Inflation Accounting

Inflation Accounting

A presen presentat tation ion by - ITM XMBA XMBA -33 -33 Dinesh M Manghani Sharon Rodrigues

INFLATION ACCOUNTING

INFLATION is the erosion or reduction in the value of money. Simply stated what one can buy for Rs.100 cannot buy the same thing for Rs.100 after some time.

For e.g a vada pav was Rs.5/- some time back but the same vada pav is around Rs.10/- today

One of the recent examples of inflation is also sugar.


Inflation accounting is a term describing a range of accounting systems designed to correct problems arising from historical cost accounting in the presence of inflation. inflation .

Inflation accounting is used in countries experiencing high inflation or hyperinflation. hyperinflation. For example, in countries experiencing hyperinflation the International Accounting Standards Board requires corporate financial statements to be adjusted for changes in purchasing power using a price index. index.


Accountants in the UK and US have discussed the effect of inflation on financial statements since the early 1900s, beginning with index number theory and purchasing power. power.

Irving Fisher's Fisher's 1911 book The Purchasing Power of Money was used as a source by Henry W. Sweeney in his 1936 book Stabilized Accounting, Accounting, which was about Constant Purchasing Power Accounting. Accounting.

In March 1979, the Financial Accounting Standards Board (FASB) wrote Constant Dollar Accounting, Accounting, which advocated using the Consumer Price Index for All Urban Consumers (CPI(CPI U) to adjust accounts because it is calculated every month.

During the Great Depression some corporations restated their financial statements to reflect inflation


Under a historical costcost-based system of accounting, inflation leads to two basic problems. First, many of the historical numbers appearing on financial statements are not economically relevant because prices have changed since they were incurred.... Second, since the numbers on financial statements represent dollars or rupeees expended at different points of time and, in turn, embody different amounts of purchasing power, they are simply not additive.

Suppose the income statement of of a company for 2006 2006--07 states sales figure of of Rs Rs.. 50 lakh and Rs. Rs.75 lakh for 2007 2007--08, 08, p prima facie the sales show the performance better by 50 50% %, the fact remains that this entire increase is not due the performance of of the company but partly because of increase in prices. prices.


Misleading reporting under historical cost accounting

In most countries, primary financial statements are prepared on the historical cost basis of accounting without regard either to changes in the general level of prices or to increases in specific prices of assets held, except to the extent that property, plant and equipment and investments may be revalued.´

³

Ignoring general price level changes in fin ancial reporting creates distortions in financial statements such as reported profits may exceed the earnings that could be distributed to shareholders without impairing the company's ongoing operations the asset values for inventory, equipment and plant do not reflect their economic value to the business future earnings are not easily projected from historical earnings the impact of price changes on monetary assets and liabilities is not clear future capital needs are difficult to forecast and may le ad to increased leverage, which increases the business's risk when real economic performance is distorted, these distortions lead to social and political consequenses that damage businesses (examples: poor tax polic ies and public misconceptions regarding corporate behavior)

Objectives of Inflation Accounting


 The

user or the decision maker gets an information which shows the Performance To

facilitate the comparison of the performance of two different periods it is necessary that the figures are adjusted for inflation.

The

monetary items and income and expenses do not show the correct Purchasing power of money. Therefore their values should be adjusted for inflation. To

ascertain the current value of assets.

Methods of Inflation Accounting


A. Current Purchasing Power (CPP) Method In CPP method common purchasing power of all the items and transactions in the balance sheet are worked out. For the purpose, an appropriate price index, wholesale or consumer price index is used. The method tries to find out the current purchasing power of transactions as well as gains or losses arising out of holding the monetary items.

In case of cash (ASSET)value will reduce because of inflation

In case/payables (LIABILITIES), inflation will result in gain as fixed/agreed money payable by the company will have less purchasing power


Items of Income Statement ± CPP Method.

Opening and Closing inventory

Transactions for the period

Depreciation on fixed assets for the period

Loss or gain arising from holding the monetary items


B. Current Cost Accounting (CCA) Method Current-cost accounting (CCA) is a method of accounting, recommended by the Sandilands Committee set up by the UK Government in 1975 to consider the most appropriate way to account for the effects of inflation in the published accounts of companies. In CCA, instead of showing assets at their historical cost (ie their original purchase price), less depreciation where appropriate, the assets are shown at their current cost (replacement cost: the price at which the assets of an organisation could be replaced, broadly in their existing state.

Objective of CCA

To show Assets and Liabilities at current replacement value.

Finding out profit or loss by matching current cost and revenues


Advantages of Inflation Accounting Assets are shown at real values uniformly.

Financial statements of a company show correct and current information about the financial performance of the company.

Inflation Accounting enables a company to get a fair price for its shares by showing the current values of fixed assets.

The

value of the assets will be more accurate and closer to its intrinsic Value.


Disadvantages of Inflation Accounting

Depreciation charging on replacement cost goes against the concept.

Both the methods CPP and CCA have serious drawbacks and there is no general consensus about the method to be used.

Charging depreciation on replacement cost not acceptable to the income tax authorities.


Impractical System Industry experts are of the view that none of the methods of Inflation Accounting are foolproof and cannot give an accurate effect of the price level changes. A more serious flaw is that it cannot be accepted as a statutory system of accounting because of gap between theory of inflation and its practical applicability. Eg : A company earns a profit of Rs. 25 lakh which, say is at a 5% rate of return on its investments. If the rate of inflation is significantly more after adjusting price level changes, the figure of Rs.25 lakh may turn into a loss figure.

But the fact remains that the company is physically holding Rs. 25 lakh (the value may be less than Rs. 25 lakh).


Importance of Inflation Accounting Concept ± Important for Financial Planning and Decision Making

- Helpful for finding out the real value of money considering the anticipated inflation rate.

Better Term

INFLATION AND FINANCIAL PLANNING & DECISION MAKING

Inflation Accounting

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