Unit 4 Accounting for Price Level Changes

Introduction of Accounting for Price Level Changes

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.
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
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 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 is never stable and most of the countries have been facing high rates of inflation. Therefore,
financial statements prepared under historical cost accounting do not reflect current economic realities. They fail to
give realistic and correct picture of the state of affairs of a concern. To overcome the limitation of historical
cost accounting, there is a need to consider the effects of changes in value of money as a result of changes
of price of goods and services. Following are the objectives of accounting for price level changes.
* To show the true result of the operations i.e. real profit or loss.
* To show the true financial position in current values.
* 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.
Methods of Accounting for Price Level Changes
There are many methods of adjustments for the effects of changes in prices. The generally
accepted methods of accounting for price level changes are as under:
1. Current purchasing power method or general purchasing power method (CPP or GPP)
2. Current cost accounting method (CCA method)
3. A hybrid method i.e mixture of CPP and CCA method.
1. Current Purchasing Power (CPP) Method:
The introduction of current purchasing power (CPP) method is one of the greatest revolutions in the field of
accounting. Under current purchasing power (CPP) method, any established and approved general price index is
used to convert the values 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 index 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.

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Under this method, financial statements are prepared on the basis of historical cost and a supplementary statement
is prepared showing historical 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 changes in value of money. This method takes into consideration the changes in the 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
1. 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.
2. Any statement prepared under CPP method is based on the historical statement.
3. Consumer price index or wholesale price index is used as conversion factor for re-stated of historical items.
4. All the items in financial statement are classified into monetary and non-monetary items. Non-monetary items
are adjusted; there is no need of any adjustment for the monetary items.
5. Net gain or loss account of monetary items is to be accounted in the profit and loss account.
Advantages of Current Purchasing Power (CPP) Method
CPP method is useful for finding out real financial position of organization. Following are the advantages of CPP
method.
1. CPP method adopts the same unit of measurement by taking into account the price changes.
2. Under CPP method, historical accounts continue to be maintained. CPP statements are prepared on
supplementary basis.
3. CPP method facilitates the calculation of gain or loss in purchasing power due to the holding of monetary items.
4. CPP method uses common purchasing power as measuring unit. So, the comparative study is easy.
5. CPP method provides reliable financial information for taking management decision to formulate plans and
policies.
6. CPP method 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.
Disadvantages of Current Purchasing Power (CPP) Method
Following are the some major points for the criticism of CPP method:
1. CPP method considers only the changes in general purchasing power. It does not consider the changes in the
value of individual items.
2. CPP method is based on statistical index number which cannot be used in an individual firm.
3. It is very difficult to choose a suitable price index.
4. CPP method fails to remove all the defects of historical cost accounting system.
5. The use of general price index for CPP method is questioned. While general price index deals with consumer
goods, business is interested in the price movement of producer goods.
Steps of Current Purchasing Power (CPP) Method
Under current purchasing power (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 of accounting for price level changes.
1. Calculation of Conversion Factor
CPP method involves the re-statement of historical figures at current purchasing power. For this purpose,
historical figures must be multiplied 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 item arose
 Conversion factor at the beginning = Price Index at the end/Price Index at the beginning
 Conversion factor at an average = Price Index at the end/Average Price Index
 Conversion factor at the end = Price Index at the end/Price Index at the end
 Average Price Index= Price Index at beginning + Price Index at the end/2
 CPP Value = Historical value X Conversion factor
Notes:
* For the items taken from the beginning period (e.g. assets, liabilities, taken from the operating balance sheet),
beginning conversion factor is used.
* For the items which occur throughout the year like sales, purchases, operating expenses etc., average conversion
factor is used.
* For the items which occur at the end of the year like tax, dividend etc. ending conversion is used.
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2. Distinction between Monetary and Non-monetary Accounts
CPP method classifies all assets and liabilities into two groups i.e. monetary items and non-monetary items.
Monetary Items: Monetary items are assets and liabilities, the amounts of which are receivable or payable only at
current monetary value. Monetary assets include cash, bank, bills receivables, debtors, prepaid expenses, account
receivables, investment in bond or debentures, accrued income etc. Monetary liabilities include creditors, account
payable, bills payable, outstanding expenses, notes payable, dividend payable, tax payable, bonds or debentures,
loan, advance income, preference share capital etc.
Non-monetary Items: Those items which cannot be stated in ficed monetary value are called non-monetary items.
Such items denote assets and liabilities that do not represent specific 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 on Monetary items
Monetary items are receivable or payable in fixed amount irrespective of changes in purchasing power of money.
The change in purchasing power of money has an effect on monetary assets and monetary liabilities, Therefore, the
holding of such items results 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 and holding of
monetary liabilities result in gain. Such gain or loss must be taken into accounts when income statement is
prepared under CPP method to arrive at the overall profit or loss.
4. Valuation of 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, cost of sales comprises the entire opening stock and current purchases less closing
stock. And closing is entirely from current purchase. Under LIFO method, cost of sales comprises current purchase
only. However, if the current purchases are less than cost of sales, a part of opening inventory may also become a
part of cost of sales. And closing stock comprises purchases made in previous year.
5. Ascertainment of Profit
Under current purchasing power method, profit can be determined in two ways. They are:
i. Re-statement Of Income Method: Under this method, historical income statement is re-stated in CPP terms.
Following conversion factors are used to restate the figures of historical cost statement.
* Sales and operating expenses are converted at the average rate application for the year.
* Cost of sales is converted as per cost flow assumption i.e. FIFO and LIFO.
* Depreciation is converted on the basis of indices prevailing on the dates when assets were purchased.
* Taxes and dividend paid are converted on the indices that were prevalent on the dates when they are paid.
* Gain or loss on monetary items should be shown as separate item to arrive at the overall profit or loss.
ii. 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, following steps are taken.
* 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 proper 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.
* Closing balance sheet prepared under historical costing is also converted. Only non-monetary items are re-stated.
The difference in balance sheet is taken as reserve after converting equity capital. Alternatively, the equity capital
may not be restated in CPP terms and balance be taken as equity.
* Profit is equivalent to net change in reserve where equity capital has also been converted or net change in equity
where equity capital 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
changed value of assets and liabilities. Under the price level change, the historical balance sheet should be revised
to reflect the true picture 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 should be separated first
of 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.
Meaning of Current Costing Accounting (CCA) Approach
Current costing method is an alternative to current purchasing power (CPP) method. CCA approach was
introduced in 1975 to overcome the difficulties of CPP method. Actually the CPP method applies the retail price
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index for finding out the conversion factors to restate the income statement and balance sheet. So
the CPP approach was criticized by the business world.
Current costing accounting (CCA) approach recognizes the changes in the price of individual due to the change in
general price level. This is the method which includes the process of preparing and interpreting financial statement
in such a way that relevant change in the price is considered significantly. In CCA method, the assets are valued in
current cost basis. It does not consider the retail price index. This method considers the replacement value of the
assets for its real accounting records. The value of assets 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 to be restated in terms of the current value of such items.
Features of Current Cost Accounting (CCA)
1. The fixed assets are recorded at replacement cost value in the balance sheet.
2. Inventories are shown 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 dividend to
shareholders.
4. Depreciation of fixed assets is to be calculated at replacement value.
5. Two types of profit i.e. profit from operation and profits from revaluation are calculated.
6. Liabilities are recorded in their original value because there is no any change in monetary unit.
Objectives of Current Cost Accounting (CCA) Approach
1. To provide correct and reliable financial information based on the current replacement cost.
2. To calculate the profit without changing the historical profit.
3. To protect the business in the event of normal inflationary situation.
4. To keep level of capital in very balance position by making valuation of assets in proper value based on
replacement value.
5. To provide realistic information to the management, investors, creditors, government and to other interested
parties.
6. To prepare the financial statement at the end of the year on the basis of current value of such items.
USA and Price-level Accounting
The Financial Accounting Standards Board was established U.S.A. in 1972. The FSAB has issued a number of
statements of accounting standards dealing primarily with specific problems. In October 1979, it issued a statement
No. 33 entitled ‘Financial Reporting and Changing Prices’ popularly known as Financial Accounting Standard 33
(FAS-33). The standard requires companies to compute inflationary effect on profits in two different ways: (i)
constant dollar method, and (ii) current cost accounting method.
The first method adjusts inventory costs and depreciation for changes in the consumer price index since the related
assets were purchased. The second method adjusts these key items for price changes of specific assets that a
company usually holds. However, this information has to be given only as supplementary information.
At the time of issue of FAS: 33 it was mentioned that the FASB will undertake a comprehensive review of this
statement not later than five years after its publication.
Consequently the Board issued an Exposure Draft in December 1984, which relates to current cost/constant
purchasing power disclosure together with all pronouncements relating to FAS-33 made from time to time.
However in October 1985, the FASB at its meeting decided that the present changing price disclosures required by
FAS-33 should be retained for the time being and the Exposure Draft issued in December 1984, as referred above,
will not be issued as a final statement.
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
cognisance 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 specialised 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.

