Accounting for Price Level Changes

The basic objective of accounting is the preparation of financial statements in a

way that the income statement should disclose the true profit or loss made by the
business during a particular period while the balance sheet must show a true and
fair view of the financial position of the business on a particular date. Financial
statements are prepared in monetary units, i.e., rupees, in our country. They can
serve very well the basic objective if the value of such monetary units remains
stable. This is possible only when there is stability in the price levels. However, it
has been our experience that over a period of time, the prices have not remained
stable. There have been inflationary as well as deflationary tendencies. The
inflationary tendencies have been more frequent and since 1931 they have been
dominating economies of all the countries of the world. It is increasingly being
accepted that inspite of all fiscal, monetary and fiscal measures, these tendencies
are likely to stay and it seems unlikely that we will return to an era of stable prices
in the near future.
Financial statements which are prepared according to the conventional or
historical cost accounting system, therefore, do not reflect current economic
realities. In the case of historical accounting system, accounts are prepared
without regard to changes in the price levels. The assets are shown at the values
they were purchased less any depreciation on such values. As a matter of fact,
their values might have gone up on account of the inflationary tendencies.
Similarly, the sales are recorded at the current market prices while the inventories
are recorded at the prices at which they were purchased. It may be possible that
goods sold may comprise those items which might have been purchased in earlier
years when the prices were lower than the current year. Thus, neither the balance
sheet nor the income statement shows the correct operating and financial position
of the business.
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 honoured 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, is 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. In other words, it will be wrong to
equate replacement cost accounting with inflation accounting.
The distinctive features of inflation accounting are as follows:
(i) The recording procedure is automatic.
(ii) The unit of measurement is not assumed to be stable.

(iii) It considers all elements of the financial statements and is not concerned
only with fixed assets or closing stocks.
(iv) Realisation principles are not followed rigidly, particularly, when recording
long-term loans and fixed assets at the current value.
On the basis of the above explanation it is clear that inflation accounting should
not be confused with current cost accounting or current purchasing power
accounting (discussed later). Of course, they are the two important techniques
which are being used for prevention of distortion of the results shown by the
financial statements on account of inflationary tendencies. Accounts all over the
world have still to go a long way before developing a really effective and
acceptable inflation accounting system.
Limitations of Conventional Financial Statements
The income statement and the balance-sheet prepared according to conventional
or historical cost accounting system have been the subject of criticism by
accountants, investors, financial analyst etc. on account of the following reasons :
(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. For a company constructed a building for a sum of Rs 5,00,000 in 1975 and
constructed a similar building in 1989 at a cost of Rs 20,00,000, the total cost of
building will be shown in the balance sheet at the end of 1989 as follows:
Rs.
Building (1975)
5,00,000
Building (1989)
20,00,000
25,00,000
The effect of non-comparative items can also be proved by taking items from the
income statement. For example, the following are the figures of sales for three
years.
Year
Sales
Average price
Index
1989
1,00,000
100
1990
1,50,000
200
1991
2,00,000
275
The price index at the end of 1991 is 300. In case the figures of sales are compared
without the price level adjustment, it appears that there has been a continuous
increase in sales over a period of three years. However, if they are adjusted taking
into consideration the change in the price level, the real situation would be different
as shown below:
Year
Average price index
Unadjusted sales
Conversion factor
Revised sales
1989
100
1,00,000
300/100
3,00,000
1990
200
1,50,000
300/200
2,25,000
1991
275
2,00,000
300/275
2.18,182
The above table shows that the figure of sales, when adjusted for price level
changes, is showing a constant declining trend.
(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. For example, if machinery was
purchased for Rs 1 lakh and its life was expected to be 10 years, a sum of Rs

10,000 would be charged as depreciation every year. If after ten years, the same
asset can be purchased for Rs 1,50,000, the firm may have to face serious
problems because of insufficiency of funds. The main purpose of providing
depreciation may, therefore, be defeated.
(iv) Mixes holding and operating gains In conventional accounting, gains on
account of holding the inventories may be mixed up with the operating gains. For
example, a business purchased 100 units .of a product at Rs 6 per unit in 1990. It
could sell only 50 of such units in that year. In 1991, it purchases another 100 units
at Rs 8 per unit and sells all 150 units at Rs 10 per unit. In such a case the profit in
1991 as per historical accounting will be as follows:
Rs.
Sales (150 units x Rs 10)
1,500
Less: Cost of sales (50 x 6 + 100 x 8)
1,100
400
As a matter of fact out of the total profit of Rs 400, a sum of Rs 100 (i.e., 50 x 2) is
only on account of holding the inventory. This is because if all the units sold had
been purchased during 1991, the profit would have been only Rs 300 (i.e., 150
units x Rs 2). Thus, Rs 100 is the holding profit while Rs 300 is the operating
profit. The historical accounting system, as seen above, does not make this
distinction.
In general, it can be said that under inflationary conditions the reported profits are
overstated and assets are under-stated when accounts are prepared according to
conventional or historical accounting. Over-reporting of profits gives rise to a
number of problems, viz. heavy taxation, heavy dividend, etc., resulting ultimately
in heavy financial strain on the company. Moreover, it brings heavy erosion in the
interpretative value of financial statements. All this has put more onerous
responsibilities on management as observed Peter Drucker:
There are the costs of today and the costs of tomorrow. I know of no business
today which operates at such a rate of return that it can meet the costs of
tomorrow. With todays rates of inflation businesses are not making profits but
only destroying capital. One of the primary tasks of management is to reduce
the costs of tomorrow and extract the maximum possible out of available
capital.
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. For example, an asset purchased for a sum of Rs 200 in 1970 would be
valued in 1990 according to CPP Method at the amount which would be needed to
buy the asset as per change in the general price index in 1990 as compared to
1970. Presuming that general price index was ISO in 1970 and 300 in 1990, the

