overall corporate performance evaluation, pricing policy, dividend policy, etc.(vi) In countries like the United Kingdom, there have been some reforms in the tax structure in the wake of introduction of accounting for changing prices. Though, the tax legislation in India at present does not give recognition to such an accounting system, even then accounting for changing prices, would be useful for generating relevant information for internal and external decision making.There is no denying the fact that inflation has come to stay. It is, therefore, the responsibility of the business as well as the government and professional bodies to take the bold step of making a positive recommendation regarding providing the shareholders and other concerned with reliable information disclosing the way inflation really hits the profits.

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The system recommended should be simple, suitable to Indian conditions and duly recognised by the government.

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