In the Replacement Cost Accounting technique the index used are those directly relevant to the company’s particular assets and not the general price index. In this sense the replacement cost accounting technique is considered to be a improvement over current purchasing power technique. Fair value accounting refers to valuing assets and liabilities at their current market values on the balance sheet. Historical cost accounting values assets and liabilities at their original purchased costs and does not reflect changes in current market values.

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1. Specific profit shown in Exhibit 1 is the amount distributable while maintaining the specific purchasing power of net assets, which include monetary items as well as physical assets.
2. SFAS 33 says that expenses are measured at amounts sufficient to maintain the physical operating capability of the enterprise (para. 100).
3. You can get an instant quote by selecting your assignment type, deadline, and page count on our website.
4. As a result, this enables the company to show their accounting profit closer to economic profits.

But when there is an increase in the price level, a company cannot increase its prices and has to take a loss on its goods, which means that the value of the company’s assets and net worth will decrease. To take this prospect into consideration, a committee headed by Francis Sandilands was framed known as Inflation Accounting Committee (UK). As per this committee, which published its report in 1975, it was recommended that to deal with concept of Inflation Accounting, the process of current cost accounting should be adopted.

Thus, the standard provides for an adjustment in respect of monetary working capital when determining current cost operating profit. This adjustment should represent the amount of additional (or reduced) accounting for price level changes finance needed for monetary working capital as a result of changes in the input prices of goods and services used and financed by the business. The profit, arrived at by deducting from the revenues at current values, the costs which are not only current values, cannot state the true picture. The causes of overstatement of profits during inflation are primarily two in number. One is the writing off depreciation on fixed assets at a lower rate than it would have been and the other is the overvaluation of stock in trade.

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. Conventional or historical cost accounting assumes that money has stable value. But in reality, value of money varies from time to time as a result of changes in the general level of prices. The change in price as a result of various economic and social forces brings about a change in the purchasing power of money. Under the CCA technique, cost of sales are to be calculated on the basis of cost of replacing the goods at the time they are sold.

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Equally, the F-test result reveals substantial differential impacts of profits measured on historical and current cost bases on the operating ability of the firm during periods of rising prices. It should be noted that a shrewd user could have estimated these additional amounts from scattered numbers required by SFAS 33. Nominal profit can be estimated by adding current cost income from continuing operations (CCICO) and the increase in current costs (before inflation). Consumer profit can be estimated by adding CCICO, the monetary purchasing power gain, and the excess of increase in specific prices over the increase in general price level.

Valuing Liabilities: Current Cost vs Fair Value

As far as sales are concerned, it needs no adjustment as it is a current revenue. One of the features of current cost accounting is to show inventories in the Balance Sheet on the basis of their value to the business, and not at cost or market price, whichever is lower. If there are stocks, certain adjustments are to be made to cost of sales. If there are no stocks, then cost of sales will comprise only current purchases and cost of sales adjustment is not necessary. (a) Opening Balance Sheet prepared under historical cost accounting method is converted into CPP terms as at the end of the year.

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. 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. This process of adjustment of cost of sales and inventory has been explained in the following illustration. (b) Conversely, when materials and services are purchased from suppliers who offer trade credit, price changes are financed by the supplier during the credit period.

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Fair value shone a light on this, whereas historical cost obscures real values. Overall the firm should weigh whether income statement and ratio volatility is an acceptable tradeoff for the benefits of relevant fair value balance sheets. The main effects of price level changes on financial statements are discussed in this article. This article is intended to help accountants understand the complex problems presented by changing costs and suggest better ways of solving those problems. The above analysis shows how the current-cost calculations and the disclosures in SFAS 33 can be modified to be potentially more useful than those originally required in 1979. Until that happens, internal accountants can choose to apply all or part of this system to give managers better information about how changing costs affect their business.

1. Working capital is that part of capital which is required to meet the day to day expenses and for holding current assets for the normal operations of the business.
2. However, using the RCA technique means adopting different price indices for the conversion of items in the financial statements.
3. Fair value accounting aims to provide more relevant information to investors by reflecting the current market values of assets and liabilities, rather than just historical costs.
4. This means that the value of the company’s assets will increase due to an increase in stock and this will increase its net worth.
5. They argue banks were holding risky, overvalued assets that posed systemic risk.

(c) For purchases of previous year—the average index of the relevant year. The computation of monetary gain or loss can be followed with the help of the following illustrations. Rs. 1,00,000 Rs. 1,00,000 would be shown on the liability side of the Balance Sheet as Current Cost Reserve. (b) Cost of sales is converted as per cost flow assumption (FIFO or LIFO) as explained in the preceding pages.

Let us make an in-depth study of the effect of price level change on financial statements. The key difference is fair value reflects current worth, while historical cost is unchanged. However, fair value advocates counter that it revealed problems already brewing. They argue banks were holding risky, overvalued assets that posed systemic risk.

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. It must be noted that, in the process of conversion, it is only the non monetary items which are adjusted to the current purchasing power of money.