PRICE LEVEL ACCOUNTING Historical Cost Accounting: Historical cost accounting is an approach to accounting using asset values based on the actual amount on money paid for assets with no inflation adjustment. This approach is said to use the accounting principle of historical cost.
Histor Historica icall cost cost is a general generally ly accept accepted ed account accounting ing princi principle ple requir requiring ing all financ financial ial statement items be based upon original cost. Historical cost means what it cost the company for the item. It is not fair market value. This means that if a company purchased a building, it is recorded on the balance sheet at its historical cost. It is not recorded at fair market value, which would be what the company could sell the building for in the open market. Criticisms of the historical costs method 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 are only interested in cost allocations and not in the value value of an asse asset. t. Whil Whilee it tell tellss the the user user the the acqu acquis isit itio ion n cost cost of an asse assett and and its its depreciation in the following years, it ignores the possibility that the current market value of that asset may be higher or o r lower than it suggests. •
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Historical Cost Accounting values can relate to transactions that could be a year old or 10 years old. So, the acquisition value may be out of date and thus balance sheet represents out of date values. Historical cost accounting is only interested in cost allocation and not in the value of an asset. So, it discloses the acquisition cost of an asset and its depreciation in the following year, but ignores the possibility that the current market value of the asset may be higher or lower than the disclosed amount. Historical Cost Accounting has also flaw in terms of inflation. It is based on the assumption that the purchasing power remains same over a period of time. But in reality, an asset purchased at the current point of time may be more expensive in future due to inflation. Historical cost financial statements are unadjusted for this inflation. As a result, in the time of high inflation, profits are inflated and thus the tax bill tends to increase. When an entity’s financial instruments are concerned, historical cost prices reflect both an old interest rate and an outdated assessment of the amounts, timing & uncertainty of future cash flows. Intangible assets acquired outside of business combination (internally generated) are not reported in historical financial statements. Reliable forecast of the future income effects of a financial instrument is unlikely to be possible from the simple extrapolation of past gain and losses based on historical cost.
Introduction to Price Level changes Prices Prices do not remain constant constant over a period of time. They tend to change due to various various economic, social or political factors. Changes in the price levels cause two types of economic conditions, inflation and deflation. Inflation may be defined as a period of general increase in the prices of factors of production whereas deflation means fall in the general price level. These changes in the price levels lead to inaccurate presentation of financial statements. This is so because the financial statements are prepared on historical costs on the assumption that the unit of account, i.e. rupees in the case of India, has static value. But the assumption is not valid because the value of the unit of account, i.e., the purchasing power of the rupee, keeps changing. Financial statements and price level changes The term ‘financial statement’ refers to two statements, i.e. the balance sheet or statement of financial position that reflects assets, liabilities and capital on a particular date and profit and loss account or income statement that shows the operating results achieved during a particular period.
Financial statements are usually based on actual or historical cost concept. They reveal the impact of various transactions involved in the accounting period on the operating and financial health of the company. The various transactions transactions include: 1. Current assets acquired and current liabilities incurred at different points of time in the accounting period. 2. Various expenses incurred and income earned at different points of time in the accounting period 3. Various assets acquired at different points of time 4. Various liabilities incurred at different points of time. Hence, it is clear that the measurement unit of various transactions, i.e. money, relates to different points of time. But the value of money does not remain the same over a period of time; it has different values at different points of time due to changes in the price level. It is generally said that profit as arrived from the profit and loss account ont eh basis of historical cost has a tendency to be overstated in times of rise in prices. This is so because during inflation the selling prices would indicate the value realized in terms of the increased prices but the costs which pertain to the earlier periods would show lower values. Price Price level level account accounting ing is a techni technique que of account accounting ing by which which the transa transacti ctions ons are recorded at current values and the impact of changes in the prices on the accounting transactions recorded on historical cost concept. Price level accounting is also known as ‘inflation accounting’ for the reason that prices are usually changing on the higher side. Methods/ techniques of price level accounting / inflation accounting 1. cur current rent pur purchas chasing ing power power tech techniqu niquee CPP technique of accounting requires the companies to keep their records and present the finan financi cial al stat statem emen ents ts on conve convent ntio ional nal hist histor oric ical al cost cost basi basiss but it furt furthe herr requ requir ires es prese presenta ntati tion on of supple supplemen mentar tary y statem statement entss in items items of curren currentt purcha purchasin sing g power power of
currency at the end of the accounting period. In this method the various items of financial statements, i.e. balance sheet and profit and loss account are adjusted with the help of recognized general price index. Any approved price index prepared by the RBI is used to convert the various items of B/S and P&L account. The main objective of this method is to take into consideration the changes in the value of money as a result of changes in the general price levels. It helps in presenting the financial statements in terms of a unit of measurement of constant value when both cost and revenue have been changing due to changes in the price levels. Mechanism for preparing financial statement under CPP method a. Conve Convers rsion ion Te Tech chniq nique: ue: in this method, various items of balance sheet and profit and loss account are adjusted with the help of recognized general price index. The conversion factor can be calculated with the help of the following formula: Conversion factor =
current Price Index . Previous price Index at the date of existing figure
And the formula for calculating the converted c onverted figure is: Converted figure = Historical figure x Conversion Factor OR Converted figure = Historical figure x current year index . Previous year index at the date of existing figure b. Mid – Peri Period od Conv Conver ersi sion on:: there there are severa severall transa transacti ctions ons which which take take place place throughout the year such as purchases, sales, expenses, etc. For conversion of such items, average index of the year can be taken as the one index for all such items. If such an average is not available, the index of the mid-year be taken for this purpose. And, if the index of the mid year is also not available, then the average of index at the beginning and at the end of the period may be taken. c. Moneta Monetary ry and Non-mo Non-moneta netary ry Accounts Accounts (Gain (Gain or Loss Loss on Monetary Monetary items) items):: distinction has to be made between these items under this method. Monetary Monetary items: which which are stated stated/f /fixe ixed d by contrac contractt in terms terms of moneta monetary ry units units (rupees) regardless of changes in general price level. e.g. cash, debtors, etc.
