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Unit 2: Price Level Accounting

Notes

Notes Limitations of historical cost-based accounting
1. Historical cost based accounting no doubt works very well under the conditions of
stable prices. However, under the conditions of inflation or deflation, it suffers from
a major limitation.
2. It is well known that the purchasing power of rupee has been persistently shrinking
since later fifties, and more alarmingly since early seventies.

3. On the contrary, historical cost-based accounting fails to recognize the impact of this
shrinkage. It records transactions represented by rupees of varying purchasing power.
4. Historical cost-based accounting overstates the profit by undercharging depreciation
and materials cost Depreciation is undercharged since it is based on the historical
cost of fixed assets instead of their current cost.
5. Historical cost-based accounting reflects assets at their historical cost instead of
current cost. It results in understatement of the net worth of an enterprise.

6. Historical cost-based accounting thus fails to serve the primary purpose of the
financial statements. It presents a distorted view of the profitability by overstating
it and of intrinsic worth by understating it.

7. Fixed asset values shown in balance sheets are unrealistic, as fixed assets are recorded
at the cost of acquisition. Whereas replacement cost in periods of rising prices goes
up.
8. Depreciation based on historical cost is inadequate as a measure of the value of the
asset used.
Thus there is a need to take into account the changes in the purchasing power of money
while preparing the financial statements.

Self Assessment

Fill in the blanks:

6. Depreciation based on ………….is inadequate as a measure of the value of the asset used.
7. Historical cost-based accounting reflects assets at their historical cost instead of ……………...
8. Under historical accounting system the sales are recorded at the …………. prices.

2.4 Methods of Accounting for Changing Prices

The following are the key methods of accounting for price level changes:

1. Current Purchasing Power method
2. Current Cost Accounting method
3. Hybrid method

2.4.1 Current Purchasing Power (CPP) Method

Under this method, all items in the financial statements are to be restated for changes in the
general price level.

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