Therefore, the current cost accounting technique focused on the current values of individual items in the formation of financial statements and not on the original cost/historical cost. The current cost accounting technique is adopted in place of the current purchasing power of replacement cost accounting technique for price level changes. But the assumption is not valid as the purchasing power of the shillings, the basic measuring unit of accounting in India, goes on changing from time to time on account of changes upwards or downwards in price level. The current cost accounting method is an alternative to the current purchasing power method.
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. Thus, items are not adjusted as a result of the change in the general price level as they are adjusted in the C.P. The current cost accounting technique has been preferred to the current purchasing power technique of price level accounting as it is a complete system of inflation accounting.
Introduction of price level accounting
Similarly, inventories are shown in the Balance Sheet at their value prevailing on the date of the Balance Sheet. These are not shown at cost or market price whichever is lower, as in case of historical accounting. COGS is not calculated on its original cost but the replacement costs of the business.
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 current liabilities. The changes in the price levels disturb the working capital position of a concern.
Monetary items need no conversion since they are already stated in current rupees at the end of the period to which the accounts relate. For example, a particular machine may have become cheaper over the last few years, whereas the general price level may have risen; the value of the machine will also be raised in accordance with general price index. Thus general price level adjustment restates financial data by bringing past rupee amounts in line to current rupee purchasing power by general index multiplier. In addition to the balance sheet and profit and loss account, an appropriation account and a statement of changes is prepared. Another problem posed by the price level changes is that how much depreciation should be charged on fixed assets.
When a price level changes, a company’s revenue increases or decreases as a result of an increase or decrease in the number of units that it sells. For example, if a business makes 10 widgets at $10 each and there is a 100% change in the price level so that each widget now costs $20, the business will sell 20 widgets at $10 each. This will result in more revenue than before the price change. The depreciation is always changed for the replacement of fixed assets; when prices are increasing, the depreciation should be changed to a higher value and not the original value.
Thus, profit is measured by comparing revenues with the current replacement cost of the assets consumed in the earning process. Revenue is the amount of money that a company makes by selling its products or services. So, if there is an increase in the price level, it increases the revenue of the company by increasing the number of units sold. But if there is a decrease in the price level, its revenue decreases because it will be able to sell less number of units.
The accounting which considered price level changes is called accounting for price level changes. 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. As depreciation under CCA is provided on current cost, the method prevents overstatement of profits and keeps the capital intact.
For purchases of previous year—the average index of the relevant year.
Method of Price Level Accounting # 1. Current Purchasing Power Technique:
However, both models are useful to an understanding of the issues of accounting for price changes. There is no effect of price level on equity share capital. Therefore, price level does not affect them but the value of the closing stock can be affected, where its value is adjusted according to the price level. 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.
Therefore, it becomes difficult for the common man to understand, analyse and then interpret. However, few people consider that the price level accounting may create problems instead of solving them. As result, they showcase the following disadvantages of price level accounting. Also, the current costs of inventory and property, plant, and equipment at the end of the year must also be disclosed. However, due to the perceived importance of these data for current and future investors and creditors, the FASB requires that certain companies disclose selected current cost data on a supplemental basis. CCA is not a generally accepted accounting principle for primary financial statements.
The following points highlight the four methods of price level accounting, i.e., 1. Stocks are valued at current replacement costs at the end of the year or the market price whichever is lower. Inflation accounting does involve a bunch of calculations and makes the financial statements complicated.
Only the non- monetary items are to be adjusted to the CPP value by multiplying appropriate conversion factors. This method has been suggested by the Sandilands Committee of U.K. The Sandilands Committee published its report in September 1975 recommending the adoption of current cost accounting for dealing with the problem of inflation accounting. Thus items are not adjusted as a result of the change in the general price level as they are adjusted in the CPP method. 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.
- The price level changes when the consumer urge for goods changes for a specified period, year or month.
- The main goal of this method is that it takes into consideration the changes resulting in the value of money due to the change in the general price levels.
- Under LIFO method, costs of sales comprise current purchases only.
- For measuring changes in the price level and incorporating the changes in the financial statements we use index numbers, which may be considered to be a barometer meant for the purpose.
- 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.
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. The crux of the current cost accounting technique is the preparation of financial statements on the current values of individual items and not on the historical or original cost. 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. The important principle to be remembered is that current costs must be matched with current revenues.
However, it is still advisable to retain profits ad restrict dividends so as to enable funds for replacement of fixed assets. ‘Specific Capital Reserves’ or ‘Replacement Reserves’ should be provided in addition to the normal depreciation provided on actual cost of the asset. Arjun Ltd. furnishes the following income statement for the year ending 31st December 2007, prepared on the basis of conventional accounting. You are required to adjust the same for price level changes under CPP method. In addition to the financial statements( balance sheet & profit and loss a/c), a statement of changes and appropriation account is prepared.
Depreciation on Fixed Assets
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 https://cryptolisting.org/ 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. The amount of backlog depreciation should adjusted against revaluation surplus on the fixed assets.
Cca is generally preferred over the current purchasing power technique of price level accounting. This is because it is a complete system of inflation accounting. Meaning of accounting for price level changes The general tendency in changes of prices of goods and services over a time is called price level. During the period of inflation, purchasing power of money declines. During the period of deflation, purchasing power of money increase. Price level changes mean increase or decrease in the purchasing power of money over a period of time.
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As a result, most companies stopped the calculations and reporting. Two of the factors in deciding to stop the calculations was the lack of use by financial analysts and a decline in the rates of inflation in the U.S. In other words, the accounting for price level changes failed to pass the cost/benefit test.
In 1975, the uk government’s inflation accounting committee designed the cca technique. Since then, it has been extensively studied and debated, and now it has been finalized by the issue of ssap 16 . The cca system considers price changes that are relevant to a specific firm or industry rather than the whole economy. It seeks to arrive at a profit figure that can be distributed safely in the form of a dividend without impairing the firm’s operational capability. As depreciation under CCA is provided on the basis of current cost, the method prevents the overstatement of profits and keeps capital intact. Financial statements prepared under the CCA method provide more realistic information and make a distinction between profits earned from business operations and gains arising from changes in price levels.