The main effects of price level changes on financial statements are discussed in this article.

Effect on Profit and Loss Account

Price level changes do not influence profit and loss account items such as wages and salaries, insurance commission, and tax, which are paid on current values. The items that are affected in these accounts are shown below.

Cost of Goods Sold

The value of goods sold is equal to the cost of opening raw materials plus purchases and wages minus closing raw materials. These purchases are always purchases in different quantities and at different prices.

Now, the problem is to determine the price to value the stores at. In this case, the LIFO method or FIFO method, or even replacement cost method, can be used.

Valuation of Closing Stock

In accounting for the valuation of closing stock and finished goods, there is always a problem due to price level changes, where cost price and market price show a large difference. The solution lies with the valuation of the cost of goods sold.

Depreciation on Fixed Assets

In historical cost accounting, depreciation is always changed on the original cost of assets.

The cost of a machine is divided by its effective working life. The depreciation is always changed for the replacement of fixed assets; when prices are increasing, the depreciation should be changed to a higher value and not the original value.

Effect on Balance Sheet

The study of the assets side of a balance sheet reveals that some current assets (e.g., debtors, bills receivables, cash, and prepaid expenses) are taken for the short term, while some provisions are made to make them equal to their market value.

Therefore, price level does not affect them but the value of the closing stock can be affected, where its value is adjusted according to the price level.

Fixed assets and long-term investments are purchased for long-term use, and price level effects are significant for these assets. Therefore, proper adjustment for depreciation should be applied.

There are some intangible assets on the balance sheet whose value is not determined by any standard yardstick, including goodwill, patents, trademarks, and copyrights. Efforts must be made to write off such assets as soon as possible.

Liability Side of the Balance Sheet

Creditors, bills payable, tax provision, and outstanding expenses do not need adjusting. Debentures and long-term liabilities are always affected by a change in price level, and necessary adjustments should be made.

When the price level increases, the value of long-term liabilities falls; on the other hand, a reduction in the price level increases the value of long-term liabilities. There is no effect of price level on equity share capital.

In conclusion, it is important to remember that price level influences only fixed assets, stock, and depreciation.

Frequently Asked Questions

How does price level changes affect a company's revenue?

When a price level changes, a company's revenue increases or decreases as a result of an increase or decrease in the number of units that it sells. For example, if a business makes 10 widgets at $10 each and there is a 100% change in the price level so that each widget now costs $20, the business will sell 20 widgets at $10 each. This will result in more revenue than before the price change.

How do price level changes affect a company's expenses?

When there is an increase in the price of goods, prices of all the goods of the company also increase and this affects its revenues. But due to the increased cost of production, it may not be possible to increase the price of goods. So, instead of increasing the price, the company reduces its expenses or may choose not to reduce them until they sell their goods at existing prices. As a result, there is no change in the company's expenses due to price level changes.

How do price level changes affect a company's balance sheet?

When prices of products decrease, the company is able to sell its existing inventory at higher prices and gets more money than before. 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. 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.

How do price level changes affect a company's Financial Statement?

All the balance sheet items such as liabilities, Equity Shares, and other expenses are not affected by changes in price levels because all of them are stated at historical prices. On the other hand, items such as Fixed Assets, accumulated Depreciation, provision for contingencies, etc. Are affected by price level changes because these are stated at market prices and they change according to the change in the value of money.

How does a company's revenue affect its income statement?

Revenue is the amount of money that a company makes by selling its products or services. So, if there is an increase in the price level, it increases the revenue of the company by increasing the number of units sold. But if there is a decrease in the price level, its revenue decreases because it will be able to sell less number of units.

True is a Certified Educator in Personal Finance (CEPF®), a member of the Society for Advancing Business Editing and Writing, contributes to his financial education site, 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.

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