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Unit 2: Price Level Accounting

1. The assets that are stated in the balance sheet are reported at values that are much lower Notes
than their current replacement values. Due to the understatement of the values, the business
is more vulnerable to takeover bids and the shareholders may not realise a fair value for
their shares at the time of such takeover.
2. Since the fixed assets are understated in value, the depreciation charged in the Income
Statement remains at a low figure. This would distort the current cost data compiled for
operational decisions such as pricing, make-or-buy, etc.

3. Another distortion caused is that which arises when the cost of raw materials and
components or goods purchased for resale is steadily rising. As the cost concept requires
that only the cost of purchase should be charged off to the income statement, the difference
between the historical cost and the replacement cost of such items is included in the profits
earned. In this way the operating profit also includes a part of holding profits.

4. Assets such as cash and other near-cash assets receivables in periods of inflation lose their
real value in terms of purchasing power. Similarly, the real values of monetary liabilities
such as creditors and loans outstanding gain their real value in terms of purchasing power
but the same does not get reflected in the statements in periods of inflation. The reverse is
true in the periods of deflation.
5. The profits and return on investment under historical cost accounting are overstated, as
revenue is recorded at increasing price levels and expenses such as depreciation and cost
of sales are charged off at the historical cost.
6. The financial statements also reflect a very high growth in sales value, profits, capital
additions, etc. The real growth rates of the items can be known only when adjustments are
done for the changes in the money value.
From the above, it is clear that accounts that have not been adjusted for the impact of inflation
can mislead both internal and external users in respect of decisions that may be taken on the
basis of financial statements prepared ignoring the inflation factor.

Applications of Inflation Accounting

In the past few years, the entire world has been experiencing high inflation. Companies have
reported very high profits on the one hand but on the other, they have faced real financial
difficulties. This is so because in reality, dividends and taxes have been paid out of capital due to
overstated figures of profits arrived at by adopting the historical cost concept. Thus, a shift from
historical cost concept to inflation accounting is recommended. The major advantages of inflation
accounting are as follows:
1. It enables the company to present a 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 become easy.
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. The 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.

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