Accounting for price level changes

Introduction

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 to time. The change in price as a result of
various economic and social forces brings about a change in the purchasing power of money.
Under Historical Cost Accounting, it is assumed that money has stable value. But in reality,
the value of money varies from time to time. The historical accounting system doesn't
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 changes

The general tendency in changes of prices of goods and services over a time is called price
level. The rise is general price level is called inflation. During the period 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 increase. Price level changes mean increase
or decrease in the purchasing power of money over a period of time. The accounting which
considered 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 value. This system of accounting ascertains profit
or loss and present financial position of the business on the basis of current prices.
Accounting for price level changes is also known as inflation accounting because most of the
countries of the world is experiencing inflation since Second World War.

According to American Institute of Certified Public Accountants (AICPA),"inflation

accounting is a system of accounting which purports to records, as a built in mechanism, all
economic events in terms in terms of currents cost."

Impact of inflation
1. Inflation causes decline in purchasing power of money. It increases expenditure and
discourages saving.
2. During inflation, purchasing power of money declines, as a result, debtors gain and
creditors lose.
3. During inflation, cost of living increases. It hurts the people whose income is fixed.
4. Capital formation is reduced. Consequently, the investment decreases. And the production
also decreases and unemployment increases.
5. Due to inflation, there is continues fall in the value of domestic currency. Hence, people
lose faith in local currency.
6. Inflation increase lack-marketing, theft, robbery, prostitution, bribery and so on. It corrupts
the society.
7. Inflation brings political instability.

Limitation of historical cost accounting (HCA)

 No consideration of price level changes
 Unrealistic fixed assets values

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  Insufficiency provision for depreciation
 Unrealistic profit
 Consequence of over-stared profit
 Mixing up of holding and operating gain
 No consideration of gain or loss on net monetary assets
 Fails to present a fair value of financial position

Objective 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 in never stable and most of the countries have
been experiencing high rate of inflation since last 40 years. Therefore, financial statements
prepared under historical cost accounting do not reflect current economic realities. They fail
to give realistic and correct pictures of the state of affairs of a concern. To overcome the
limitations of historical cost accounting, there is a need to consider the effects to changes in
value of money as a result of changes in price of goods and services.
•    To show the true result of the operations i.e. real profit or loss.
•    To show the true financial position in current value.
•    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.

Method of accounting for price level changes

There are many methods of adjustment for the effects of changes in price. The generally
accepted methods accounting for price level are as under:
 Current purchasing power method or general purchasing power method [CPP method]
 Current cost accounting method [CCA method]
 A hybrid method i.e. mixture of CPP and CCA method.

Current purchasing power (CPP) method

This method was evolved by the Institute of Chartered Accountants of England and Wales in
May 1974. The institute issued the provision statement of the standard accounting practice
(SSAP) No. 7 entitled "Accounting for changes in the Purchasing Power of Money." this
standard advocated the preparation of a supplementary based on current purchasing. Power
approach, using he retile price index as an index of general price change.

Under current purchasing power method, any established and approved general price index is
used to cover the value 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 owned 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 cost items in terms of current value

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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 cages in value of
money. This method takes into consideration the changes in 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

•    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.
•    Any supplementary statement prepared under CPP method is based on the historical
statement.
•    Consumer price index (retail price index) or wholesale price index is used as conversion
factor for re-statement of historical items.
•    All the items in financial statement are classified into monetary and non-monetary items,
non-monetary of historical items.
•    Net gain or loss on adjustment of monetary items is to be accounted in the profit & loss
account.

Steps of CPP method

Under 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:
•    Calculation of conversion factor.
•    Distinction of gain or loss on monetary items.
•    Calculation of gain or loss on monetary items.
•    Valuation of cost of sales & inventories.
•    Ascertainment of profit.
•    Preparation of re-sated balance sheet.

1. Calculation of conversion factor

Conversion factor= price index at the date of conversion/ price index at the date of time arose

2. Distinction between monetary account and non-monetary accounts

CPP method classified all assets and liabilities into two groups' i.e. monetary items and non-
monetary items. Monetary items are assets and liabilities, the amount of which are receivable
or payable in fixed amounts irrespective of changes in purchasing power. Such items are
receivable or payable only at current monetary value. Monetary assets include cash, bank,
bills receivable, debtors, prepared expenses, account receivable, investment in bonds cash,
bank, bills receivable, debtors, prepared expense, account receivable, investment in bonds or
debentures, accrued income etc. monetary liabilities include creditors, account payable, bills 
payable, outstanding expense, notes payable, dividend payable, tax payable, bonds or
debentures, loan, advance income, preference share capital etc.

Monetary accounts are automatically stated in current rupees and therefore, do not required to
be re-stated.

Non-monetary items are those items which cannot be stated in fixed monetary value are
called non-claims. Non-monetary accounts – Such items denote the assets and liabilities that
do not represent special monetary claims. Non-monetary accounts include land, building,
machinery, vehicles, furniture, inventory, equity share capital, irredeemable preference share

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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 monetary items

Monetary items are receivable or payable in fixed amount irrespective of changes in
purchasing power of money. The changes in purchasing power of money have an effect on
monetary assets and monetary liabilities. Therefore, the holding of such items result 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 holding of
monetary liabilities result in gain. Such gain or loss must be taken into amount when income
statement is prepared under CPP method to arrive at the overall profit or loss.

