Inflation Accounting

Definition

Inflation is that state of affair when money in circulation is more than the production of commodities and services and purchasing power of money comes down and prices of commodities and services increases.

Accounting for changing prices (Inflation Accounting) has become synonymous with accounting for inflation due to the unprecedented pressure of inflationary price rise in most countries in recent decades. In periods of sustained price rise, historical costs lose their relevance and may even become misleading as measurements of economic value.

Explanation

The price as experience says do not remain constant of products, it varies due to economic, social and political reasons. The change in price may be due to inflation or deflation. The change price level leads to an accurate presentation of financial statement which are prepared to show the correct picture of financial discipline of the corporate.

The financial statements are prepared on historical costs on the assumption that the unit of account i. e. Rupee in our country has a static value. In practical life, the value of money changing from time to time, the period after world war second has shown an upward trend of increasing prices.

Financial statements which are prepared on the basis of historical cost records suffer from a number of shortcomings during a period of rising prices. They are:

1. Fixed assets are stated at historical costs in the balance sheet; they do not show the true current worth and are often unrealistically low.

2. Depreciation is charged on the historical cost of the assets. As a result, depreciation provision is also inadequate for financing the replacement cost of fixed assets. The firm may, therefore, have to face serious problems because of the paucity of funds.

3. In a period of rising prices, there is a significant overstatement of profits since the cost of goods sold is calculated on a historical cost basis and no allowance is made for the reduction in the purchasing power of money. Also, overstatement in profits results in a heavy financial strain for the company in terms of heavy dividend, heavy taxation, etc,

In June 1969, the APB of the AICPA recommended that supplementary statements should be appended to the annual accounts of companies so as to disclose the effect of general price level changes on the financial position. Inflation accounting seeks to incorporate realism into financial statements by
adjusting them, so as to reflect in a true and fair manner the financial performance and the position of an enterprise in a particular period.

The balance sheet prepared at a point of time includes some items such as cash, debtors, etc., that are stated at current purchasing power; others such as inventory, are stated in monetary units that reflect the purchasing power of the recent past; and still others such as furniture, land, plant and equipment that are stated at historical cost.

When the general price level is rising rapidly, reported profits of a company which has a major proportion of its assets which are stated at historical costs are overstated. If profits are overstated, it follows that costs and expenses are under-stated, This may lead to reporting illusory profits.

Thus, accountants use the concept of Inflation Accounting so as to convert monetary units having varying purchasing power into a single monetary unit.

Objectives of Inflation Accounting

The objective of Inflation Accounting is to adjust historical cost figures for substantive changes in the general level in the economy, The following are some of the objectives of Inflation Accounting:

(i). To remove the various distortions with which financial statement based on historical cost suffer.
(ii). To provide for more meaningful inter-period comparison.
(iii). To improve the meaning and measurement of income and expenses in the face of changing the purchasing power of money.
(iv). To improve decision making in the organization.

Further, Inflation-adjusted information helps decision-makers in the following ways:

1. Allocation of capital is achieved through the pricing mechanism in capital markets. Prices based on financial information which is incomplete or misleading results in poor pricing and allocation decision. As inflation rates vary from year to year, an element of uncertainty is there in business activities. Further, even though management is aware of the need to incorporate inflation in making the business decision, it is hundred in doing so by the lack of systematic and explicit recognition of inflation’s effect in financial reports.

The system of inflation accounting, if introduced, will help the various parties who have an interest and stake in the business viz. shareholders, employees, external users, management and government.

2. Management will be better equipped to tackle the problems caused by inflation and in turn improve productivity in the long run.

3. Information about the specific price changes on individual enterprises and by industry grouping will help the policymakers to analyze the impact of the differential impact of inflation on each’ industry. inflation accounting will also help in giving a clearer disclosure and in turn help the government in making various policy decisions.

4. The public understanding of the business and the various effects of inflation goes up. This helps business in being somewhat less critically viewed by the general public helps them in their continuous exercise of mobilizing funds for expansion, new investment and also to provide employment.

Methods of Accounting for Inflation

Various methods have been proposed in accounting to reflect the true changes in the purchasing power of money. However, no consensus has yet been reached on a specific solution and the professional bodies in various countries argue that the method Should be accurate, reasonable, effective and easy to implement. The following are the various methods that have been put forward for inflation accounting:

  1. Current Cost Accounting (CCA)
  2. Current Purchasing Power Method (C.P.P)

Inflation and Productivity Measurement

Productivity can be measured as a ratio of Sales Revenue to the number of employees.

Productivity = Sales Revenue / No. of Employees

If the physical output and number of employees remain the same while sales price and hence sales revenue increase by 15 percent due to Inflation, the productivity will go up by 15 percent despite no change in real productivity.

intensification of Budgeting

As a result of Inflation, the preparation of budgets by the organization may need to be intensified, to achieve more effective use of the existing resources. An additional form of the budget—the requirement budget may need to be prepared, as is presently being done by a few organizations.

Inflation and Dividend Policy In a period of inflation, the Board of Directors must make sure that they are mainly distributing current earnings as dividends. During inflation, earlier costs may have been matched against revenues, with the result that net income is higher than what it would otherwise be. The Board of Directors must make sure that they are not unintentionally distributing earnings from past years.

Limitations of Inflation Accounting

Financial statements prepared on the historical cost basis do not, as a rule, depict the real state of affairs of the organization. The figures presented in the Financial Statement do not reflect present-day values. Nevertheless, accounts prepared on the basis of historical cost have the following advantages over other systems of accounting:

  1. It is based on actual events and data.
  2. It is widely used and understood by all.
  3. Comparison of figures over a period of time can be made easily.
  4. It forms the basis of tax assessments.
  5. Manipulation of accounting records is difficult under historical costs.

Thus, there is an imperative need for inflation-adjusted financial statements to be presented to the shareholders and other interested parties. Yet, there are a number of objections to inflation accounting. They are:

(1) The financial statements lose their credibility as the objectivity concept is violated.
(2) The method is not acceptable to the tax authorities.
(3) Inflation accounting may sometimes result in arbitrary profits.

Thus, the main problem with Inflation Accounting is that the method has not been able to come up with an accounting system that would satisfy all. The method has still a long way to go and the search is on for a method that would take into account inflation and still be objective and simple in its implementation.

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