TOPIC :

THE PRICE LEVEL PROBLEM

(Conclusions)

JUN REY M. MORALES, C.E.

MEM - Construction Management

The Price Level Problem

ACCOUNTANTS View measures the goods and services that enter into his calculation of net income essentially at their acquisition cost, that is, at the prices paid when these goods and services were originally acquired by the company. ECONOMISTS View measures cost not in terms of the price originally paid for goods and services but rather in terms of real prices, that is, he adjusts acquisition prices to allow for changes in purchasing power or in the economic significance of the specific goods or services.

The Price Level Problem

- the difference between the accounting concept of income and the economists concept of income. - this difference arises because the purchasing power of the monetary unit of measurement is different at different times.

Proposals to deal with this problem:

1. LIFO Method of Inventory - has become a generally accepted accounting principle and is also allowed for tax purposes. 2. DEPRECIATION on Replacement Cost - is not a generally accepted accounting principle in the United States. 3. Price Level Adjustments - involves the preparation of supplementary financial statements rather than a change in the principles underlying the regular balance sheet and income statement

A. LIFO METHOD OF INVENTORY

Last-In, First-Out is a method of measuring inventory cost

Inventory is costed as if the units most recently added to inventory were the first units sold
Ending inventory is therefore assumed to consist of the oldest units and is measured at the cost of these oldest units In certain industries, LIFO does match economic flow of values since they claim, the profit margin that actually influences business pricing decisions is the margin between sales prices and current costs, not the margin between sales prices and cost levels that existed at the time the inventory was purchased.

A. LIFO METHOD OF INVENTORY

o there is a tendency to limit the amount of reported net income to an amount which might be made available to shareholders without impairing the scope and intensity of the operations of a going concern. o such restrictions in reported income serve to conserve funds by reducing income taxes.

o under LIFO, inventory is valued forever in terms of whatever the price level happened to be at the time LIFO was introduced.
o as time goes on and price levels change, the inventory figure under LIFO departs further and further from reality, becoming neither a reflection of actual purchase costs nor of current costs.

B. DEPRECIATION ON REPLACEMENT COST

Since the fixed assets of a company may have been purchased at various times extending many years into the past, price fluctuations cause the expense and asset amounts associated with these items to deviated even farther from current cost than is the case with inventory.

C. PRICE LEVEL ADJUSTMENTS

the process of making such Adjustments is a fairly long and complicated one, and it requires information as to the approximate date on which each asset was acquired. instead of adjusting all items, some accountant advocate that only depreciation expenses be adjusted.

Conclusions :
1. Of the techniques discussed, only LIFO is currently in accordance with generally accepted accounting principles. 2. Depreciation on replacement costs may become accepted either as in accordance with accounting principles, as a basis of income taxation, or both.

2. The overall adjustment of all financial statement items to current prices is likely to remain as a supplementary report rather than as a substitute for figures based on historical cost.

References :
ANTHONY, Robert N. Management Accounting (Text and Cases), 1970 www.simplified-accounting.com