stated in fixed monetary amounts. amounts. These are Non-monetary items: these cannot be stated bldgs, machinery, inventories of materials and finished goods meant for sale. Assets may sell at any price inspite of its use. Hence, under CPP method, all such items are to be restated to represent current general purchasing power.
A change in purchasing power of money affects both monetary and non-monetary items. Gain/ loss on these items must be taken into account in this method and must be shown as a separate item to arrive at overall P/L. 2. Replace Replacemen mentt Cost Cost Accou Accountin nting g Tech Techniqu niquee
Replacement Cost Accounting Technique (RCA) is an improvement over CPP technique. In the Replac Replaceme ement nt Cost Cost Account Accounting ing Techni Technique, que, the index index used, used, are those those direct directly ly relevant to the company’s particular assets and not the general price index. In this sense the replacement cost accounting technique is considered to be an improvement over curren currentt purcha purchasin sing g power power techni technique. que. But adoptin adopting g the replac replaceme ement nt cost cost accoun accountin ting g tech techni niqu quee will will mean mean usin using g a numb number er of pric pricee indi indice cess for for conve convers rsio ion n of finan financi cial al statements and it may be very difficult to find out the relevant price index to be used in a partic particula ularr case. case. Furthe Further, r, the replac replacemen ementt cost cost account accounting ing techni technique que provid provides es for an element of subjectivity and on this ground it has been criticized by various thinkers. Another problem posed by this price level changes (and more so by inflation) is that how much much depre depreci ciat atio ion n shoul should d be char charge ged d on fixed fixed asse assets ts.. The The purp purpos osee of charg chargin ing g depreciation is two fold – (i) to show the true and fair view of the financial statements and the profitability of the concern, and (ii) to provide sufficient funds to replace the assets after the expiry of the life of the asset. It may not be possible to charge depreciation on replacement cost basis. However, it is still advisable to retain profits and restrict dividends so as to enable funds for replacement of fixed assets. For this purpose, ‘Specific Capital Reserves’ or ‘Replacement Reserves’ should be provided in addition to the normal depreciation provided on actual cost of the asset. 3. Current Current value value Acco Accounti unting ng Tec Techniq hnique ue
In the Current value Accounting Technique of price level accounting all assets and liabilities are shown in the balance sheet at their current values. The value of the net assets at the beginning and at the end of the accounting period is ascertained and the difference in the value in the beginning and the end is termed as profit or loss, as the case may be. In this method also, like replacement cost accounting technique, it is very difficult to determine relevant current values and there is an element of subjectivity in this technique. 4. Current Current Cost Accoun Accounting ting Tec Techniq hnique ue
The crux crux of the Current Current Cost Cost Accoun Accountin ting g Techni Technique que is the prepar preparati ation on of financ financial ial statements (B/S and P&L account) on the current values of individual items and not on the historical or original cost. The Current Cost Accounting Technique (CCA) has been preferred to the CPP technique of price level accounting as it is a complete system of inflation accounting. The financial
statements prepared under this technique provide more realistic information and make a distinction between profits earned from business operations and the gains arising from changes in price levels. As depreciation under CCA is provided on current cost, the method method prevent preventss oversta overstatem tement ent of profit profitss and keeps keeps the capital capital intact intact.. The effect effect of holding monetary items in terms of gains and losses having an impact on the finance of the business is also highlighted. However, there are many difficulties in the operation of CCA technique: a. It is very very difficult difficult to to determine determine the ‘value ‘value to the the business’ business’ of a real real asset. asset. b. There is an element element of subject subjectivit ivity y in this this techniqu technique. e. c. It does does not not hold hold good during during the periods periods of depreciatio depreciation n Some important adjustments required under CCA technique: i). Current Cost of Sales Adjustment (COSA): 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. The important principle is that current costs must be matched with current revenues. As for sales are concerned, it is current revenue and out of the costs, all operating expenses are current costs. But in case of inventories, certain adjustments will have to be made, known as cost of sales adjustment. Cost of sales adjustment can be calculated with the help of the following formula: COSA = (C-O) – I a (C – O) Ic Io Where C = Historical cost of closing stock O = Historical cost of opening stock Ia = Average Index Number Ic = Index Number appropriate to closing stock Io = Index Number appropriate to opening stock ii). Depreciate Adjustment: under the CCA method, assets are shown in the balance sheet on current replacement costs after allowing for depreciation. This will require an adjustment in depreciation also. Current year’s depreciation under CCA can be calculated with the help of following formula: = Opening Current Value of Assets + Closing Current Value of Assets 2 x Life of Asset
And, Depreciation Adjustment = Current Years Depreciation of CCA – Depreciation of Historical Cost iii). Backlog Depreciation: whenever an asset is revalued, the profit on revaluation is transferred to Revaluation Reserve Account. But, the revaluation also gives rise to a backlo backlog g deprec depreciat iation ion.. This This backlo backlog g deprec depreciat iation ion should should be charge charged d to Revalu Revaluati ation on Reserve Account.
