The following are the main effects of price level changes on the financial statements.
Effect on profit and loss account
The change in price level does not affect profit and loss account items such as: wages and salaries, insurance commission, tax etc. are paid on current values. The items which affect profit and loss accounts are as:
- 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 what price the stores be valued? LIFO method or FIFO method or replacement cost method.
- Valuation of closing stock. In accounting the valuation of closing stock and finished goods there is always a problem due to the change in price level their cost price and market price shows a high difference. The solution to this problem 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 the 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 on increased value and not on the original value.
Effect upon the balance sheet
The study of Balance sheet assets side reveals that some current assets like debtors, bills receivables. Short term investment, cash and prepaid expenses are taken for short-term and for debtors, bills receivables and investment some provisions are made to make them equal to their market value, thus price level does not affect them but the value of closing stock can be affected its value be adjusted according to price level.
The fixed assets and long term investments are purchased for long term use and price level effects these assets very much, thus proper adjustment for depreciation be made. There are some intangible assets in Balance sheet whose value is not determined by any standard yardstick these are: goodwill, patents, trademark and copyrights etc, effort-be made to write off such assets as soon as possible.
The liability side of the Balance sheet
Creditors, bills payable, tax provision outstanding expenses need no adjustment yet. Debentures and long term liabilities always affected by a change in price level and for them necessary adjustment be made. When there is an increcse in price level long term liabilities value falls and on the other hand fall in price level increases the value of long term liabilities. No effect of price level on equity share capital.
Conclusion. Price level effects only fixed assets, stock and depreciation.