Inflation Accounting

A presentation by - ITM XMBA -33Dinesh M Manghani

Sharon Rodrigues

Inflation Accounting

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 backbut the same vada pav is around Rs.10/- today

One of the recent examples of inflation is also sugar.

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

Inflation accounting is used in countries experiencing high inflation or Inflation accounting is used in countries experiencing high inflation or hyperinflationhyperinflation. .

For example, in countries experiencing hyperinflation the International For example, in countries experiencing hyperinflation the International Accounting Standards Board requires corporate financial statements to be Accounting Standards Board requires corporate financial statements to be adjusted for changes in purchasing power using a adjusted for changes in purchasing power using a price indexprice index..


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

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

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

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


Under a historical cost-based system of accounting, inflation Under a historical cost-based system of accounting, inflation leads to two basic problems. leads to two basic problems.

First, many of the historical numbers appearing on financial First, many of the historical numbers appearing on financial statements are not economically relevant because prices statements are not economically relevant because prices have changed since they were incurred.... have changed since they were incurred....

Second, since the numbers on financial statements Second, since the numbers on financial statements represent dollars or rupeees expended at different points of represent dollars or rupeees expended at different points of time and, in turn, embody different amounts of purchasing time and, in turn, embody different amounts of purchasing power, they are simply not additive.power, they are simply not additive.

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


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

Ignoring general price level changes in financial reporting creates distortions in financial statements such asIgnoring general price level changes in financial reporting creates distortions in financial statements such as

reported profits may exceed the earnings that could be distributed to shareholders without impairing the reported profits may exceed the earnings that could be distributed to shareholders without impairing the company's ongoing operations company's ongoing operations

the asset values for inventory, equipment and plant do not reflect their economic value to the business 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 future earnings are not easily projected from historical earnings

the impact of price changes on monetary assets and liabilities is not clear the impact of price changes on monetary assets and liabilities is not clear

future capital needs are difficult to forecast and may lead to increased leverage, which increases the business's risk future capital needs are difficult to forecast and may lead to increased leverage, which increases the business's risk

when real economic performance is distorted, these distortions lead to social and political consequenses that when real economic performance is distorted, these distortions lead to social and political consequenses that damage businesses (examples: poor tax policies and public misconceptions regarding corporate behavior) damage businesses (examples: poor tax policies and public misconceptions regarding corporate behavior)

Misleading reporting under historical cost accountingMisleading reporting under historical cost accounting


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 periodsit 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 transactionsin the balance sheet are worked out.

For the purpose, an appropriate price index, wholesale or consumer priceindex is used. The method tries to find out the current purchasing power of transactionsas 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 gainas 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 AccountingAdvantages of Inflation Accounting

Assets are shown at real values uniformly.Assets are shown at real values uniformly.

Financial statements of a company show correct and current Financial statements of a company show correct and current informationinformation

about the financial performance of the company.about the financial performance of the company.

Inflation Accounting enables a company to get a fair price for its sharesInflation Accounting enables a company to get a fair price for its shares

by showing the current values of fixed assets. by showing the current values of fixed assets.

The value of the assets will be more accurate and closer to its intrinsicThe value of the assets will be more accurate and closer to its intrinsic

Value. Value.


Disadvantages of Inflation AccountingDisadvantages of Inflation Accounting

Depreciation charging on replacement cost goes against the concept.Depreciation charging on replacement cost goes against the concept.

Both the methods CPP and CCA have serious drawbacks and there is Both the methods CPP and CCA have serious drawbacks and there is

no general consensus about the method to be used. no general consensus about the method to be used.

Charging depreciation on replacement cost not acceptable to the Charging depreciation on replacement cost not acceptable to the incomeincome

tax authorities.tax authorities.


Impractical SystemImpractical System

Industry experts are of the view that none of the methods of Inflation 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 Accounting are foolproof and cannot give an accurate effect of the price level changes. level changes.

A more serious flaw is that it cannot be accepted as a statutory system 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 of accounting because of gap between theory of inflation and its practical applicability. applicability.

Eg : A company earns a profit of Rs. 25 lakh which, say is at a 5% rateEg : 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 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 after adjusting price level changes, the figure of Rs.25 lakh may turn into

a loss figure. 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

Documents

Inflation Accounting