prepared for M.com Sem 4 by Ashish siddiqui, assistant professor...

1. Accounting for Price level
changes
Presentation
By
Ashish Siddiqui
MBA, M.com, C..S (inter)
Assistant Professor,
SSB (AICTE approved)
Compiled by Ashish siddiiqui

2. introduction
 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
 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 Compiled by Ashish siddiiqui
system.

3. Meaning
 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.
Compiled by Ashish siddiiqui

4. Nature of price changes
Basically price changes can be divided in the classes as follows:
1. General Price Changes
2. Specific Price Changes
3. Relative Price Changes
Compiled by Ashish siddiiqui

5. Nature of price changes…cont..
General Price Changes
 General price-level changes reflect the value of the monetary unit over time. The
total supply of money and the total supply of goods and services in the economy
fluctuate, but not usually at the same rate. This disparity leads to inflation or
deflation, changing the value of the monetary unit. Changes in commodity prices
or a discrepancy between total supply and demand of goods and services can also
lead to general price changes.
 Because prices change at different rates, general price changes can only be
measured by calculating the average level of current prices and comparing it with a
base period
 For example, if the base period is 1998 and prices have increased by 50% between
1998 and 2003, the index will be 150 in 2003. The reciprocal of this ratio expresses
the change in purchasing power. Thus, while prices have increased by 50%,
purchasing power has decreased by one third. Purchasing power refers to the
amount of goods and services that can be purchased with a monetary unit.
Compiled by Ashish siddiiqui

6. Nature of price changes…cont..
Specific Price Changes
 Specific price change is the change in the price of a particular commodity, or the
change in its exchange value. Specific price changes are caused by some factors
specific to the commodity, such as:
- Changes in tastes of consumers
- Technological improvements
- Speculation
- Natural or artificial changes in the supply of particular products, etc
Compiled by Ashish siddiiqui

7. Nature of price changes…cont..
 Relative Price Changes
 Normally speaking, prices of different goods and services do not move in
sync with each other, much less in the same direction. A relative price change
is defined as the change in the price of a specific commodity as compared to
an index such as the Consumer Price Index. For example, if the Consumer
Price Index increased by 10% over last year and car insurance doubled in the
Maritimes, we can say that the relative price increase in car insurance is
approximately 82%.
Compiled by Ashish siddiiqui

8. Shortcomings of Historical cost based
accounting
 Historical cost method, over a period of time has been subject to many criticisms, especially
as it considers the acquisition cost of an asset and does not recognize the current market value.
Historical costs is only interested in cost allocations and not in the value of an asset. While it tells
the user the acquisition cost of an asset and its depreciation in the following years, it ignores the
possibility that the current market value of that asset may be higher or lower than it suggests.
 Another main criticism of historical accounting method is its obvious flaws in times of
inflation. The validity of historic accounting rests on the assumption that the currency in which
transactions are recorded remains stable, i.e. its purchasing power remains the same over a period
of time. Another main point with regards to inflation is rise in prices for an asset. An asset
purchased at a point in time may be expensive in future. The traditional accounting principles
record all assets at an original cost and continue to use these historic figures throughout the asset's
life, while economists make a more intelligible assumption that money has a time-value attached
to it. The economist's approach is broadly embraced in the corporate finance model whose
objective is centred on value creation for the shareholders.
 In addition effects of inflation may not be the same for all the companies in the market and
historical cost accounts become almost unhelpful when comparing corporate performance
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9. Distortion in reported Profit
The Accounted would define Business profit as the difference between the business
Revenue and its related cost. However during the inflationary this business profit
reveals errors in actual profit. This distortion is due to following reasons;
 Cost of goods sold
 Depreciation
 Miscellaneous expenses
 Purchasing power and gains and losses
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10. Suggested Adjustment
techniques/methods
 Creation of Reserves:
A part of profit is transferred to the reserves which may used for the
meeting the increased cost of asset replacement. Reserves eliminates the
problem of assets replacement as well as reduce the overstated profits. The
techniques is very used in many countries. Bur it is often an arbitrary
decision how much of the profit should be charged be transferred to
reserves. The transfer may not help adjust completely the inflation factor.
 Revaluation of assets:
The book value of the assets is revised which helps the cost of assets to
conform to the current price and thereby provides a realistic measure of
capitalization. Depreciation is charged on the revised value which is able to
meet the replacement cost of assets. The overstatement of profits is also
checked, It is common method used in many countries.
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11. Suggested Adjustment
techniques/methods…cont..
 LIFO Method of inventory valuation.
Inventory is valued in such a way that helps match current revenue with
current cost of goods. Income statement shows a collection of the most recent
purchased cost. However this method is useful in those cases where raw
material purchased at frequent intervals and where all goods produced are
sold during the same period. In many countries this method of inventory
valuation is not allowed as understates the profit and thereby reduces tax
liability.
 Current value accounting
This method is applied in the case of price rise of the specific commodities. Since a
firm is continually replacing its assets , it is the replacement cost and not the
historical cost that should be taken into account while preparing the income
statement or the balance sheet. If the value of the inventory rises by 40% the equity
needs upward revaluation by the same percentage so that the risen cost of inventory
is met increased liabilities.
Compiled by Ashish siddiiqui