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.

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 market value, which would be what the
company could sell the building for in the open market.
 Introduction to Price Level changes

Prices do not remain constant over a period of time. They tend to

change due to 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

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 include:
1.Current assets acquired and current liabilities
2.Various expenses incurred and income earned a
3.Various assets acquired
4.Various liabilities
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.
Distinction has to be made between these items
under this method.
Monetary items: which are stated/fixed by contract in terms of
monetary units (rupees) regardless of changes in general price
level. e.g. cash, debtors, etc.
Non-monetary items: these cannot be stated in fixed
monetary amounts. These are 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.
Techniques of price level accounting

1.Replacement Cost Accounting Technique

Replacement Cost Accounting Technique (RCA) is an
improvement over CPP technique. In the Replacement Cost
Accounting Technique, the index used, are those directly 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 current purchasing power
technique. But adopting the replacement cost accounting
technique will mean using a number of price indices for
conversion of financial statements and it may be very difficult to
find out the relevant price index to be used in a particular case.
Further, the replacement cost accounting technique provides for
an element of subjectivity and on this ground it has been criticized
by various thinkers.
2.Current value Accounting Technique
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.

3.Current Cost Accounting Technique

The crux of the Current Cost Accounting Technique is the preparation of financial
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 prevents overstatement of profits and keeps the
capital intact. The effect of holding monetary items in terms of gains and losses
having an impact on the finance of the business is also highlighted.
A.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) – Ia (C – O)
Ic I o
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
B. 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
backlog depreciation. This backlog depreciation should be charged to Revaluation
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 current liabilities. The changes in the price levels
disturb the working capital 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 vice-versa, in order to maintain the monetary
working capital of the enterprise. This adjustment reflects the amount of additional
finance needed to maintain the same working capital due to the changes in price
levels. The method of calculating MWCA is the same as that of COSA symbolically.
MWCA = (C-O) – Ia (C – O)
Ic I o
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 x A
B+S
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.
3.It enables a company to maintain its real capital by avoiding payment of
dividends and taxes out of its capital due to inflated profits in historical
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.
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.
3.The concept of price level accounting appears to have more theoretical
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.