Price level accounting is a type of financial accounting strategy that seeks to allow for the impact of changes in the value of a currency as the economy goes through a period of inflation or recession. The British Government appointed Sandilands Committee with a chairman named Mr Francis C.P. Sandilands to recommend and consider the price level accounting. By recommending the adoption of the current cost accounting technique as the price level accounting in the reports of the committee (in 1975), it replaced the replacement cost accounting technique. This method covers the adjustment of the various items in financial statements like profit and loss and balance sheet with the help of the general price index. However, the CPI(Consumer Price Index) and WPI(Wholesale Price Index) prepared by RBI can be chosen for the conversion of historical costs. CPP stands for current purchasing power; CCA stands for current cost accounting.
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- The CPP method adjusts historical cost financial statements by applying a general price index, such as the Consumer Price Index (CPI), to convert historical costs into current purchasing power.
- There is no universally accepted method for applying PLA, leading to inconsistencies across different organizations.
- PLA ensures that dividends, profits, and capital are not overstated or understated due to price level changes, thereby protecting shareholders’ interests.
- The price level is analyzed through a basket of goods approach, in which a collection of consumer-based goods and services is examined in aggregate.
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As a result, this enables the company to show their accounting profit closer to economic profits. Items of profit and loss and balance sheet items are adjusted with the help of general price index number. There are two main methods used in inflation accounting—current purchasing power (CPP) and current cost accounting (CCA).
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The price level changes (inflation or deflation) have a link with the purchase of goods and services and also with the purchasing power of money. Briefly, if R refers to the amount required to purchase a specific quantity of goods, in that case, one dollar would buy 1/R. Adjusts the asset value to current price levels, accounting for inflation or changes in purchasing power.
Shareholders rely on financial statements to assess the value and performance of their investments. PLA ensures that dividends, profits, and capital are not overstated or understated due to price level changes, thereby protecting shareholders’ interests. Replacement Cost Accounting Technique is referred to as an improved version of CPP( current purchasing power technique). The major drawback of CPP is that it does not consider the price index individually related to the assets of the company.
The other meaning of price level refers to the price of assets traded on the market such as a stock or a bond, which is often referred to as support and resistance. As in the case of the definition of price in the economy, demand for a security increases when its price drops. The movement in prices is used as a reference for inflation and deflation, or the rise and fall of prices in the economy.
Governments also benefit from the use of price level accounting methods when assessing the impact of the current economy on the purchasing power of both individual consumers and corporate entities. The current purchasing power method is a technique used to measure financial performance and assets over time by adjusting figures for the effects of inflation. This allows users to understand the true value of money in terms of what it can purchase at a specific point in time. Adjusting financial statements to current price levels can distort historical data, making it challenging to compare financial performance over long periods.
Current Cost Accounting (CCA)
Likewise, creditors tend to gain during a period of rising prices as debts are now repaid in dollars of less purchasing power than those originally borrowed. CPP is a mixed method in which financial statements are prepared on a historical basis. Changes in the general level of prices represent changes in the general purchasing power of the monetary unit.
There is no universally accepted method for applying PLA, leading to inconsistencies across different organizations. This lack of standardization can make comparisons between companies difficult and reduce the reliability of financial statements. Specific adjustments apply to individual items or categories, while general adjustments use an overall price index. Inflation accounting does involve a bunch of calculations and makes the financial statements complicated. Therefore, it becomes difficult for the common price level accounting man to understand, analyse and then interpret.
But apart from this, the method needs the presentation of supplementary financial statements of items at the end of the accounting period in the current purchasing power of the money/currency. 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. Profit calculated using historical costs can be misleading during inflationary times. PLA adjusts revenues and expenses to current prices, ensuring that the profit reflects the true economic performance of the business.
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PLA requires regular adjustments to financial data based on changes in price levels. This process can be complex, requiring sophisticated calculations and a deep understanding of economic indicators, making it difficult for smaller firms without the necessary expertise. In the RCA technique, the index used is directly related to the company’s assets and not to the general price index. However, using the RCA technique means adopting different price indices for the conversion of items in the financial statements. Therefore, it makes the calculation of the relative price index difficult in a particular case.