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Accounting for price level changes ppt

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prepared for M.com Sem 4 by Ashish siddiqui, assistant professor...

prepared for M.com Sem 4 by Ashish siddiqui, assistant professor...

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  • 1. Accounting for Price level changes Presentation By Ashish Siddiqui MBA, M.com, C..S (inter) Assistant Professor, SSB (AICTE approved) Compiled by Ashish siddiiqui
  • 2. 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 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 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 Compiled by Ashish siddiiqui system.
  • 3. Meaning 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. Compiled by Ashish siddiiqui
  • 4. Nature of price changesBasically price changes can be divided in the classes as follows: 1. General Price Changes 2. Specific Price Changes 3. Relative Price Changes Compiled by Ashish siddiiqui
  • 5. Nature of price changes…cont.. General Price Changes General price-level changes reflect the value of the monetary unit over time. The total supply of money and the total supply of goods and services in the economy fluctuate, but not usually at the same rate. This disparity leads to inflation or deflation, changing the value of the monetary unit. Changes in commodity prices or a discrepancy between total supply and demand of goods and services can also lead to general price changes. Because prices change at different rates, general price changes can only be measured by calculating the average level of current prices and comparing it with a base period For example, if the base period is 1998 and prices have increased by 50% between 1998 and 2003, the index will be 150 in 2003. The reciprocal of this ratio expresses the change in purchasing power. Thus, while prices have increased by 50%, purchasing power has decreased by one third. Purchasing power refers to the amount of goods and services that can be purchased with a monetary unit. Compiled by Ashish siddiiqui
  • 6. Nature of price changes…cont.. Specific Price Changes Specific price change is the change in the price of a particular commodity, or thechange in its exchange value. Specific price changes are caused by some factorsspecific to the commodity, such as:- Changes in tastes of consumers- Technological improvements- Speculation- Natural or artificial changes in the supply of particular products, etc Compiled by Ashish siddiiqui
  • 7. Nature of price changes…cont..  Relative Price Changes Normally speaking, prices of different goods and services do not move insync with each other, much less in the same direction. A relative price changeis defined as the change in the price of a specific commodity as compared toan index such as the Consumer Price Index. For example, if the ConsumerPrice Index increased by 10% over last year and car insurance doubled in theMaritimes, we can say that the relative price increase in car insurance isapproximately 82%. Compiled by Ashish siddiiqui
  • 8. Shortcomings of Historical cost based accounting Historical cost method, over a period of time has been subject to many criticisms, especiallyas it considers the acquisition cost of an asset and does not recognize the current market value.Historical costs is only interested in cost allocations and not in the value of an asset. While it tellsthe user the acquisition cost of an asset and its depreciation in the following years, it ignores thepossibility that the current market value of that asset may be higher or lower than it suggests. Another main criticism of historical accounting method is its obvious flaws in times ofinflation. The validity of historic accounting rests on the assumption that the currency in whichtransactions are recorded remains stable, i.e. its purchasing power remains the same over a periodof time. Another main point with regards to inflation is rise in prices for an asset. An assetpurchased at a point in time may be expensive in future. The traditional accounting principlesrecord all assets at an original cost and continue to use these historic figures throughout the assetslife, while economists make a more intelligible assumption that money has a time-value attachedto it. The economists approach is broadly embraced in the corporate finance model whoseobjective is centred on value creation for the shareholders. In addition effects of inflation may not be the same for all the companies in the market andhistorical cost accounts become almost unhelpful when comparing corporate performance Compiled by Ashish siddiiqui
  • 9. Distortion in reported Profit The Accounted would define Business profit as the difference between the business Revenue and its related cost. However during the inflationary this business profit reveals errors in actual profit. This distortion is due to following reasons; Cost of goods sold Depreciation Miscellaneous expenses Purchasing power and gains and losses Compiled by Ashish siddiiqui
  • 10. Suggested Adjustment techniques/methods Creation of Reserves: A part of profit is transferred to the reserves which may used for the meeting the increased cost of asset replacement. Reserves eliminates the problem of assets replacement as well as reduce the overstated profits. The techniques is very used in many countries. Bur it is often an arbitrary decision how much of the profit should be charged be transferred to reserves. The transfer may not help adjust completely the inflation factor. Revaluation of assets: The book value of the assets is revised which helps the cost of assets to conform to the current price and thereby provides a realistic measure of capitalization. Depreciation is charged on the revised value which is able to meet the replacement cost of assets. The overstatement of profits is also checked, It is common method used in many countries. Compiled by Ashish siddiiqui
  • 11. Suggested Adjustment techniques/methods…cont.. LIFO Method of inventory valuation. Inventory is valued in such a way that helps match current revenue with current cost of goods. Income statement shows a collection of the most recent purchased cost. However this method is useful in those cases where raw material purchased at frequent intervals and where all goods produced are sold during the same period. In many countries this method of inventory valuation is not allowed as understates the profit and thereby reduces tax liability. Current value accounting This method is applied in the case of price rise of the specific commodities. Since a firm is continually replacing its assets , it is the replacement cost and not the historical cost that should be taken into account while preparing the income statement or the balance sheet. If the value of the inventory rises by 40% the equity needs upward revaluation by the same percentage so that the risen cost of inventory is met increased liabilities. Compiled by Ashish siddiiqui