Question 3
Why is it necessary these days to account for price-level changes? Also explain the monetary and non-monetary items while accounting for price-level changes.
1. Meaning of Price-Level Changes / Inflation Accounting
Price-level change means change in the general purchasing power of money due to inflation or deflation.
In periods of continuous inflation, the value of ₹1 falls – it can buy less goods and services than before.
Traditional financial accounts are prepared on historical cost basis and assume that the value of money is constant. This assumption is not correct in an inflationary economy. Therefore, it has become necessary to adjust accounts for price-level changes. This is called price-level accounting or inflation accounting.
2. Necessity / Importance of Accounting for Price-Level Changes
(1) To Present True and Fair Financial Position
Balance Sheet prepared at historical cost shows:
- Fixed assets at old purchase prices,
- Inventories at old cost,
- Capital and reserves without adjustment for loss of purchasing power. Importance of accounting for Price Level Changes
In inflation, these figures become unrealistic. Price-level accounting restates assets, liabilities and capital in terms of current purchasing power, giving a more realistic and fair view.
(2) To Show Real Profit or Loss
Under historical cost:
- Sales are at current prices,
- Expenses like depreciation, cost of goods sold etc. are based on old costs.
This mixes different rupee values and leads to overstatement of profit in inflationary period.
Price-level accounting adjusts historical costs, so that current revenue is matched with current cost, and real profit (inflation-adjusted profit) can be ascertained. Importance of accounting for Price Level Changes
(3) To Avoid Capital Erosion
If profits calculated without inflation adjustment are fully distributed as dividend, part of it may actually be capital and not real profit.
- The enterprise then loses its capacity to replace fixed assets and inventories at higher current prices.
- Price-level accounting helps to keep intact the real capital of the business by separating holding gain / loss from operating profit. Importance of accounting for Price Level Changes
(4) Better Basis for Managerial Decisions
Decisions such as pricing, product-mix, make-or-buy, expansion, replacement of assets etc. need current cost information.
If management relies only on historical cost data, decisions may be wrong.
Price-level accounting provides relevant and up-to-date figures, improving the quality of decisions. Importance of accounting for Price Level Changes
(5) Meaningful Comparison of Performance
Comparison of:
- Profits of different years, or
- Financial statements of different firms
is misleading if they are based on different price levels.
Price-level adjusted statements remove the effect of changing purchasing power and make inter-period and inter-firm comparison more meaningful. Importance of accounting for Price Level Changes
(6) True Measurement of Return on Investment
Ratios like Return on Capital Employed, Earnings per Share, Dividend payout etc. should be computed on the basis of real values, not historical values.
Price-level accounting restates capital and profits in the same rupee value, thus giving a real rate of return, useful for investors and management. Importance of accounting for Price Level Changes
(7) Protection of Creditors and Long-Term Lenders
During inflation, the real value of monetary liabilities falls, whereas the real value of assets may rise.
Price-level accounts reveal the actual position of business and help creditors, banks and debenture-holders to judge the real security of their loans.
(8) Social and Governmental Use
Governments need reliable, inflation-adjusted data for taxation policy, price control, wage negotiations and other economic decisions.
Price-level accounting provides more realistic information about profits and capital, which can be used for fair taxation and wage adjustments. Importance of accounting for Price Level Changes
3. Monetary and Non-Monetary Items in Price-Level Accounting
In price-level accounting, all items are divided into monetary and non-monetary items, because their behaviour under inflation is different.
A. Monetary Items
(1) Meaning
Monetary items are those assets and liabilities which are fixed in terms of money units.
Their amounts are to be received or paid as a fixed number of rupees, irrespective of the change in purchasing power.
Examples:
- Cash in hand and at bank
- Debtors, bills receivable, loan given (monetary assets)
- Creditors, bills payable, bank overdraft, long-term loans, debentures (monetary liabilities) Importance of accounting for Price Level Changes
- Outstanding expenses, accrued incomes, provision for tax etc.
(2) Behaviour Under Price-Level Changes
- The nominal rupee amount of monetary items remains the same,
- But their real purchasing power changes with inflation or deflation.
During inflation:
- Holders of monetary assets (cash, debtors) suffer a loss of purchasing power.
- Payers of monetary liabilities gain because they settle fixed rupee amounts which now have less purchasing power.
In price-level accounting, this gain or loss in purchasing power on monetary items is identified as Monetary Gain or Monetary Loss (also called purchasing power gain or loss). Importance of accounting for Price Level Changes
B. Non-Monetary Items
(1) Meaning
Non-monetary items are those assets and liabilities which are not fixed in terms of money.
Their values change with the price level and are generally carried at cost or revalued amounts.
Examples:
- Fixed assets: land, building, plant, machinery, furniture, vehicles etc.
- Inventories / stock of goods
- Investments in shares
- Intangible assets: goodwill, patents, trademarks
- Owner’s equity: share capital, reserves and surplus (from the viewpoint of the business, these are residual interests, not monetary liabilities).
- Prepaid expenses, some provisions etc.
(2) Behaviour Under Price-Level Changes
- In inflation, the current value of these items usually increases.
- If they are shown at old historical cost, the Balance Sheet does not reflect their real worth. Importance of accounting for Price Level Changes
In price-level accounting:
- Non-monetary items are re-stated using a suitable price index or current value method.
- For example, the historical cost of a machine is multiplied by the conversion factor (current price index ÷ index at date of purchase) to show its value in current rupees.
4. Treatment Summary
- Monetary Items → Normally not restated; instead, we compute the monetary gain or loss due to change in purchasing power.
- Non-Monetary Items → Restated to current purchasing power or current cost, so that financial statements show realistic values. Importance of accounting for Price Level Changes
5. Conclusion
In an inflationary environment, it is essential to account for price-level changes; otherwise, financial statements based on historical cost give distorted profits and unrealistic asset values. By distinguishing between monetary and non-monetary items and adjusting them properly, price-level accounting presents a more true and fair view of the financial position and performance of the enterprise. Importance of accounting for Price Level Changes
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