Accounting for price level changes

Accounting for Price Level Changes
Prof. Mallikarjun Bali
BLDEA’s VP Dr. P G H College of Engg & Tech Bijapur
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 system.
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.
Price Level Accounting
In view of the above, it has been increasingly felt that the accountant will be failing in his duties if he continues to remain
content with the time honored and traditional system of accounting by historical cost. He should move with the time and
evolve a suitable system of accounting to deal with the changing price levels.
Price level accounting may, therefore, be defined as that technique of accounting by which the financial statements are
restated to reflect changes in the general price level. Such changes, as stated earlier, may be either inflationary or
deflationary. Of course, inflation has come to stay and, therefore, price level accounting is more concerned with
inflationary tendencies.
Inflation Accounting
It will not be out of place here to define the term inflation accounting. According to the American Institute of Certified
Public Accountants, .Inflation accounting is a system of accounting which purports to record as a built-in mechanism all
economic events in terms of current cost.. Thus, inflation accounting is a system of maintaining the accounts just like
historical accounting. The difference lies in the process of matching-cost against revenue. In historical accounting cost
represents historical cost wherein inflation accounting it represents the cost prevailing at the reporting date or time. .This
matching process in inflation accounting should be automatic and inbuilt in the system itself and not ad hoc in nature

dealing only with some economic and financial events. la other words, it will be wrong to equate replacement cost
accounting with inflation accounting.
Types of Prices
1. 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.
2. Specific Price Changes
Specific price change is the change in the price of a particular commodity, or the change in its exchange value. Specific
price changes are caused by some factors specific to the commodity
3. Relative Price Changes
Normally speaking, prices of different goods and services do not move in sync with each other, much less in the same
direction. A relative price change is defined as the change in the price of a specific commodity as compared to an index
such as the Consumer Price Index. For example, if the Consumer Price Index increased by 10% over last year and car
insurance doubled in the Maritimes, we can say that the relative price increase in car insurance is approximately 82%.
Limitations of Conventional Financial Statements
(i) Fall to disclose current worth of the enterprise. The financial statements prepared under the conventional system are
merely statements of historical facts. They do show the true current worth of the enterprise.
(ii) Contains non-comparable Items. The financial statements contain items which comparable since they are usually a
composite of historical and current costs.
(iii) Creates problems at the time of replacement. According to the conventional method, depreciation is charged on the
historical cost of the asset. Problems, may, therefore, arise when the asset has to be replaced and larger funds are required
on account of inflationary conditions.
(iv) Mixes holding and operating gains. In conventional accounting, gains on account of holding the inventories may be
mixed up with the operating gains.
Methods of Accounting for Changing Prices
The following are the generally accepted methods of accounting for price level changes:
1. Current Purchasing Power Method or General Purchasing Power Method (CPP or GPP Method).
2. Current Cost Accounting Method (CCA Method).
3. Hybrid Method, i.e., a mixture of CPP and CCA methods.
Current Purchasing Power Method
The method of current purchasing power was evolved by the Institute of Chartered Accountants of England and Wales by
issue of the Provisional Statement of Standard Accounting Practice No. 7 (SSAP-7) entitled, .Accounting for Changes in
the Purchasing Power of Money., in May 1974.
According to this method all items in the financial statements are to be restated for changes in the general price level. For
this purpose, any approved price index is used to convert the various items of the balance sheet and the profit and loss
account.
Preparation of the financial statements according to CPP Method The following steps are taken in preparing the financial
statements.
(i) Conversion factor.
(ii) Mid-period conversion
(iii) Monetary and non-monetary items
(iv) Gain or loss on monetary items
(v) Cost of Sales and Inventories
Determination of Profit
The profit under CPP Method can be determined in two ways:
Net change method This method is based on the normal accounting principle that profit is the change in equity during an
accounting period. In order to determine this change the following steps are taken:

