ACCOUNTING FOR THE EFFECTS OF CHANGING PRICES
1. Understand the distinction between changes in the general level of prices in an economy, which affect the purchasing power of the measuring unit, and changes in the fair values of specific assets and liabilities.
2. Restate financial statements based on acquisition costs to a common measuring unit.
3. Remeasure financial statements based on acquisition costs to current fair values.
4. Prepare financial statements based on fair values and a common measuring unit.
The conventional accounting model, with exceptions for items such as marketable securities and financial instruments, reports assets and related expenses at acquisition cost. Inventories and fixed assets appear at acquisition cost on the balance sheet, and then, later, some allocated portion of this acquisition cost appears on the income statement when firms sell or use the assets. The conventional accounting model also uses the dollar, the euro, or other currency to measure acquisition cost amounts over time on the presumption that the currency reflects a common measuring unit—that is, one dollar (or one euro) spent yesterday and one dollar (or one euro) spent today reflect equal sacrifices of purchasing power. Changing prices, either for specific assets and liabilities or in general across the broad market basket of goods and services in an economy, cause distortions in the measurement of earnings and financial position. When prices change only a bit, U.S. GAAP and IFRS tolerate these distortions either because the distortions lack materiality or because accountants worry about injecting subjectivity into the financial reporting process if they adjust for changing prices.
Prices seldom remain stable. Changes in supply and demand resulting from new technologies, demographic shifts, consumer tastes and other factors cause prices to change. Even relatively small annual changes in prices can cumulate over time, resulting in...