4. Cost of sales and inventories

Cost 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 method, cost of sales comprises the entire
opening stock and current purchases less closing stock. And closing stock is entirely from
current purchases. Under LIFO method, costs of sales comprise current purchases only.
However, if the current purchases are less, than closing stock comprises purchases made in
previous year.

The following conversion factor is used to restate the historical figures in CPP value.
For purchases – average
For opening stock – beginning
For closing stock     
If FIFO method is used – average
If LIFO method is used and closing stock is out of opening stock – beginning; but if closing
stock is out of purchases – then average

5. Ascertainment of profit
Under current purchasing power method profit can be determined in two ways. They are:

(A) 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. It involves following steps -
a. Sales and operating expenses are converted at the average rate application for the year.
b. Cost of sales converted as per cost flow assumption i.e. FIFO and LIFO.
c. Depreciation is converted on the basis of indices prevailing on the date when fixed assets
were purchased.
d. Taxes and divided paid are converted on the indices that were prevalent on the dates when
they were paid.
e. Gain or loss on monetary items should be shown as a separate item to arrive at the overall
profit or loss.

(B) 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, the following
steps are taken.
a. 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
conversion factors. Equity share capital is also converted. The difference in the balance sheet

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is taken as reserve. Alternatively, the equity share capital may not be converted and the
difference in balance sheet be taken as equity.
b. Closing balance sheet prepared under historical costing is also converted. Only non-
monetary items are re-stated. The difference is balance sheet is taken as reserve after
converting equity capital. Alternatively, the capital may not be re-stated in CPP terms and
balance be taken as equity.
c. Profit is equivalent to net change in reserve where equity capital has also been converted or
net change in equity where equity has not been re-stated.

6. Restated balance sheet

The historical balance sheet is prepared as per the historical income statement, so it can not
represent the revised or changes value of assets and liabilities. Under the price level change,
the historical balance sheet should be revised to reflect the true pictures 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 are to be separated first 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.

The following things are to be considered while preparing the restated balance sheet.
a) Monetary assets and monetary liabilities do not need any adjustment
b) Conversion factor for the stock will be determined by the methods of issuing the stock
from store i.e. LIFO or FIFO.
c) Conversion factor of the fixed assets and depreciation depends up on the date of
acquisition.
d) Conversion factor for the equity share capital depends upon the date of shares issue; if
the date is not given the beginning conversion factor is used.
e) The balancing figure of the restated balance sheet is the current purchasing power
retained profit. It should be equal to the profit by the restatement under CPP method.

Advantages or merits of CPP method

•    This system adopts the same unit of measurement by taking into account the price
changes.
•    Under this system, historical accounts continue to maintain. CPP statements are prepared
on supplementary basis.
•    This system facilitates the calculation of gain or loss in purchasing power due to the
holding of monetary items.
•    It uses common purchasing power as measuring unit. So, the comparative study is easy.
•    This method provided reliable financial information for taking management decision to
formulate plans and policies.
•    It 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.

Criticisms of CPP method

•    This method considers only the changes in general purchasing power. It does not consider
the changes in the value of individual items.
•    CPP method is based on statically index number which cannot use in an individual firm.
•    It is very remove all the defects of historical cost accounting systems.
•    The use of general price index for CPP method is questioned. While general price deals
with consumer goods, business is interested in the price movement of producer goods.

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Current costing accounting (CCA) approach

Current costing method is an alternative to CPP method. To overcome the difficulties of CPP
method, CCA approach was introduced in 1975 in Britain. 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 citizen by the business world. To modify the
CPP system UK government form a committee under the chairmanship of C P Sandale. His
committee issues the report in 1975. The committee strongly recommended for the adaption
of CCA approach in place of CPP method. In 1980 accounting committee of UK government
finessed the CCA approach by issuing standard accounting practice 16 [SSAP-16].

CCA approach recognizes the changes in the price of individual due to the change in general
price level. This is the method which included the process of preparing and interpreting
financial statement in such a way that relevant hanged in the price is considered significantly.
In this method the assts are valued in current cost basis. It doesn't consider the retails price
index. This method considered the replacement value of the assets for its real accounting
records. The value of assets at which 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 too restated in terms of the current value of
such items.

Objective of CCA approach

1. To provide correct and reliable financial information based on the current replacement
cost.
2. To calculated the profit without changing the historical profit.
3. To protect he business in the event of normal inflationary situation
4. To keep the level of capital in very balance position by making valuation of assets in
proper value bade on replacement value.
5. To provides the realistic information to the management, investors, creditors, government
and to other interested parties.
6. To prepared the financial statement at the end of the year on the basis of current value of
such items.

