Changes in the general level of prices which occur as a result of a change in the value of the monetary unit are measured by index numbers. Specific price changes occur if prices of a particular asset held change without any general price movements. The British Government appointed Sandilands Committee with a chairman named Mr Francis C.P. Sandilands to recommend and consider the price level accounting.
The Current Purchasing Power (CPP) method, also known as general price level accounting, addresses inflation by converting historical costs into current purchasing power units. This approach uses a general price index, typically the Consumer Price Index (CPI), to adjust all monetary amounts in financial statements. Price level changes, primarily driven by inflation or deflation, significantly impact the accuracy and relevance of financial statements. When prices rise consistently over time, the purchasing power of money decreases, making historical cost figures less meaningful. Imagine you’re a farmer who bought a tractor for $50,000 five years ago.
Methods of Price Level Accounting (With Calculations) Financial Analysis
In order to get rid of the problems related with historical costing, Accounting for Changing Price-Level has been recommended. The current purchasing power technique or CPP of price level accounting make the companies keep the records and show the financial statements on a historical cost basis. But apart from this, the method needs the presentation of supplementary financial statements of items at the end of the accounting period in the current purchasing power of the money/currency. The Sandilands Committee published its report in September 1975 recommending the adoption of current cost accounting for dealing with the problem of inflation accounting. In this method, historic values of items are not taken into account; rather current values of individual items are taken as the basis for preparing profit and loss account and balance sheet.
In case depreciation is charged on original cost, after 10 years we shall have Rs 1, 00,000 from the total depreciation provided. But due to inflation the cost of the machine might well have gone up to Rs 2, 00,000 or even more in 2011 when the machine is to be replaced and we may find it difficult to replace the asset. Assuming that all sales and purchases were made at an average of the period, beginning and ending price indices. Based on the current status in the economy and the price level prevailing, the process makes it easier to figure what type of value can be received from the purchases. (b) Conversely, when materials and services are purchased from suppliers who offer trade credit, price changes are financed by the supplier during the credit period. To this extent extra funds do not have to be found by the business and this reduces the need for a COSA and in some cases for a MWCA on debtors.
For example, a land costing Rs. 50,000 in 1998 may sell for Rs. 1, 00,000 in 2000. Therefore, under CPP method, all such items are to be restated to represent current general purchasing power. To consider and recommend the accounting for price level changes, the British Government had appointed a committee in 1973. This committee presented its report on 25th June, 1975 and recommended the Current Cost Accounting (CCA) technique for financial reporting in place of CPP or RCA techniques for price level changes.
Key principles of CCA
Thus items are not adjusted as a result of the change in the general price level as they are adjusted in the CPP method. Current cost is the cost at which the assets can be replaced as on a date. While the current purchasing power method is known as the general price level approach, the current cost accounting method is known as the specific price level approach or replacement cost accounting.
Without adjusting the price changes, higher profits create resentment and urge for higher wages among the workers. Moreover, new entrepreneurs get attracted by excessive accounting for price level changes profits to enter the business. However, if the current purchases are less than cost of sales, a part of the opening inventory may also become a part of cost of sales.
- This states that when financial statements are denoted according to the price changes, the profitability can be compared for two concerns developed at different times.
- As depreciation under CCA is provided on current cost, the method prevents overstatement of profits and keeps the capital intact.
- In case depreciation is charged on original cost, after 10 years we shall have Rs 1, 00,000 from the total depreciation provided.
- (c) Fixed assets are converted on the basis of the indices prevailing on the dates they were purchased.
- (ii) To provide sufficient funds to replace the assets after the expiry of the life of the asset.
This happens because the taxes and dividends have been paid from the capital as a result of overstated profits arisen out of adopting the historical cost concept. Therefore, to alter this historical cost concept, price level accounting is recommended. Contrary to monetary items, non-monetary items denote such assets and liabilities that do not represent specific monetary claims and include land, buildings, machinery, investments, stocks, etc.
Method of Price Level Accounting # 3. Current Value Accounting Technique:
(ii) To make necessary entries for recording the changes in the ledger using the index numbers and the replacement cost. Replacement Cost Accounting (RCA) Technique is an improvement over Current Purchasing Power Technique (CPP). One of the major weaknesses of Current Purchasing Power technique is that it does not take into account the individual price index related to the particular assets of a company.
