Question

State how Price Level changes are ignored in Financial Statement Analysis.

Answer 1

Price level changes (inflation or deflation) are ignored in financial statement analysis because accounting data is strictly recorded on the Historical Cost Concept.

This limitation affects the analysis in the following ways:

• Fixed Asset Valuation: Assets purchased in the past continue to be shown in the balance sheet at their original purchase price (less depreciation), completely ignoring their current, inflated market value.
• Misleading Comparisons: When comparing financial statements of two different years, a rise in sales revenue might just be due to higher product prices caused by inflation, rather than an actual increase in the volume of goods sold.
• Distorted Profits: Depreciation is calculated on the older historical cost of machinery rather than its higher replacement cost, which can lead to overstating the company’s true net profits.

Consequently, financial statement analysis reflects a book-value position rather than the real, current economic reality of the business.