When you’re composing financial statements, it’s important to consider the changing value of money and adjust for inflation/deflation. That’s why constant purchasing power is such an important concept for accountants and small business owners to master. How much do you know about constant purchasing power accounting? Learn more with our simple guide, including how to calculate constant purchasing power.
Constant purchasing power accounting explained
Constant purchasing power accounting (CPPA) is a method of preparing financial statements wherein adjustments for changes in the value of money are included. It’s also referred to as current purchasing power accounting, constant dollar accounting, and general price level accounting. But what is current purchasing power accounting? In short, it means that all non-monetary items that are recorded on the historical-cost basis should be adjusted by applying a general price index.
Importance of constant purchasing power accounting
So, what’s the reason for implementing constant purchasing power accounting in the first place? In short, it’s because the historical cost basis of accounting assumes that the value of items on the balance sheet haven’t changed since they were acquired. Obviously, this isn’t the case when inflation/deflation has taken place, and often it means that the real value of a certain asset will differ from the value reported on the balance sheet.
How does constant purchasing power accounting work?
The methodology behind constant purchasing power accounting is relatively simple. First off, it’s important to note that it only applies to non-monetary items that are recorded on the historical cost basis. Monetary items that aren’t recorded on the historical cost basis don’t need to be adjusted for inflation/deflation.
Remember, “monetary items” covers cash and cash equivalents like accounts receivable, while “non-monetary items” covers fixed assets like property and equipment, as well as other, more intangible assets like patents and so on.
Here’s a quick overview of how your main financial documents should be treated when using constant purchasing power accounting within the IASB (IFRS) framework:
Income statement – All items should be adjusted.
Cash flow statement – All items should be adjusted.
Financial statement – Monetary items shouldn’t be adjusted, items already adjusted for current market value/fair value shouldn’t be adjusted, equity should be adjusted, and all other non-monetary items should be adjusted.
Example of constant purchasing power accounting
Let’s look at an example to see how constant purchasing power accounting works in the real-world. As you’ll see, learning how to calculate constant purchasing power isn’t particularly difficult, so long as you have access to the appropriate financial documents and a general price index. Imagine Company A has the following expenses for the year ending December 2019:
Sales expenses – $250,000
Interest expenses – $20,000
Rental expenses – $150,000
Administration expenses – $200,000
These expenses are spread evenly throughout the accounting period, apart from rent (paid in advance at the beginning of the period) and interest (accrues at end of period). The price index information reads as follows:
January 1, 2019 – 100
December 31, 2019 – 110
2019 average – 105
Using constant purchasing power accounting, you can calculate the adjustments you need to make:
Sales expenses = $250,000 x 110/105 = $261,904.76
Interest expenses = $20,000 x 110/110 = $20,000
Rental expenses = $150,000 x 110/100 = $165,000
Administration expenses = $200,000 x 110/105 = $209,523.81
So, there you have it. As you can see, constant purchasing power accounting has raised Company A’s expenses. This is because the value of money increased throughout the accounting period.
Constant purchasing power: GAAP and IFRS
Constant purchasing power accounting is authorized under both GAAP and IFRS. So, if you’re using either of these accounting frameworks, you should be able to implement constant purchasing power accounting relatively easily.
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