Question

Currently, financial reporting does not take into account changes in prices, either at the general level or at the specific level. Many analysts believe that not taking price changes into account distorts the meaningfulness of financial reports. Explain how changing prices affect financial reports

Answer 1

Yes, Currently, financial reporting does not take into account changes in prices, either at the general level or at the specific level. Many analysts believe that not taking price changes into account distorts the meaningfulness of financial reports.

How Changing Prices Affect Financial Reports:

These changes in the price levels lead to inaccurate presentation of financial statements which otherwise are prepared to present a true and fair view of the company's financial health. This is so because the financial statements are prepared on historical costs on the assumption that the unit of account.

Accounting for price-level changes also referred to as inflation accounting is a financial reporting procedure which records the consequences of inflation on the financial statements that a company prepares and publishes at the end of the financial year, which is based on the assumption of a stable currency. The 1970s and 1980s were exciting period for accountants who welcomed change. The extremely high rates of inflation that were a feature of the period posed a considerable challenge to the traditional historically based financial accounting model. Within a period of less than twenty years, the professional accountancy bodies turned from conservative advocates of the historical cost status quo to radical reformers, urging the introduction of new systems and ideas.

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. The rise in general price level is called inflation. During the period of inflation, purchasing power of money declines. The fall in the general price level is called deflation. During the period of deflation, purchasing power of money increases. Price level change means increase or decrease in the purchasing power of money over a period of time. The accounting which considers price level changes is called accounting for price level changes. According to Collins, (1997) Accounting for price level changes is a system of maintaining accounts in which all items in financial statements are recorded at current values. This system of accounting ascertains profit or loss and presents financial position of the business on the basis of current prices. Accounting for price level changes is also called inflation accounting.

Types of accounting price level changes:

i. Current Purchasing Power:

Current Purchasing Power of accounting requires the companies to keep their records and present the financial statements on conventional historical cost basis but it further requires presentation of supplementary statements in items of current purchasing power of currency at the end of the accounting period.

ii. Replacement Cost Accounting:

Replacement Cost Accounting (RCA) is an improvement over Current Purchasing Power Technique (CPP). One of the major weaknesses of Current Purchasing Power technique is that it does not take into account the individual price index related to the particular assets of a company.

iii. Current Value Accounting:

In the Current Value Accounting 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.

iv. Current Cost Accounting:

The crux of the current cost accounting technique is the preparation of financial statements (Balance Sheet and Profit and Loss Account) on the current values of individual items and not on the historical or original cost. The current cost accounting (CCA) has been preferred to the current purchasing power (CPP) 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.