ACCOUNTING FOR PRICE LEVEL CHANGES Introduction The basic objective of accounting is to prepare

financial statements that will provide adequate and reliable information that gives a true and fair view
of the operating result and financial position of a business based on which the users of that information
can make their decisions These financial statements are prepared in monetary units such as Cedis, Nira,
Dollars, Pounds etc. They serve their basic objective if the value of such monetary unit remains stable.
This is possible only when there is a stable price level. Historical cost accounting, which has been the
accounting system adopted normally in the preparation of financial statement, suffer from some
significant defects that are especially pronounced in time of changing price. When the historical cost
system proves to be unsatisfactory, any one of a range of alternative systems could be adopted. This
chapter examines some of the alternatives.

Defect of Historical Cost Accounting

 Historical cost accounting is based upon records of transactions. Transactions such as sales and
purchases are recorded at the monetary amount at which goods or service change hands.

 Once recorded at that amount in the books of the entity, the value remains fixed. Because of this fixed
values, historical cost accounting is said to be objective and up to a point that is true. However,
accounting is a process by which raw transaction data is translated into useful and informative
statements, a process which as we have seen invo1ve often substantial judgment based. E.g.
adjustments like provisions.

 Thus, in times of changing prices, historical cost accounting may fail to produce useful information for
users. Some of these defects are explain below:

i. In a time of changing prices reported result in the income statements may be distorted as
revenue at current value are match with cost incurred at an earlier date.
ii. ii. Cost of sale is likely to be understated in a time of price inflation.
iii. iii. The valuation of assets in the statement of financial position is at cost less accumulated
depreciation. The resultant net book value may bear no relationship to the current value of
these assets.

The three points listed above are likely to give rise to faulty estimates of returns on capital employed
(ROCE). Typically, in a time of rising prices profit are likely to be overstated and assets understated,
relative to current values thus, given rise to unrealistically rosy measurements of ROCE.

 The results of comparison of performance and position statements over time will be unreliable,
because amounts are not valued in terms of common units.

 Borrowings are shown in monetary terms, but in a time of rising prices a gain is actually made (or a
loss in times of falling prices) at the expense of the lender, in real terms, the value of the loan has
decreased (in a time of rising prices) or increased (in a time of falling prices).

 Conversely, gains arising from holding assets are not recognized. Depreciation writes off the historical
cost over time, but where asset values are low (because it is based on outdated historical costs),
depreciation will be correspondingly lower, so that a realistic charge for asset consumption is not
matched against revenue in the performance statements. ASSETS VALUATION ALTERNATIVES Various
methods exist for the valuation of individual assets and liabilities at the beginning and at the end of the
period in order to determine income:

Net Realizable Value (NRV) / Exit Value

The net realizable value means the estimated amount that would be received from the sale of the set
less the estimated cost of its disposal. The term exit value is often used as it is the amount receivable
when an asset leaves the business.

Economic Value (Present Value)

This is the value of an asset valued as the sum of the future expected net cash flows associated with the
asset, discounted (adjusted) to its present value ( what the future cash-flows would be worth today)

Deprival Value
Deprival value is based on the concept of the value of an asset being the amount of money the owner
would receive to compensate him exactly for being deprived of it. That is, the deprival value of an asset
is the loss that the rational business person would suffer if he or she were deprived of the use of an
asset. This loss will depend on what would rationally have been done with the asset if he or she had not
lost (been deprived of) it.

ALTERNATIVE ACCOUNTING METHODS It is upon these limitations that the price level accounting has
become relevant. Price level accounting maybe defined as a technique of accounting by which financial
statements are restated to reflect changes in general price level. Basically, there are three methods of
accounting for price level change.

 Current Purchasing Power Accounting (CPP Accounting)

 Current Cost Account(CCA)

 Hybrid (Combination of CPP and CCA)

Current Purchasing Power Accounting (CPPA)

Under the CPPA, the accounts are adjusted so that all figures are shown in terms of money with the
same purchasing power. Hence, items are adjusted by means of a general price index. The elements of
CPP Accounting are the adjusted historical cost basis of valuation together with profit measurement
based on the maintenance of real financial capital. In converting the figures in the basic historical cost
account to the CPP accounts, a distinction is drawn between;  Monetary Items  Non -Monetary
Items Monetary Items - these are items whose amounts are fixed by contract or by statute regardless of
changes in the general price level and the-purchasing power of the currency. Example of such items
includes investment in bond, debenture, preference shares, cash, debtors, creditors, etc. Here, the
holders of monetary asset (or liabilities) lose (gain) general purchasing power during a period of
inflation to the extent that income from that asset does not adequately compensate those losses. Non-
Monetary Items - these are items whose values are not fixed by contract or statute and they include
stocks and non-current asset. Note that, owners of equity capital have residual claim on its net
monetary and non- monetary item thus equity interest is neither a monetary or Non-monetary.

Advantages of CPP Accounting a.

It is simple and objective as it relies on a standard index or stable monetary units. It is true systems of
inflation accounting as it adjust for changes in the units of measurement.

b. It measures the impact on the company in terms of shareholders purchasing power.

c. It restates asset value in terms of stable monetary value thus, provide a more meaningful basis of
comparison with other companies.

d. Since it is based on historical cost accounting, the data is easily verified and measurement of value
can be readily audited

e. It avoids the subjective valuation of current value accounting as single price index is applied to all
non-monetary assets.

Disadvantages

a. It is complex in it application

b. Failure to capture economic substance when specific and general price movement diverges.

c. The unfamiliarity of information stated in terms of CPP unit

d. Retail price index may not be appropriate for valuation of most asset and liabilities.

CURRENT COST ACCOUNTING

In valuing assets, current cost accounting (CCA) adopts the principle of value to the business. Value to
the business is often expressed diagrammatically, as follows

 Statement of financial position assets valuations under CCA may therefore, be a mix of net realizable
values, replacement cost and value in use (economic value).

 In the income statement-CCA requires the disclosure of a set of four adjustments to historical cost
profit:

Cost of sales;

Depreciation adjustment

Monetary capital and one secondary adjustment for:

Fixed assets disposal.

After the above adjustments the next is the application of a gearing adjustment to the current cost
operating profit to convert it into a figure of current cost profit attributable to shareholders. The
purpose of adjustment is to make allowance for the impact of price changes on the funds needed to
maintain the net operating assets of the business.