Introduction of price level accounting
Price level Accounting is also termed inflation accounting. It refers to the type of financial accounting that seeks to allow for changes in the currency during the various periods of inflation or recession in the economy.
Price level Accounting converts the values using index numbers from depreciated costs to current values. The main idea is to determine the price level when the changes in the economy trigger the neediness of the changing price level for the services and goods purchased by the business, individual, or other entity.
Based on the current status in the economy and the price level prevailing, the process makes it easier to figure what type of value can be received from the purchases.
Objectives of price level accounting
- Fair and truth of the financial position and operational results
- Gives strength to the decision making
- Shows real worth of the company
- Maintains efficiency in operational business
- Ensures that business has adequate funds to replace assets
Advantages of inflation accounting
The company reports very high profits during high inflation but on the other way faced financial difficulties. This happens because the taxes and dividends have been paid from the capital as a result of overstated profits arisen out of adopting the historical cost concept. Therefore, to alter this historical cost concept, price level accounting is recommended.
The price level accounting presents a more realistic view of the company’s profitability. This happens because the current expenses/costs are matched with the current revenues only.
Depreciation is charged on the current value of assets in price level accounting. As a result, this enables the company to show their accounting profit closer to economic profits. Moreover, the replacement of assets can be done when required.
Maintain real capital
Helps the company to maintain real capital to avoid payment of taxes and dividends out of the capital due to inflated profits in accounting historically.
balance sheet reveals a fair and true view
The balance sheet also reveals a fair and true view of the financial position of the company since assets are valued at the current position and not in distorted historical values.
Comparing becomes possible when price level accounting is adopted. This states that when financial statements are denoted according to the price changes, the profitability can be compared for two concerns developed at different times.
Employees, the public and the investors are not misled using inflation accounting which shows realistic profits. Without adjusting the price changes, higher profits create resentment and urge for higher wages among the workers. Moreover, new entrepreneurs get attracted by excessive profits to enter the business.
The social image of the company that prepares the financial statements adjusted to the price level changes gets improved.
The price level accounting establishes a realistic price for the shares which also affects the investment market of the company.
Disadvantages of inflation accounting
However, few people consider that the price level accounting may create problems instead of solving them. As result, they showcase the following disadvantages of price level accounting.
Altering accounts according to the price changes becomes a never-ending process. The process includes constant changes and adjustments in the financial statements.
Inflation accounting does involve a bunch of calculations and makes the financial statements complicated. Therefore, it becomes difficult for the common man to understand, analyse and then interpret.
Price level accounting appears to have theoretical importance rather than practical due to which the adjustment in the accounts may lead to window dressing because of the element of subjectivity in it. People can alter the accounts according to the amounts most suited making the financial statements inaccurate.
Depreciation charged on the assets on current values is not acceptable by the Income Tax Act, 1961. As a result, adjusting depreciation to price changes will not serve any practical purpose.
Lastly, in the deflation period, when the prices fall, adjustments means overstatement of profits and charging lesser depreciation.
Methods of Price Level accounting
The price level changes (inflation or deflation) have a link with the purchase of goods and services and also with the purchasing power of money. Briefly, if R refers to the amount required to purchase a specific quantity of goods, in that case, one dollar would buy 1/R.
However, if we consider money as a commodity, its price level will have a positive correlation while a negative correlation for its demand. The price level changes when the consumer urge for goods changes for a specified period, year or month. Moreover, the price level is termed as the value of assets traded on the market.
1. Current purchasing power Technique 2. Replacement Cost Accounting Technique 3. Current Value Accounting 4. Current Cost Accounting
The current purchasing power technique or CPP of price level accounting make the companies keep the records and show the financial statements on a historical cost basis. But apart from this, the method needs the presentation of supplementary financial statements of items at the end of the accounting period in the current purchasing power of the money/currency.
This method covers the adjustment of the various items in financial statements like profit and loss and balance sheet with the help of the general price index. However, the CPI(Consumer Price Index) and WPI(Wholesale Price Index) prepared by RBI can be chosen for the conversion of historical costs.
The main goal of this method is that it takes into consideration the changes resulting in the value of money due to the change in the general price levels. It presents the financial statements in terms of constant value ( a unit of measurement) when both revenue and costs changes due to the change in price levels.
Although this method is simple and followed by companies still it is termed as only the first ladder for inflationary accounting or price level accounting.
Mechanisms under the CPP method:
- Conversion technique
- Mid- period conversion
- Non- monetary and monetary accounts
- Adjustment of cost of inventory and sales
- LIFO method
- FIFO method
- Ascertainment of profits
- Net change method
- Conversion of income method
Replacement Cost Accounting Technique
Replacement Cost Accounting Technique is referred to as an improved version of CPP( current purchasing power technique). The major drawback of CPP is that it does not consider the price index individually related to the assets of the company.
In the RCA technique, the index used is directly related to the company’s assets and not to the general price index. However, using the RCA technique means adopting different price indices for the conversion of items in the financial statements. Therefore, it makes the calculation of the relative price index difficult in a particular case. Furthermore, this method gets criticized by thinkers due to the element of subjectivity in it.
Current Value accounting
In this method of price level accounting, all the liabilities and assets are represented in the balance sheet at the current values. The difference in the net assets calculated at the beginning and end of the accounting period is ascertained which is known as the profit or loss.
Similar to the RCA technique, this method also includes an element of subjectivity. Moreover, it becomes difficult to determine with a relevant price index.
Current Cost accounting
The British Government appointed Sandilands Committee with a chairman named Mr Francis C.P. Sandilands to recommend and consider the price level accounting. By recommending the adoption of the current cost accounting technique as the price level accounting in the reports of the committee (in 1975), it replaced the replacement cost accounting technique.
Therefore, the current cost accounting technique focused on the current values of individual items in the formation of financial statements and not on the original cost/historical cost.
Key characteristics are as follows:
- Depreciation charged on fixed assets is on current value.
- Stocks are valued at current replacement costs at the end of the year or the market price whichever is lower.
- COGS is not calculated on its original cost but the replacement costs of the business.
- The surplus that arose from revaluation is not distributed rather transferred to the revaluation account.
- In addition to the financial statements( balance sheet & profit and loss a/c), a statement of changes and appropriation account is prepared.
Adjustments under the CCA technique : 1. Current Cost of Sales Adjustment (COSA) 2. Backlog Depreciation 3. Monetary Working Capital Adjustment (MWCA) 4. Current Cost Operating Profit 5. Gearing Adjustment