In order to trace the impact of inflation on the financial statements, it becomes necessary to pinpoint the limitations of the conventional statements conveying historical financial infor mation for end-users within an organisation and also outsiders.
1. Changes in the price level are not taken into account. The financial statements prepared under the conventional system are merely statements of historical facts. They fail to give realistic and correct picture of the state of affairs of a concern. Monetary unit is never stable under inflationary conditions. This instability has resulted in a number of distortions in the financial statements and is the most serious limitation of historical accounting.
2. Fixed assets are shown in the position statement at the cost at which they were ac-quired. Further purchase of assets at different points of time is clubbed together as additions to the existing assets, without any regard to change in the purchasing power of rupee. For example, we constructed a building at a cost of Rs. 1,00,000 in 1990 and constructed a similar building in 2000 at a cost of Rs 2,50,000. The rupee value in 1990 is not the same as in 1990. The value is significantly less in 2000. These buildings are shown as follows:
Building (1990) Rs. 1,00,000
Building (2000) Rs. 2,50,000
Current Purchasing Power Method (CPP)
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). For measuring changes in the price level and incorporating the changes in the financial statements we use index numbers, which may be considered to be a barometer meant for the purpose. Under this method any established and approved general price index is used to convert the values of various items in the Balance Sheet and Profit and Loss Ac-count. This method takes into consideration the changes in the value of items as a result of the general price level, but it does not account for changes in the value of individual items. For example, a particular machine may have become cheaper over the last few years, whereas the general price level may have risen; the value of the machine will also be raised in accordance with general price index.
Thus general price level adjustment restates financial data by bringing past rupee amounts in line to current rupee purchasing power by general index multiplier. The preparation of the financial statements according to CPP method, needs understanding of the following steps:
(i) Conversion Factor:
CPP method involves the restatement of historical figures at current purchasing power. For this purpose, historical figures must be multiplied by conversion factors and the formula for the calculation of conversion factor is:
Conversion Factor = Price Index at the date of revaluation/Price Index at the date of existing figures