what is Accounting for price level changes?

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 changes 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.

Accounting is the language of business. The basic objective of accounting is to prepare financial statements is such a ay 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 financial position of the business on a particular date .the recording of business transactions under the assumption the monetary unit is stable is called historical cost accounting (HCA). Under HCA, assets are recorded by the business astute price at which they are acquired and there will be no change in their value even if the market value of such change. Likewise, liabilities are recorded at get amount contracted for and such amounts are not revenues are recorded on a 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 doesn't consider to 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 accounts (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
 Inflation means the increase in general level of prices. Due to increase in general level of price, the value or purchasing power of money declines. In other words, inflation is upward movement in the prices of goods and services. When the price of goods or services decreases, the movement is referred to as deflation. Due to deflation, the value or purchase power of money increases.

During last 30-40 years, almost all continues of the word have expected some degree of inflation. Inflation has user verbal social, political and economic effects. The border in inflation fails more heavily on those who cannot bear. It brings political instability. Inflation is economically unsound, political these who cannot bear. It brings political instability. Inflation is economically unsound, political dangerous and morally distrust. The impact of inflation can be explained as under.
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 increase. It hurts the people whose income is fixed.
4.    Capital formation is reduced. Consequently, the investment decrease. 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)
Financial statements prepped under historical or conventional accounting system suffer from a number of limitations, which are mentioned as below:
No consideration of price level changes: financial statements prepared under historical cost accounting are merely statement of historical facts. Changes in the value of money as a result of changes in general level of price are not taken into account. Hence, they fail to give true and fair picture of the affairs of the organizations.
Unrealistic fixed assets values: in historical cost accounting, fixed assets are recorded and presented further; assets acquired on difference dates are acquired. Changes in the market value of such assets are ignored. Further. Assets acquired on different dates are added up at acquisition cost without any regard to changes in the purchasing power of money. Hence, fixed assets values are unrealistic and do not reflect the current worth of business.
Insufficiency provision for depreciation: depreciation is a mechanism of generating funds to replace the fixed assets when the replacement becomes due. In HCA, depreciation is charged on the basis of historical cost of fixed assets, not at the price at which the same assets are acquired. The provision made by way of depreciation charge on the original cost will not be sufficient for the replacement of assets.
Unrealistic profit: income statement prepared under HCA does not reveal true profit. Revenues are recorded on current value basis whereas expenses are recorded at historical cost. Profits are over-stated during the period of inflation.
Consequence of over-stared profit: during the period on inflation, profits are over-stated under HCA. The consequences of over-statement profit are:
•    There will be payment of more-taxes.
•    Dividend payment might be out of capital.
•    Employment & trade unions could demand for higher wages and bonus.
•    Over-statement of profit may mislead to shareholders, mangers and creditors in decision-making.
Mixing up of holding and operating gain: in conventional or historical cost accounting, gain or loss on account of holding inventories may be mixed up with operating gain or loses. Holding gain or losses should be segregated from operating gain or losses to determine the true operating performance.
No consideration of gain or loss on net monetary assets: during the period of inflation, holders of monetary items assets lose and holder of monetary liabilities gain. Income statement prepared under historical costing ails to take into account gain or loss on monetary items.
Fails to present a fair value of financial position: balance sheet consists of monetary and non-monitory items. Monetary items like cash, loan, debtors, creditors etc. are shown at their current money value. Non-monetary items like inventory, building, land etc are shown at historical costing, not at current value. During periods on inflation, non-monetary items are understated. Thus, balance sheet fails to present a fair value 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 ad 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:
i.    Current purchasing power method or general purchasing power method [CPP method]
j.    Current cost accounting method [CCA method]
k.    A hybrid method i.e. mixture of CPP and CCA method.
Current purchasing power (CPP) method
The introduction of CPP method is one of the greatest revaluations is accounting field. This method was evolved by the institute of charade accountants in England and Wales in May 1974. The institute issued to provision statement of the standard accounting practice (PSS AP) 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 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
The main features of CPP method are as follow:
•    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.

Advantages or merits of CPP method
CPP method is useful for finding out real financial position of organization. Following are the advantages 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
Following are the some major points for the criticism 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.
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
CPP method involves the re-statement of historical figure at current purchasing power. For this purpose, historical figure must be multiple by conversion factors: the formula for the calculation of conversion factor is:

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

 The following conversion factor is used to restate the historical figures in CPP value.
i.    For purchases     average
ii.    For opening stock    beginning
iii.    For closing stock     
FIFO method         average
LIFO method
Out of opening stock    beginning
Out of purchases       average

5.    Ascertainment of profit
Under current purchasing power method profit can be determined in two ways. They are:
Re-statement of income method: under this method, historical income statement us re-stated in CPP terms. Following conversion factors are used to restate the figures of historical cost statement.
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.

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 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.
i.    Monetary assets and monetary liabilities do not need any adjustment
ii.    Conversion factor for the stock will be determined by the methods of issuing the stock from store i.e. LIFO or FIFO.
iii.    Conversion factor of the fixed assets and depreciation depends up on the date of acquisition.
iv.    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.
v.    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.

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 forensics' C.p sandaled. His committee issues the report in 1975. Te 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
The main objectives of CCA approach are as follows
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
2.    Depreciation adjustment
3.    Inventory adjustment
4.    Cost of sales adjustment [COSA]
5.    Monetary working capital adjustment [MWCA]
6.    Gearing adjustment
7.    Current cost accounting reserve[CCAR]
8.    Current cost income statement [CC statement]
9.    Current cost balance sheet

1.    Fixed assets adjustment
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 an earn income in future also. The present value of any future income which is to be earned is the economic value. It s 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 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 an 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.