Current Purchasing Power Method
The current purchasing power (CPP) method is also known as general price-level accounting.
In the United States, the CPP method is recommended by the Accounting Policy Board and the Financial Accounting Standards Board (FASB).
CPP adjusts historical cost based on changes in the general level of prices, as measured by the general price level index. Changes in the general level of prices represent changes in the general purchasing power of the monetary unit.
CPP is a mixed method in which financial statements are prepared on a historical basis. These statements, in the end, are converted based on the current purchasing power of the currency. Profit and loss items and balance sheet items are adjusted with the price index.
The basic idea of the CPP method is to apply changes in the value of money in response to changes in general price index.
In general, inflation reduces an individual’s purchasing power to purchase goods and services, while deflation increases an individual’s purchasing power to purchase goods and services.
Historical financial statements show transactions at various points in time and, as such, they also show replacement purchasing powers at various points in time.
CPP accounting transforms diverse historical measures into a single measure: namely, that of current purchasing power, which represents purchasing power at the same point in time.
Thus, CPP accounting makes all accounting numbers comparable in terms of general purchasing power. This is achieved by removing the mixed purchasing power element from historical financial statements.
CPP differs from current cost accounting (CCA) in that, under CPP, the current values of various assets are not worked out; instead, financial statements are stated in terms of dollars of uniform value.
Hence, the CPP method considers changes in price levels that are denoted by the general price index. Thus, all amounts are expressed in units of equal purchasing power.
Since the CPP method reflects the effects of changes in the general price level, it is also known as general price-level accounting.
Monetary and Non-Monetary Items
The CPP method distinguishes between monetary items and non-monetary items.
Monetary items are those assets and liabilities that represent a claim to receive, or an obligation to pay, a fixed amount of foreign currency. Examples of monetary items include cash, accounts payable, accounts receivable, and long-term debt.
Monetary items are translated at the current rate while non-monetary items (such as fixed assets, stock, plant and buildings) are translated at historical rates.
During a period of rising prices, holding monetary assets results in a loss of purchasing power. Likewise, creditors tend to gain during a period of rising prices as debts are now repaid in dollars of less purchasing power than those originally borrowed.
Non-monetary items such as stocks, plants, and buildings increase in value in an inflationary context. The lower cost and net realizable value can be taken and then further adjusted.
Various indices can be used. For example, the index used could be the cost of living index or the general index of retail prices.
Techniques to Understand the Current Purchasing Power (CPP) Method
The following techniques are applied to understand the CPP method:
- Conversion technique
- Mid-period conversion
- Monetary and non-monetary accounts
In this method, historical figures are stated at current purchasing power. Items of profit and loss and balance sheet items are adjusted with the help of general price index number.
Conversion Factor = Current Price Index Number / Previous Price Index at the Date of Existing Figure
A building was purchased in 2018 for $160,000. The general price index was 250. Convert the figures in current dollars in 2019 using the general price index of 500.
= Current Price Index / Previous Year Index at the Date of Existing Figure
= 500 / 250 = 2 times
Converted Value = Historical Cost x Conversion Factor
= $1,60,000 x 2 = $3,20,000
Multiple transactions take place over the year in any business, including purchases, sales, and expenses. To convert such items, the average index of the year can be taken as the one index for all such items. When such an index is not available, the index of mid-year can be taken.
Monetary and Non-Monetary Accounts
For the conversion of historical costs in terms of CPP of currency, monetary accounts are those accounts of assets and liabilities that are not subject to reassessment of their recorded values due to change of purchasing power of money.
|Jan. 2018||Dec. 2018|
|Retail Price Index No.||200||300|
Calculate the net monetary value.
|Monetary Liabilities||(30,000 x 300) / 200 =||45,000|
|Increase in Liabilities||(10,000 x 300) / 240 =||12,500|
|End Balance of Current Liabilities||40,000|
|Gain Holding Monetary Liabilities||17,500|
|Monetary Assets||25,000 x 300 / 200 =||37,000|
|Increase in Assets||12,000 x 300 / 240 =||15,000|
|Balance of End||37,000|
|Net Gain||17,500 – 15,500 =||2,000|
Suitability of the CPP Method
The CPP method is useful when the aim is to maintain purchasing power in general. It is further suitable:
- To assist decision-makers in evaluating trends, particularly when data for a series are expressed in units of constant purchasing power.
- To assist shareholders in keeping the purchasing power of their investment intact.
Implementation Problems for CPP Method
There are several implementation problems associated with the CPP method:
- The critical problem in inflation accounting is training accountants (and others) to prepare and interpret information adjusted for the effects of inflation.
- Price indices to be used for the revaluation of assets.
- Corporate profits are watched closely by managers, governments, and investors. Managers may have an interest in maintaining the present level of profit and may resist any adjustment to this profit (e.g., to maintain the current rate of taxation).
- Finally, labor unions may also not agree to adjust financial statements for the effects of inflation, especially if they fear that due to the adjustment, profits and, hence, bonuses will decline.
About the Author
True Tamplin, BSc, CEPF®
True Tamplin is a published author, public speaker, CEO of UpDigital, and founder of Finance Strategists.
True contributes to his own finance dictionary, Finance Strategists, and has spoken to various financial communities such as the CFA Institute, as well as university students like his Alma mater, Biola University, where he received a bachelor of science in business and data analytics.