Let us make an in-depth study of the advantages and disadvantages of price level accounting.
Advantages of Price Level Accounting:
In the past few years of high inflation, companies have reported very high profits on the one hand but on the other they have faced real financial difficulties. This is so because in reality dividends and taxes have been paid out of capital due to overstated figures of profits arrived at by adopting historical cost concept. Thus a change from historical cost concept to price level or inflation accounting has been recommended.
The major advantages of Inflation Accounting are as follows:
(1) It enables company to present more realistic view of its profitability because current revenues are matched with current costs.
(2) Depreciation charged on current values of assets in inflation accounting further enables a firm to show accounting profits more nearer to economic profits and replacement of these assets when required.
(3) It enables a company to maintain its real capital by avoiding payment of dividends and taxes out of its capital due to inflated profits in historical accounting.
(4) Balance Sheet reveals a more realistic and true and fair view of the financial position of a concern because the assets are shown at current values and not on distorted values as in historical accounting.
(5) When financial statements are presented, adjusted to the price level changes, it makes possible to compare the profitability of two concerns set up at different times.
(6) Investors, employees and the public at large are not misled by inflated book profits because inflation accounting shows more realistic profits. Higher paper profits without adjustment for price level changes cause resentment among workers and they demand higher wages and also excessive profits attract new entrepreneurs to enter the business. Inflation accounting helps in avoiding further competition from prospective entrepreneurs.
(7) The financial statements prepared by a company adjusted to the price level changes also improve its social image.
(8) Inflation accounting also affects the investment market as it helps to establish a realistic price for the shares of a company.
Disadvantages of Price Level Accounting:
Some people are of the opinion that inflation accounting may create more problems than solving them because of the following inherent disadvantages of the price level accounting:
(1) Adjusting accounts to price level changes is a never-ending process. It involves constant changes and alterations in the financial statements.
(2) Price level accounting involves many calculations and makes financial statements so complicated and confusing that it becomes very difficult for man of ordinary prudence to understand, analyze and interpret them.
(3) The concept of price level accounting appears to have more theoretical importance than practical because adjusting the accounts to the changes in the price levels may lead to window dressing of accounts due to the element of subjectivity in it. People may adjust the accounts according to the values most suited to them, thereby, making the financial statements more inaccurate.
(4) Depreciation charged on current values of fixed assets is not acceptable under the Income Tax Act, 1961 and hence adjusting it to price level changes does not serve any practical purpose.
(5) During deflation, when the prices are falling, adjustments of accounts to price level changes will mean charging lesser depreciation and overstatement of profits.