iv). Monetary Working Capital Adjustment (MWCA): 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. It is referred to as the excess of current assets over curren currentt liabil liabiliti ities. es. The changes changes in the price price levels levels disturb disturb the workin working g capita capitall position of a concern. CCA method requires a financing adjustment reflecting the effects of changing prices on net monetary items, leading to a loss from holding net monetary assets or to a gain from holding net monetary liabilities when prices are rising, and viceversa versa,, in orde orderr to main mainta tain in the the monet monetar ary y work workin ing g capi capita tall of the the enter enterpr pris ise. e. This This adjust adjustmen mentt reflec reflects ts the amount amount of additi additional onal finance finance needed needed to mainta maintain in the same same working working capital due to the changes in price levels. The method of calculating calculating MWCA is the same as that of COSA symbolically. MWCA = (C-O) – I a (C – O) Ic Io
Where C = Closing Monetary Working Capital O = Opening MWC Ia = Average Index for the period Ic = appropriate Index for closing MWC Io = appropriate Index for opening MWC v). Gearing Adjustment: During the period of rising prices, shareholders are benefited to the extent fixed assets and net working capital, are financed while the amount of borrowings to be repaid remains fixed except interest charges. In the same manner, there is a loss to the shareholders in the period of falling prices. To adjust such profit or loss on account of borrowings, ‘gearing adjustment’ is required to be made. ‘Gearing adjustment’ is also a financing adjustment like COSA and MWCA. This adjustment reduces the total adjustment for cost of sales, depreciation and monetary working capital in the proportion of finance by borrowings to the total financing. Gearing adjustment can be calculated with the help of the following formula: Gearing Adjustment =
B B+S
x A
Where B = Average net borrowings S = Average Shareholders’ interest A = Total of the current cost adjustments. Advantages of price level accounting 1. It enables company to present more realistic view of its profitability because current revenues are matched with current costs. 2. Depreciation charged on current values of assets in inflation accounting further enables a firm to show accounting profits more nearer to economic profits and replacement of these assets when required.
enable less a comp compan any y to main mainta tain in its its real real capi capita tall by avoi avoidi ding ng paym paymen entt of 3. It enab divi divide dends nds and taxes taxes out of its its capi capita tall due due to infl inflat ated ed prof profit itss in hist histor oric ical al accounting. 4. Balance sheet reveals a more realistic and true and fair view of the financial position of a concern because the assets are shown at current values and not on distorted values as in historical accounting. 5. When financial statements are presented, adjusted to the price level changes, it makes possible to compare the profitability of two concerns set up at different times. 6. Investors, employees and the public at large are not misled by inflated book profits because inflation accounting shows more realistic profits. Higher paper profi profits ts without without adjust adjustmen mentt for price price level level changes changes cause cause resent resentmen mentt among among workers and they demand higher wages and also excessive profits attract new entrepreneurs to enter the business. Inflation accounting helps in avoiding further competition from prospective entrepreneurs. 7. The financ financial ial statem statement entss prepar prepared ed by a compan company y adjust adjusted ed to the price level level changes also improve its social image. 8. Inflation accounting also affects the investment market as it helps to establish a realistic price for the shares of a company. Disadvantages of price level accounting 1. Adjusting accounts to price level changes is a never-ending process. It involves constant changes and alterations in the financial statements. 2. Price level accounting involves many calculations and makes financial statements so complicated and confusing that it becomes very difficult for man of ordinary prudence to understand, analyze and interpret them. The conc concep eptt of pric pricee leve levell acco accoun unti ting ng appe appear arss to have have more more theo theore reti tica call 3. The importance than practical because adjusting the accounts to the changes in the price levels may lead to window dressing of accounts due to the element of subjectivity in it. People may adjust the accounts according to the values most suited to them, thereby, making the financial statements more inaccurate. 4. Depreciation charged on current values of fixed assets is not acceptable under the Income Tax Act, 1961 and hence adjusting it to price changes does not serve any practical purpose. 5. During deflation, when the prices are falling, adjustments of accounts to price level changes will mean charging lesser depreciation and overstatement of profits.
