Application of Inflation Accounting

8/7/2019 Application of Inflation Accounting

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Inflation Accounting : DefinitionsInflation Accounting : DefinitionsInflation Accounting : DefinitionsInflation Accounting : Definitions

y Decrease in purchasing power of money due to an

increase in the general price level

y A process of steadily rising prices resulting indiminishing purchasing power of a given nominal sum

of money

The Penguin Dictionary of Economics

y Rise in prices brought about by the expansion of the

supply of bank money, credit, etc.

Oxford Advanced Learners Dictionary of Current English


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Some Aspects on Inflation AccountingSome Aspects on Inflation Accounting

Problems:

y Subjectivity

y Often complicated calculations

Benefits:y maintaining production capacity

y shows the internal logic of accounting


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Change in the price level is described byChange in the price level is described by

indexesindexes

Change in the price level is described byChange in the price level is described by

indexesindexesy General indexes

Price Index of Gross Domestic Product

Cost-of-living Index

C

onsumer Price Index Wholesale Price Index

Production Price Index

y Special indexes Industry indexes

Commodity group indexes

Commodity indexes


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Finnish Wholesale Price IndexFinnish Wholesale Price Index

19601960--19941994

Finnish Wholesale Price IndexFinnish Wholesale Price Index

19601960--19941994

0

200

400

600

800

1000

1200

1400

1600

1800

1960 1965 1970 1975 1980 1985 1990

Source: Statistical Yearbook of India 1995


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Yearly Change (%) in the FinnishYearly Change (%) in the Finnish

Wholesale Price IndexWholesale Price Index

Yearly Change (%) in the FinnishYearly Change (%) in the Finnish

Wholesale Price IndexWholesale Price Index

-10

-5

0

5

10

15

20

25

30

1960 1965 1970 1975 1980 1985 1990

Source: Statistical Yearbook of India 1995


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Inflation Accounting MethodsInflation Accounting MethodsInflation Accounting MethodsInflation Accounting Methods

y CPP - Current Purchasing Power

y CCA - Current Cost Accounting

y

The Finnish AHI-Method (AktivoitujenHankintamenojen Indeksointisovellutus)


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Current Purchasing Power (CPP)Current Purchasing Power (CPP)Current Purchasing Power (CPP)Current Purchasing Power (CPP)

y

Retains historic cost accounting conventionsy In U.S. General Purchasing Power (GPP)

y Expresses accounts in terms of purchasing units

y The purchase power of money at the end of the accounting

period as the basey Maintains the general purchasing power of the invested

capital

y The original purchasing costs are corrected by correctioncoefficients applying some general index, for example RetailPrice Index


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y Monetary items - financial assets and liabilities - remainunchanged

y Inventories: FIFO purchase cost is corrected by asuitable correction coefficient to correspond thepurchase power of the end of accounting period

y Fixed assets:

The purchase cost is corrected to correspond the purchasepower of the end of the accounting period

The balance value of the fixed assets is the same percentageof the corrected purchase cost as the book value is of theoriginal purchase cost


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y Equity is defined as Assets - Liabilities

y Shareholders point of view

y Unsuitable for financing decisions

y Work intensive method


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Current Cost Accounting (CCA)Current Cost Accounting (CCA)Current Cost Accounting (CCA)Current Cost Accounting (CCA)

y Maintaining the production level of the

company

y Main focus on replacement of production

capacity

y Money is retained as the unit of

measurement

y Different special indexes are applied todifferent items

y Work intensive


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Inflation accounting is not fair value accounting. Inflation

accounting, also called price level accounting, is similar

to converting financial statements into another currency

using an exchange rate. Under some (not all) inflationaccounting models, historical costs are converted to price-

level adjusted costs using general or specific price indexes.

Income statement general price level adjustment

example

Inflation accounting modelsInflation accounting models


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(a) 30,000 x 105/100 = 31,500

(b) 30,000 x 110/100 = 33,000

(c) (30,000 x 105/100) - 30,000 = 1,500

(d) (63,000 x 110/105) - 63,000 = 3,000

2001 2002 2003 Total

Revenue 33,000 36,302 39,931 109,233

Depreciation 30,000 31,500 (a) 33,000 (b) 94,500

Operating

income 3,000 4,802 6,931 14,733

Purchasing

power loss - 1,500 (c) 3,000 (d) 4,500

Net income 3,000 3,302 3,931 10,233

On the income statement, depreciation is adjusted for

changes in general price levels based on a general price

index.


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The role of inflation accounting inThe role of inflation accounting in

financefinance

In economics, monetary correction is an adjustment made

periodically in certain base values of the economy in a

period of inflation. It is aimed at compensating for the loss

of value of money. And in terms of tax accounting,

restatement can be referred to as active monetary

variation, or passive monetary variation.

Inflation has two components, and these are monetary

inflation and historical cost inflation. In an economy or firmwhich uses the fair value accounting model only one

component of inflation applies, that is, monetary inflation.

Historical cost inflation is impossible in an economy,

company or group of companies making use of real value

accounting model.


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N

ominal Balance SheetN

ominal Balance SheetFAInv

FixAssAssets

DebtEq

FA = Financial Assets

Inv = Inventories

FixAss = Fixed AssetsAssets = Total Assets

Debt = Liabilities

Eq = Owners Equity


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Adjustments to the Balance SheetAdjustments to the Balance Sheet --

AssetsAssets


AssetsAssetsy Financial Assets and Inventories (FIFO) remain unchanged

y Fixed Assets - first AHI-year The original purchase cost is revaluated to the price level of the current

year

Depreciation/year is computed according to the economic lifetime of theasset

The depreciations up to the current year are subtracted from the revaluatedpurchase cost

y Fixed Assets - after the first year The AHI-balance value of the previous year is revaluated to the current year

New depreciation is computed based on the remainingeconomic lifetime


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Equity and LiabilitiesEquity and Liabilities


Equity and LiabilitiesEquity and Liabilities

y Equity

The accounting result is replaced by the AHI-

result

y Liabilities

Liabilities remain unchanged

y Inflation Reserves

Correspond to the adjustments made in theStatement of Income and the Balance Sheet


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Numerical ExampleNumerical ExampleNumerical ExampleNumerical Example

Correcting annual reports for a company overyears 1975-1976 using the AHI-method. Aperiod of high inflation rate.

Wholesale Price Index1972 338

1973 398

1974 495

1975 5621976 626

0

100

200

300

400

500

600

700

1972 1973 1974 1975 1976


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Wholesale Price Index and its RelativeWholesale Price Index and its Relative

Change 1960

Change 1960--19941994

Wholesale Price Index and its RelativeWholesale Price Index and its Relative

Change 1960

Change 1960--19941994

0

200

400

600

800

1000

1200

1400

1600

1800

1960 1965 1970 1975 1980 1985 1990

-10

-5

0

5

10

15

20

25

30

1960 1965 1970 1975 1980 1985 1990


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Documents

Application of Inflation Accounting