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.