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Price reflects the value sacrificed for the acquisition of an item at the moment of purchase; therefore price paid is a historical fact and does not necessarily reflect the value of the item after the transaction, since this may change. Value changes when supply or demand changes. If the value of an asset that was acquired at a specific cost changes in the course of time, the accounting records will no longer reflect its value.When recording accounting transactions at historical cost it is assumed, by implication, that prices remain stable. This is obviously not so in practice and consequently profit determination in a period of rising price levels poses a problem. The price of the acquisition or expense is not necessarily a reflection of the value sacrificed.Price level changes can be general or specific in nature. General price level changes reflect increases or decreases in the value of the monetary unit. Prices are expected to show a specific trend. If an item was $10 three years ago and the same item now costs $20, it may be concluded that the price level has risen, the buying power of money has decreased and that there is inflation. Specific price level changes can result from technological advances, changes in consumer demand, etc.If the value of money changes, measuring accounting transactions in terms of stable monetary units is obviously not a suitable method. Financial accounting statements should be adjusted for the following reasons: (1) To create a more accurate basis for the evaluation of the investment in an undertaking, (2) To enable meaningful comparisons between the results of different years and (3) To make comparisons between undertakings more meaningful.Adjusting for price level changes can be partial adjustments, general adjustments or specific adjustments based on current replacement value.Partial level changes affect those assets that have a relatively long lifespan, for example fixed assets subject to depreciation and acquisitions where there is a lapse of time between the time of acquisition and the allocation of that cost to the accounting records for a specific period. For example, inventory.In some countries, the financial statements of an undertaking are adapted to reflect the general purchasing power of money as at the last day of the accounting period (general adjustments). Usually an index, such as the consumer index, is used to convert historical amounts to current purchasing power equivalents. The purpose is to convert all amounts in the financial statements to a common accounting unit with the same purchasing power.Current cost accounting is another method of accounting for the influence of inflation on the financial statements, showing some (or all) of the items in terms of their current cost. The most popular method is to prepare a distinct and separate accounting statement that reflects the financial result as restated by the following adjustments: (1) Depreciation - An adjustment for the difference between depreciation based on the current cost of the fixed assets and depreciation determined on the historical cost. (2) Cost of sales - An adjustment for the difference between current cost on inventory at the date of sale and the amount used to determine the historical cost. (3) Leverage - Where the total liabilities exceed the monetary assets and where the total monetary assets exceed total liabilities.Consistent inflation has shown that the traditional historical cost accounting system has serious limitations. These limitations have already resulted in deviations from the strictly historical cost conversions. For example, many undertakings have revaluated their fixed assets and adopted the last-in-first-out (LIFO) basis of inventory valuation in order to determine a more accurate measure of accounting for cost of sales.
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Michael Russell
Your Independent guide to Accounting
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