The Effect of Price Changes
Inflation has become an important fact of life in almost all countries of the world. As a result it is necessary to take into account the effects of price changes on financial reporting.
We know that a change in price affects the purchasing power of a monetary unit. We have alternative methods of accounting for price changes. The main objective of purchasing-power accounting is to restate the unit of measure into a common denominator. The restatement means to a scale adjustment.
I could say that I bought an accounting book for US $100 and I bought another accounting book for CDN $100. So I spent $200 US and CDN dollars. Saying like this is meaningless to me because the scale of measurement of the value of US and CDN dollar is different. I could say that I bought two books for US $171 or for CDN $240 if I assume that the exchange rate or price for US $ is CDN $1.40. So if the price of US$ changes, we have to adjust the scale of measurement. That is why it is very important that when we measure the current costs and the historical costs of the assets of a company we do understand the effect of price changes and of the resulted changes in purchasing power of a monetary unit.
The Nature of Price Changes
Prices reflect the exchange value of goods and services in the economy. In general, these prices can be classified as either input prices or output prices. As we know, input prices are the prices of factors of production at intermediate stages and output prices are the prices charged by an enterprise for its final goods and services.
One thing is sure that price changes occur only when the prices of goods or services are different from what they were previously in the same market. For example, if Company A purchases 100kg of Apples for $100 from Company B and resells it to Company C for $110, it is not price change. Price change will occur only if Company A now start charging Company B more or less than $100 per 100kg of Apples or Company B now start charging Company C more or less than $110 per 100kg of Apples or both Company A and Company B now start charging more or less for 100kg of Apples.
Basically price changes can be divided in the classes as follows:
1. General Price Changes
2. Specific Price Changes
3. Relative Price Changes
General Price-Level Changes
General price-level changes reflect the value of the monetary unit over time. The total supply of money and the total supply of goods and services in the economy fluctuate, but not usually at the same rate. This disparity leads to inflation or deflation, changing the value of the monetary unit. Changes in commodity prices or a discrepancy between total supply and demand of goods and services can also lead to general price changes.
Because prices change at different rates, general price changes can only be measured by calculating the average level of current prices and comparing it with a base period. Products and services change over time and good comparisons can only be drawn if goods and services are the same or similar at both dates. The ratio between the current prices and the base prices reflect the change in the price index. For example, if the base period is 1998 and prices have increased by 50% between 1998 and 2003, the index will be 150 in 2003. The reciprocal of this ratio expresses the change in purchasing power. Thus, while prices have increased by 50%, purchasing power has decreased by one third. Purchasing power refers to the amount of goods and services that can be purchased with a monetary unit.
General purchasing power refers to the ability to purchase all types of goods and services whereas specific purchasing power refers to the ability to purchase specific goods and services. The Consumer Price Index is a measure which falls between general and specific purchasing power. While the CPI measures the change in price of specific goods and services commonly bought by all consumers, it is extensive enough to be considered to be a general index.
Specific Price Changes
Specific price change is the change in the price of a particular commodity, or the change in its exchange value. Specific price changes are caused by some factors specific to the commodity, such as:
- Changes in tastes of consumers
- Technological improvements
- Natural or artificial changes in the supply of particular products, etc
For example, the price of a 21¡± TOSHIBA TV in 1988 is $750, while in 2003 is around $200. Why the price of the same TV dropped so much in years?
- Consumer tastes: Consumers are looking for TVs with finer video and audio quality, larger screens, better design, or even game and internet functions.
- Technological improvements: New video and audio technology has made current TVs more enjoyable. In addition, improved technology has significantly lowered TV production costs.
- Changes in the supply: Consumers nowadays have more TV brands to choose from. TVs imported from developing countries have intensified market competition and dragged down market price.
How do we recognize the specific price changes in accounting? In traditional accounting, the historical cost basis is used. The original transaction price of goods or services acquired is matched with the revenue associated with the period or the goods sold. Therefore, changes in the specific input prices of goods sold are included in the computation of the reported net income for the period.
Current sales price ¨C Historical cost = Income
For example, Commodity A was purchased in January 2002 at $10 each. When it¡¯s sold at $15 in January 2003, it can be purchased at the market for $12. Under traditional approach, income = 15-10 = $5. The price increase $2 is absorbed into net income.
A more relevant matching is the current cost basis. The current input prices are matched with the current output (revenue) prices. The price changes, which are the differences between current and historical input prices, are treated as holding gains (increase) and holding loss (decrease). In the example above, current income of Commodity A = 15-12 = $3. Holding gain = 12-10 = $2.
Current sales price ¨C Current replacement cost = Income
The current cost approach is more relevant as a measure of operating efficiency and as a better basis for predicting the results of future transactions. Therefore it¡¯s more relevant in meeting the objectives of financial report users. However, an objection is frequently made regarding the use of current costs, on the ground that a subjective value is substituted for a verifiable exchange price (historical cost). In addition, current input prices can be assumed to represent current costs to the firm only if the firm generally purchases the same types of assets and is continuing to do so, while this is usually not the case in reality.
Relative Price Changes
Normally speaking, prices of different goods and services do not move in sync with each other, much less in the same direction. A relative price change is defined as the change in the price of a specific commodity as compared to an index such as the Consumer Price Index. For example, if the Consumer Price Index increased by 10% over last year and car insurance doubled in the Maritimes, we can say that the relative price increase in car insurance is approximately 82%.
How do price changes impact accounting? Traditionally since accounting uses historical costs, price changes are not isolated and reported separately. All gains and losses are hidden in the bottom line. However the various income statement and balance sheet accounts can be adjusted for general price level changes through the use of foreign exchange gains and losses accounts. But any gains or losses from specific price changes would not be measured and separated from net income.
If instead we chose to use current costs instead of historical costs, net income can still be measured without the effects of price changes. But this would require that all accounts be adjusted for both the effects of general as well as specific price changes. The complexity of this exercise is probably one reason why historical costs are still used.
A general price change is defined as the change in the value of a monetary unit such as the Canadian dollar. Some examples would be a decrease in the value of the dollar due to an increase in the money supply from overprinting or an increase in value due to demand from foreign investors wishing to invest in Canada.
As was explained earlier, specific price changes are not due to movements in the exchange value of the Canadian dollar but are caused by more specific reasons such as changes in technology, or changes in the supply of goods available. Some examples would be changes to the prices of a given computer; they tend to decline in price over time. Another example would be changes to the price of crude oil as OPEC manipulates it.
Relative price changes occur when goods or services increase or decrease in value relative to a standard such as the Consumer Price Index.