Feature of current cost accounting

1. The fixed assets rerecorded at replacement cost value in the balance sheet.
2. Inventories are show 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
divided to shareholders.
4. Depreciation of fixed assets is to be calculated at replacement value.
5. Two types of profit i.e. profit form operation and profit from revaluation are calculated.
6. Liabilities are recorded in their original value because there is no any change in monetary
unit.

Major steps in current cost accounting approach

There are nine steps in current cost accounting approach

1. Fixed assets adjustment

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The main purpose of CCA approach is to show the fixed assets in their current value. There
are three method of valuing the fixed assets. The surplus in the increase in value of fixed
assets is transferred to the current cost accounting reserve.

Current replacement value: it is the amount which is to be paid for the replacement of old
fixed assets. When the old fixed assets are to be replaced by purchasing the new fixed assets,
certain amounts of money is to be spent. The amount is called replacement value. Under this
method the fixed assets are to be recorded in replacement value, the net replacement value
under this method the fixed assets are to be recorded in replacement. The replacement value
is calculated buy deducting the replacement value of accumulated depreciation from
replacement of fixed assets.

Net realizable value: the expected value of assets which can be recorded by the sale of such
assets after deducting the realization expenses is called net realizable value. The net
realization value is shown in the balance sheet. With the help of net realizable value, the
inventors and the creditors can know about the future risk of the business.
Economic recoverable value: the existing assets and earn income in future also. The present
value of any future income which is to be earned is the economic value. It is shown in the
assets side of balance sheet. According to SSAP-16 the following recommendation was made
for identifying the value to the business of non monetary assets.

Formula for calculation of fixed assets adjustment

Fixed assets adjustment= net CCFA – net HCFA
Net CCFA = net current cost fixed assets = current cost fixed assets- current cost depreciation
Net HC fixed assets= net historical fixed assets = historical fixed assets- historical
depreciation

2. Depreciation adjustment
Depreciation is changed on fixed assets for the use of assets in business. Depreciation is the
difference between the current cost and historical cost and historical cost depreciation figures
for the year concerned. Depreciation adjustment is debited to profit and loss account credited
to current cost accounting reserve. When the fixed assets are revaluated each year, there will
be shortfall of depreciation due to the effect of price rise during the period. This shortfall of
depreciation is called backing depreciation adjustment will be calculated as follows:

Depreciation adjustment= current cost depreciation of current year – historical depreciation

of current year

3. Inventory adjustment
Actual the closing stock in the historical sheet is to be revalued according to current cost
methods. The inventory is revalued by multiplying the inventory by the related convection
factors. Any real increase in value of inventory should be transfer to the cost accounting
reserve.
Inventory adjustment = CC inventory – HC inventory

4. Cost of sales adjustment [COSA]

It calculated the changes in the value of cost of goods sold. It is actually the difference
between historical cost of sales and the current value of cost of goods sold. The value of stock
should be calculated at the date of sales not at the date of purchase. The COSA effectively

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converts cost of sales from historical cost to current cost basis. COSA is debited to profit and
loss account and credited to current cost accounting reserve.
COSA= (c-o) – Ia [c/ic- o/io]

5. Monetary working capital adjustments [MWCA]

Monetary working capital is the difference between monetary current assets and monetary
current liabilities. Monetary current assets included debtors, bills receivable, prepaid
expenses, stock which is not include in the cost of sales adjustment. Likewise monetary
current liabilities included creditors, not included in the bank overdraft because bank
overdraft is include in bills payable but it does not including the bank overdraft because bank
overdraft is included in borrowing while calculating the Gering ratio. Similarly, under the
current assets stock and cash are not included stock is used in COSA and cash is used in for
calculating the Gering ratio. Monetary working capital adjustment is calculated as under:

Net monetary working capital = trade debtors + prepared expense + bills receivable –
creditors – accrued expense – bills payable.

6. Gearing adjustment
Total capital of a company may comprise shareholder's fund and borrowing. Gearing is the
ratio of borrowed capital and total capital employed. It is the ratio of average net borrowing
to the sum of borrowed capital and average shareholders' equity. Gearing adjustment is
debited to current cost accounting reserve and credited to current cost profit and loss account.
Gearing ratio and gearing adjustment can be calculated as follows:

Gearing adjustment (GA) = gearing ratio x total adjustment

7. Current cost accounting reserve (CCAR)

The adjustment amount of reserve is called the current cost reserve. It is the amount of
additional reserve which is to be shown on the liability side of current cost balance sheet.
Current cost accounting reserve is calculated as follows:

8. Current cost income statement

Historical income statement does not show the revised profit because it is prepared on the
basis of historical data. Therefore the historical income is to be relating to identify the
adjusted profit and loss. The adjustment profit and loss is how in the current cost balance
sheet.

9. Current cost balance sheet

This is actually the final steps in CCA approach. Historical balance sheet converted in the CC
balance sheet. After completing the all eight steps, this balance sheet is prepared which shows
the adjustment or revised value of all the assets and liabilities. All the current liabilities, share
capital, long term debts, debentures are shown in historical value on the other hand fixed
assets, stock accumulated depreciation are shown in replacement value where as current
other  than stock are shown in historical value.