(a) Opening balance sheet prepared under historical cost accounting method is converted into CPP terms as at the end
of the year. This is done by application of proper conversion factors to both monetary as well as non-monetary
items. Equity share capital is also converted. The difference in the balance sheet is taken as reserves.
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 cost accounting is also converted. Of course, monetary items are
not restated, as explained earlier. The difference between the two sides of the balance sheet is put as Reserves
after converting the equity capital. Alternatively, the equity capital may not be restated in CPP terms and the
balance be taken as equity.
(c) Profit is equivalent to net change in Reserves (where equity capital has also been converted) at net change in
Equity (where equity capital has not been restated).
Conversion or restatement of income statement method In case of this method, the income statement prepared on
historical cost basis is restated in CPP terms generally on the following basis:
(a) Sales and operating expenses are converted at the average rate applicable for the year.
(b) Cost of sales is converted as per cost flow assumption (FIFO or UFO) as explained in the preceding pages.
(c) Fixed assets are converted on the basis of the indices prevailing on the dates they were purchases. The same applies to
depreciation,
(d) Taxes and dividends paid are converted on the basis of indices that were prevalent on the dates they were paid.
(e) Gain or loss on account of monetary items should be calculated and stated separately in Restated Income Statement to
arrive at the overall figure of profit or loss.
Criticism of the CPP Method
The Current Purchasing Power Method contained in SSAP-7 did not find favour with a large number of accountants,
economists, and Government authorities on account of the following reasons:
(1) CPP Method is based on Index Nos. which is statistical averages. The method cannot, therefore, be applied with
precision to individual firms.
(2) The selection of a suitable price index is a difficult task, since there are various price indices characterizing different
price situations.
(3) The method deals with changes in the general price level and not with changes in prices of individual items, except in
so far as individual prices happened to move in step with general price index.
Current Cost Accounting Method
In view of the general complaint that CPP method is not adequate for reporting price level changes, the U.K. Government
appointed a committee under the chairmanship of Sir Francis Sandilands. The report of the committee was published in
September, 1975 and SSAP-7 was withdrawn. In its report, the committee recommended the adoption of current cost
accounting system as a method for correcting the deficiencies of the historical cost accounting which fails to provide
sufficient information as required by the users of accounts. The current cost accounting system has been extensively
studied and debated. It has now been finalized by the issue of Statement of Standard Accounting Practice-16 (SSAP-16) in
March, 1980, by the Accounting Committee of U.K.
Meaning The method requires each item of financial statements to be restated in terms of the current value of the item.
No cognizance is taken of changes in the general purchasing power of money. Assets are shown in terms of what such
assets would currently cost.
Adjustments/previsions In order to achieve the objectives stated above, the following adjustments/provisions are usually
made.
Revaluation Adjustment. The fixed assets are shown at their .Value to the business. But not at their depreciated original
cost. Value to the business means the amount which the company would lose, if it were deprived of the assets. It may be
defined in any one of the following ways;
(a) Net current replacement value: This refers to the money now required to buy a new asset of the same type as an
existing one less an amount of depreciation that recognizes the fact that the true replacement of the asset would
not be a new asset but an asset which has the same remaining useful life as the existing asset.
(b) Net realizable value: This is the value which is represented by the net cash proceeds if the existing asset is sold
now.
(c) Economic/recoverable value: This refers to the present value of net income that will be earned for using the
existing assets during the rest of its life.

The difference between the value of fixed assets under Current Cost Accounting System and Historical Cost
Accounting System is transferred to a capital reserve styled as .Current Cost Accounting Reserve.
Depreciation Adjustment. The charge to the profit and loss account for depreciation should be equal to the value of the
fixed assets consumed during the period. When the fixed assets are valued on the basis of their net current replacement
cost the charge should be based on such cost. A suitable depreciation adjustment is, therefore, required in historical cost
profit to determine the current cost profit.
1. On the basis of total replacement cost of the asset
2. On the basis of average current cost of assets
Backlog Depreciation When the Fixed Assets are revalued every year there will also be shortfall of depreciation
representing the effect of price rise during the year on the accumulated depreciation till date. This shortfall is called .Back-
log Depreciation. Which is the amount needed to uplift the accumulated depreciation to a figure needed to cover the total
depreciation provision based on the replacement cost at the year end. This backlog depreciation arising out of current cost
is charged against the Current Cost Accounting Reserve and credited to the Provision for Depreciation Account.
Cost of sales adjustment (COSA) CCA method is based on this important principle that current cost must be matched
against current revenue for determining the operating profit or loss. The amount of sales is the current revenue and hence
no adjustment is required in its figure. However, items which enter into the computation of cost of sales such as, raw
materials consumed or finished goods sold, have to be taken at the present value at which these would have to be replaced
if consumed or sold. The difference in values is termed as cost of sales adjustment which is debited, before deriving the
operating profit to Profit and Loss Account and credited to Current Cost Accounting Reserve Account.
Monetary working capital adjustment (MWCA) Due to increase in prices, additional monetary working capital is
required for efficient and profitable operation of the enterprise. The term monetary working capital refers to the aggregate
of accounts receivable and prepayments less accounts payable and accruals. Current cost accounting ensures this through
the medium of a .Monetary Working Capital Adjustment. The additional net monetary working capital required purely on
account of increase in the price levels (and not on account of increase in scale of operations) is provided for by charging
to the Profit and Loss Account with such increase and crediting the Current accounting Reserve.
Gearing adjustment Finally, under the Current Cost System, there is also a .Gearing Adjustment.. This is necessary
because a part of the net operating assets are financed by borrowings which are to be repaid in the same monetary amount
irrespective of changes in prices. The other adjustments referred to in sub-paragraphs (ii) to (iv) above, and which cover
the impact of price changes on the assets for the purpose of determining the profits, must, therefore, be appropriately
reduced to reflect the net adjustment as applicable only to shareholders Funds. This is done by adding back a
proportionate amount calculated as a Gearing Adjustment.
Evaluation of CCA System
1. It does not provide adequately for backlog depreciation
2. Fails to provide funds for replacement of new types of assets
3. Inadequate gearing adjustment
4. Ignores gains or losses on monetary items
5. Variations in accounting methods
Hybrid Method
Recently some authorities have suggested another method which is essentially a compromise formula between CPP
method and CCA method. According to this method the adjustments of fixed assets and inventories are to be made with
reference to specific indices in place of a general index as is the case under CPP method. Besides this, purchasing power
gains and losses in respect of monetary items are also considered which are ignored under CCA method. Advocates of this
method argue that by combining these two methods, the advantages of both can be obtained.
The method, on the face, appears to be a satisfactory compromise formula but its acceptance may prove difficult because
of theoretical objections against such a compromise. Moreover, the method is also subject to the limitations of both CCA
and CCP methods.
The method is still in its evolutionary stage and suggestions varying in nature and implications would continue to be made
in the coming years. It will take a long time before a set of well defined procedures and guidelines is developed. The
method cannot, therefore, be recommended for practical application at the present moment.

India and Price Level Accounting
The 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 cognizance 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 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 specialized 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.
(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.
(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.
(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.
(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.

Accounting for price level changes

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