(b) Mid-Period Conversion:
For crop production businesses, inventory valuation becomes particularly critical. If wheat was harvested when market prices were $6 per bushel, but current prices are $8 per bushel, which value should appear in financial statements? CCA would use current market prices, while CPP would adjust the historical cost based on general price indices. Agricultural businesses face unique challenges when dealing with price level changes. Commodity prices, land values, and equipment costs often fluctuate more dramatically than general price levels. A farming operation might see corn prices drop 20% while fertilizer costs increase 15% in the same period, making accurate financial reporting complex.
This adjustment should represent the amount of additional (or reduced) finance needed for monetary working capital as a result of changes in the input prices of goods and services used and financed by the business. Monetary items are those assets and liabilities the amount of which are fixed by contract or otherwise, and expressed in units of money, regardless of changes in general price level. One disclosure required by Statement 33 was the reporting of the effects of general inflation as indicated by the change in the consumer price index. The second disclosure reported the effects of the changes in the specific prices of inventory and property, plant and equipment. Working capital is that part of capital which is required to meet the day to day expenses and for holding current assets for the normal operations of the business.
In price level accounting the financial statements prepared under conventional accounting system is adjusted based on single price index. The single index can not be sufficient to measure the changes in prices in all financial items. Price level adjustments fundamentally change how we interpret financial ratios and performance metrics. Return on assets calculations become more meaningful when assets reflect current values rather than outdated historical costs. Debt-to-equity ratios might improve significantly when asset values are updated to current levels.
- If there are no stocks, then cost of sales will comprise only current purchases and cost of sales adjustment is not necessary.
- To consider and recommend the accounting for price level changes, the British Government had appointed a committee in 1973.
- The effect of holding monetary items in terms of gains and losses having an impact on the finance of the business is also highlighted.
- Monetary items are those assets and liabilities the amount of which are fixed by contract or otherwise, and expressed in units of money, regardless of changes in general price level.
Further, the replacement cost accounting technique provides for an element of subjectivity and on this ground it has been criticized by various thinkers. It must be noted that, in the process of conversion, it is only the non monetary items which are adjusted to the current purchasing power of money. Further, if assets and liabilities are converted as stated above, it may be found that a loss or gain arises from the difference of the converted total value of assets and that of liabilities. This method covers the adjustment of the various items in financial statements like profit and loss and balance sheet with the help of the general price index.
It has also received great attention as it play important role in solving problems related with financial reporting that arise due to rapidly growing prices. The agricultural sector, with its inherent price volatility and long-term asset investments, stands to benefit significantly from improved price level accounting methods. As stakeholders demand greater transparency and accuracy in financial reporting, these techniques will likely become more prevalent and sophisticated.
Method of Price Level Accounting # 2. Replacement Cost Accounting Technique:
While repayment rights on borrowing are normally fixed in monetary amount, the proportion of net operating assets so financed increases or decreases in value to the business. Thus, when these assets have been realized, either by sale or use in the business, repayment of borrowing could be made so long as the proceeds are not less than the historical cost of those assets. Most businesses have other working capital besides stock involved in their day-to-day operating activities. For example, when sales are made on credit the business has funds tied up in debtors. Conversely, if the suppliers of goods and services allow a period of credit, the amount of funds needed to support working capital is reduced.
By recommending the adoption of the current cost accounting technique as the price level accounting in the reports of the committee (in 1975), it replaced the replacement cost accounting technique. The important principle to be remembered is that current costs must be matched with current revenues. As far as sales are concerned, it needs no adjustment as it is a current revenue. One of the features of current cost accounting is to show inventories in the Balance Sheet on the basis of their value to the business, and not at cost or market price, whichever is lower. If there are stocks, certain adjustments are to be made to cost of sales. If there are no stocks, then cost of sales will comprise only current purchases and cost of sales adjustment is not necessary.
The resulting total depreciation charge thus represents the value to the business of the part of fixed assets consumed in earning the revenue of the period. The same is true is in deflation also, as current revenues are not matched with current costs. This adjustment depends upon the method adopted for the outflow of inventories, viz., first-in-first-out or last-in-first-out. The company reports very high profits during high inflation but on the other way faced financial difficulties.