Objectives of Accounting for Price Level Changes
The general tendency in changes in prices of goods and services over time is called price level. The rise in the general price level is called inflation. Historical cost accounting financial statements are prepared on the assumption that the monetary unit is stable. During the period of inflation, the purchasing power of money declines. The fall in the general price level is called deflation. But in reality, the monetary unit is never stable and most of the countries have been facing high rates of inflation. During the period of deflation, the purchasing power of money increases. Price level change means an 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.
Therefore, financial statements prepared under historical cost accounting do not reflect current economic realities. They fail to give realistic and correct pictures of the state of affairs of a concern.
The following are the objectives of accounting for price level changes.
- To show the true result of the operations i.e. real profit or loss.
- To show the true financial position in current values.
- To show the realistic value of fixed assets in the financial statements.
- To provide sufficient depreciation to generate funds for the replacement of fixed assets.
- To indicate the real capital employed.
- To make a distinction between holding gain or loss and operating gain or loss.
- To make accounting records reliable for the various users.
Inflation causes a decline in the purchasing power of money. It increases expenditure and discourages saving. During inflation, the purchasing power of money declines, as a result, debtors gain and creditors lose. During inflation, the cost of living increases, it hurts the people whose income is fixed. To overcome the limitation of historical cost accounting, there is a need to consider the effects of changes in the value of money as a result of changes in price of goods and services.
