Accounting for Price Level Changes Introduction, History, Limitations

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. 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 the price 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.

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 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 Price Level Accounting

• Gives strength to the decision making.
• Fair and truth of the financial position and operational results.
• Shows real worth of the company.
• Ensures that business has adequate funds to replace assets.
• Maintains efficiency in operational business.

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.

Investment Market

The price level accounting establishes a realistic price for the shares which also affects the investment market of the company.

Misled

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.

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.

Depreciation

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.

Social Image

The social image of the company that prepares the financial statements adjusted to the price level changes gets improved.

Realistic View

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.

Comparison

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.

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.

Limitations

Deflation Period

Lastly, in the deflation period, when the prices fall, adjustments means overstatement of profits and charging lesser depreciation.

Window Dressing

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.

Alterations

Altering accounts according to the price changes becomes a never-ending process. The process includes constant changes and adjustments in the financial statements.

Depreciation

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.

Complications

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.