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(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. Current Purchasing Power Accounting, though simple to apply, does not ensure the maintenance
of the operating capability of an enterprise. Current cost accounting, on the other hand, is a rational and
comprehensive system of accounting for changing prices, as it considers the specific effects of prices on individual
enterprises and thus ensures that profits are reported only after maintaining the operating capability. However, the
introduction of a full-fledged system of Current Cost Accounting on a wider scale in India will inevitably take
some time. During this transitional phase, periodic revaluations of fixed assets along with the adoption of UFO
formula for inventory valuation would reflect the impact of changing prices substantially in the case of
manufacturing and trading enterprises.
(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. The detailed price
indices published in its monthly bulletins by the Government of India can be adopted in a number of cases. There
is no doubt that further steps will have to be taken for the timely publication of statistical information required by
various industries for the implementation of accounting for changing prices.
(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.
Since the presentation of statements adjusted for the impact of changing prices is voluntary, the enterprises may or
may not get this information audited. However, the audit of such statements would enhance their credibility.
(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. However, in periods of rapid and violent fluctuations in prices, the information provided by historical
cost-based accounting system may need to be supplemented by information regarding the impact of changing
prices. The areas in which such information may be of prime importance to management include investment
decisions and allocation of resources, divisional and overall corporate performance evaluation, pricing policy,
dividend policy, etc.
(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. Though, the tax legislation in India at present does not give
recognition to such an accounting system, even then accounting for changing prices, would be useful for
generating relevant information for internal and external decision making.
There is no denying the fact that inflation has come to stay. It is, therefore, the responsibility of the business as well
as the government and professional bodies to take the bold step of making a positive recommendation regarding
providing the shareholders and other concerned with reliable information disclosing the way inflation really hits
the profits. The system recommended should be simple, suitable to Indian conditions and duly recognised by the
government.

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