Accounting for Price-Level Changes Theory and Procedures 1st Edition

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Nominal profit can be estimated by adding current cost income from continuing operations (CCICO) and the increase in current costs (before inflation). Consumer profit can be estimated by adding CCICO, the monetary purchasing power gain, and the excess of increase in specific prices over the increase in general price level. In both estimates, the errors that overstate CCICO are offset by the errors that understate cost changes. On the other hand, the separate schedule in Exhibit 4 does the calculating for the user and also shows how these additional concepts relate to specific profit and shareholders’ equity. 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.

As a result, this enables the company to show their accounting profit closer to economic profits. The price level accounting presents a more realistic view of the company’s profitability. This happens because the current expenses/costs are matched with the current revenues only. 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.

  1. The process includes constant changes and adjustments in the financial statements.
  2. Our mission is to empower readers with the most factual and reliable financial information possible to help them make informed decisions for their individual needs.
  3. 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.
  4. No gearing adjustment arises where a company is wholly financed by shareholders’ capital.
  5. The cost of Sales Adjustment amounting to Rs. 8,000 (Rs. 32,000 – Rs. 24,000) will be charged to Profit and Loss Account and credited to Current Cost Accounting Reserve.

Another problem posed by the price level changes (and more so by inflation) is that how much depreciation should be charged on fixed assets. When prices of products decrease, the company is able to sell its existing inventory at higher prices and gets more money than before. This means that the value of the company’s assets will increase due to an increase in stock and this will increase its net worth.

(1) It is not possible to find accurately the replacement cost till the replacement is actually made. Suppose a machine was purchased in 2000 for Rs 1, 00,000 having a life of 10 years. 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. Fixed assets and long-term investments are purchased for long-term use, and price level effects are significant for these assets. The suggested disclosures are not competing ways of estimating one “ideal” kind of profit.

These are called the Depreciation Adjustment, Cost of Sales Adjustment and Monetary Working Capital Adjustments. (b) Closing Balance Sheet prepared under historical cost accounting is also converted. The difference between the two sides of the balance sheet is put as reserves after converting the equity capital. Alternatively, the equity capital may not be restated in CPP terms and the balance be taken as equity. This method is based on the normal accounting concept that profit is the change in equity during an accounting period.

Price Level Accounting

All the balance sheet items such as liabilities, Equity Shares, and other expenses are not affected by changes in price levels because all of them are stated at historical prices. On the other hand, items such as Fixed Assets, accumulated Depreciation, provision for contingencies, etc. Are affected by price level changes because these are stated at market prices and they change according to the change in the value of money. This analysis emphasizes processing rules rather than measuring current costs as inputs, because perfect inputs will not produce reliable outputs if the calculations are not empirically valid. For the purpose of this analysis, it is assumed that most current costs are directly observable and others can be estimated carefully by preparers and auditors.

SFAS 33 says that expenses are measured at amounts sufficient to maintain the physical operating capability of the enterprise (para. 100). It further explains that distributable income results after deducting the cost of replacing inventory units that were sold, rather than their historical costs (paras. 94b and 125). Exhibit 1 shows the current-cost disclosures from Schedule B of SFAS 33, with the proposed measurements in the final column.

Disadvantages of inflation accounting

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.

Under this method, the openings as well as closing balance sheets are converted into CPP terms by using appropriate index numbers. The difference in the balance sheet is taken as reserves after converting the equity capital also. Monetary accounts are those assets and liabilities which are not subject to reassessment of their recorded values owing to change of purchasing power of money. The amounts of such items are fixed, by contract or otherwise in term of rupees, regardless of change in the general price level. In the United Kingdom, SSAP 16 (1980) required two adjustments for this second objective.

Show how the plant account would appear in the Balance Sheet as at 31st Dec. 2004. (b) Cost of sales is converted as per cost flow assumption (FIFO or LIFO) as explained in the preceding pages. Muntasir Minhaz Muntasir runs his own businesses and has a business degree. Whenever an asset is revalued, the profit on revaluation is transferred to Revaluation Reserve Account.

Achieving Two More Objectives of SFAS 33

Substituting the author’s proposed expense measurements in Exhibit 1 produces a physical loss of $16,300, meaning that the company’s physical assets were eroded by approximately $16,300 before paying dividends. The under-statements of expenses also cause SFAS 33’s disclosures of increases in current costs to be understated by $7,392. Under the CCA technique, cost of sales are to be calculated on the basis of cost of replacing the goods at the time they are sold.

It covers four objectives of SFAS 33 and different ways of achieving those objectives. Although SFAS 33’s methods came closer to achieving those objectives than historical-cost methods, this analysis demonstrates that newer methods can produce more reliable measurements with the same underlying data. For the preceding six years, inflation had been greater than 5%, and it reached 11.3% by the end of 1979. Many people were confused accounting for price level changes about accounting for changing prices, but much has been learned in the past four decades. Lastly, in the deflation period, when the prices fall, adjustments means overstatement of profits and charging lesser depreciation. Price level accounting appears to have theoretical importance rather than practical due to which the adjustment in the accounts may lead to window dressing because of the element of subjectivity in it.

How do price level changes affect a company’s balance sheet?

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. CPP method involves the restatement of historical figures at current purchasing power. The $9,108 that SFAS 33 calculated for increase in current cost of depends upon the calculation for cost of goods sold (CGS). Depreciation charged on the assets on current values is not acceptable by the Income Tax Act, 1961. As a result, adjusting depreciation to price changes will not serve any practical purpose.

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