asset would be valued at Rs 400 (i.e., 200 x 300/150) as per CPP Method. This is
because the current purchasing power of a sum of Rs 200 spent in 1970 is
equivalent to Rs 400 in 1990.
It should be noted that under the CPP Method, only the changes in general
purchasing power of money are taken into account. It does not consider the
changes in the value of individual assets. For example, a particular machine may
have become cheaper over the last few years, whereas the general price index may
have risen. In such a case, the value of the machine will also be raised in
accordance with the general price index.
Preparation of the financial statements according to CPP Method The following
steps are taken in preparing the financial statements.
(i) Conversion factor: CPP Method requires the restatement of historical figures
as disclosed in the financial statement at current purchasing prices. This is done
by multiplying the historical figures by the conversion factor calculated as follows:
Price Index at the date the item arose
Price Index at the date of conversion
Conversion factor =
The retail price index is considered to be the appropriate price index under CPP
Method.
Illustrations 14.1 A company purchased a machinery on 1990 for a sum of Rs
90,000. The retail price index on that date stood at 150. You are required to
restate the value of the machinery according to CPP Method on 3 1 st December,
1995 when the price index stood at 200.
Solution
Price Index at the date the item arose
Price Index at the date of conversion
Conversion factor =
3
4
150
= 200 =
Value of machinery on 3 1st December, 1995 after conversion
= Existing value Conversion factor
Rs. 1,20,000
3
4
= 9,000 =
Alternatively, Converted value of machinery
Price index at the when item arose
Existing value Price index at the date of conversion
=
344 Accounting Theory
Rs. 1,20,000
150
90,000 200
==
In case one desires to know only the difference between existing value and the
converted value of an item it can directly be known by applying the following
formula :
Difference = Existing value (conversion factor - 1)
Rs. (ii) Mid-period conversion: In case of transactions occurring throughout a
period, it
will be advisable to convert them according to the average index of the period.
Such transactions^ generally include revenue items such as sales and purchases

of goods, payment of expenses, etc. In case the information regarding average

index is not available, it may be calculated by taking the average of the index
numbers at the beginning and at the end of the period.
(iii) Monetary and non-monetary items; While converting the figures under
CPP
Method, a distinction is to be made between monetary items and non-monetary
items.
Monetary items are those whose amounts are fixed by contract in terms of
monetary units (rupees, dollars, pounds, etc.) regardless of changes in the general
price level. Examples of monetary items are cash, debtors, creditors, loan capital,
outstanding expenses, etc. Holders of monetary assets lose general purchasing
power during a period of inflation, since their claims against the firm remain fixed
irrespective of any change in the general price level. The converse applies to
those having monetary liabilities. For examle, a person lends to a firm a sum of
Rs. 1,000 on 1st Jan. 1990, payable on 31st December, 1990. The price index on
1.1.90 is Rs. 100 while it is Rs. 150 on 31st December, 1990. On account of
increase in the price levle if the creditor is to be compensated for loss in
purchasing
power, he should be paid a sum of Rs. 1,500 (i.e., 1,000 15/100). However, he will
be paid as per contract a sum of Rs. 1,000. Thus, the debtor (i.e., the firm) is
gaining Rs. 500 while the creditor (i.e., the lender) is losing a sum of Rs. 500.
Monetary items need no conversion since they are already stated in current rupees
(dollars or pounds) at the end of the period to which teh accounts relate.
Non-monetary items. These are the items that cannot be stated in fixed monetary
amounts. They include tangible items such as buildings, machinery, inventories of
materials of finished goods meant for slae. For example, a building costing Rs.
15,000 in 1976 may sell for Rs. 35,000 today though it has been used and may also
be of old fashion. This may largely be due to change in the general price level.
Thus, non-monetary items do not carry a fixed value like monetary items. Hence,
under CPP method, all such items aer to be restated current general purchasing
power.
Accounting for Price Level Changes 345
Investments in bonds or debentures have the characteristics of fixed monetary
claims and, therefore, they come in the category of monetary items. Preference
shareholders also generally have a right to get only the fixed amount of their share
capital and, therefore, they also fall in the category of monetary items. However,
the holders of the equity share capital have the residual claim on a company.s net
asses. The equity interest is, therefore, a non-monetary item.
(iv) Gain or loss on monetary items : It has already been stated above that
change
in the purchasing power of money affects both monetary as well as non-monetary
items. Of course in case of monetary items, the firm receives or pays amount
fixed as per terms of the contract but it does gain or lose in terms of real
purchasing
power. Such gain or loss, termed as .general price level gain or loss., should be
taken into account under the CPP method but it should be shown as a separate
item in the restated income statement to arrive at the overall profit or loss. This is
particularly important in case of gain since the amount may not be available for
distribution by way of dividend on account of inadequate liquidity.