Examples of monetary items include cash, accounts payable, accounts receivable, and long-term debt. Monetary items are those assets and liabilities that represent a claim to receive, or an obligation to pay, a fixed amount of foreign currency. Thus, CPP accounting makes all accounting numbers comparable in terms of general purchasing power. Based on the current status in the economy and the price level prevailing, the process makes it easier to figure what type of value can be received from the purchases. (1) It is not possible to find accurately the replacement cost till the replacement is actually made.
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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. During the period of rising prices, shareholders accounting for price level changes are benefitted 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.
The difference in the net assets calculated at the beginning and end of the accounting period is ascertained which is known as the profit or loss. Adjusting to the price level change means charging lower depreciation and overstating profits, which is also negative from many perspectives. In contrast, during periods of inflation, prices generally rise, so adjustments to current values would result in an understatement of profits. The same is true is in deflation also, as current revenues are not matched with current costs. This adjustment depends upon the method adopted for the outflow of inventories, viz., first-in-first-out or last-in-first-out. Thus, the standard provides for an adjustment in respect of monetary working capital when determining current cost operating profit.
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- Additionally, during periods of deflation, this approach can result in overstating profits.
- The committee presented its report in the year 1975 and recommended the adoption of Current Cost Accounting Technique in place of Current Purchasing Power of Replacement Cost Accounting Technique for price level changes.
- Hence, it may not be possible to charge depreciation on replacement cost basis.
- The accounting adjustment for monetary items is subject to the recording of a net gain or loss.
- Institute of Chartered Accountants in England and Wales recommended that changes in the price level should be reflected in the financial statements through the current purchasing power method (CPP).
Replacement Cost Accounting (RCA) Technique 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. Assuming that all sales and purchases were made at an average of the period, beginning and ending price indices. This process of adjustment of cost of sales and inventory has been explained in the following illustration. The increase in stock of Rs 3,000 in CCA method over Historical Cost basis will be credited to Current Cost Account Reserve.
Are there any potential implementation problems associated with using the CPP method?
In order to convert historical figures into their current purchasing power equivalents, the average index of the year or mid-year can be used. Monetary accounts are those that remain unaffected by changes in purchasing power, while non-monetary accounts are subject to reassessment. During a period of rising prices, holding monetary assets results in a loss of purchasing power. Monetary items are translated at the current rate while non-monetary items (such as fixed assets, stock, plant and buildings) are translated at historical rates.
It refers to the type of financial accounting that seeks to allow for changes in the currency during the various periods of inflation or recession in the economy. In addition to the balance sheet and profit and loss account, an appropriation account and a statement of changes is prepared. (4) The fixed assets should not be written-up in the balance sheet when the prices are not stable. The following points highlight the four methods of price level accounting, i.e., 1.
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Suppose a machine was purchased in 2000 for Rs 1, 00,000 having a life of 10 years. In case depreciation is charged on original cost, after 10 years we shall have Rs 1, 00,000 from the total depreciation provided. But due to inflation the cost of the machine might well have gone up to Rs 2, 00,000 or even more in 2011 when the machine is to be replaced and we may find it difficult to replace the asset. (d) The cost of goods sold during the year has to be ascertained on the basis of prices prevailing at the date of consumption and not at the date of purchase.
There are two main methods used in inflation accounting—current purchasing power (CPP) and current cost accounting (CCA). Inflation accounting is a special technique used to factor in the impact that soaring or plummeting costs of goods in some regions of the world have on the reported figures of international companies. Financial statements are adjusted according to price indexes, rather than relying solely on a cost accounting basis, to paint a clearer picture of a firm’s financial position in inflationary environments. In this method, historical figures are stated at current purchasing power. Items of profit and loss and balance sheet items are adjusted with the help of general price index number.
