ACCOUNTING: Inflation Accounting

Inflation Inflation AccountingAccounting

Inflation = BubbleInflation = Bubble

Inflation: DefinitionsInflation: DefinitionsInflation: DefinitionsInflation: Definitions• Decrease in purchasing power of money due to

an increase in the general price level

• “A process of steadily rising prices resulting in diminishing purchasing power of a given nominal sum of money”

The Penguin Dictionary of Economics

• “Rise in prices brought about by the expansion of the supply of bank money, credit, etc.”

Oxford Advanced Learner’s Dictionary of Current English

Inflation Inflation • Monetary inflation occurs when the money

supply of a country is increased over and above the demand and need for currency (“too much money chasing too few goods”). This results in depreciation in the value of currency.

• The impact of monetary inflation on prices is usually not evenly distributed across all goods and services within an economy.

InflationInflation

• Inflation distorts, or eradicates, the meaning of financial statement numbers.

• As such, when inflation is a substantial problem, its effects need to be removed/adjusted so that financial reports remain useful.

Inflation doesn't mean growthInflation doesn't mean growth

Inflation kills the EconomyInflation kills the Economy

Inflation & PoliticsInflation & Politics

IllusionIllusion

Gift on FestivalGift on Festival

Meaning : Inflation AccountingMeaning : Inflation Accounting• Prices are continuously rising in the

commodities/goods while the accounts are maintained at historical cost only. In such circumstances, accounts are required to maintain on Present Value basis.

• Thus, impact of inflation on financial position of a business is increasingly felt in view of the fact that the accounts are prepared on the basis of historical cost only.

Meaning : Inflation Accounting Contd.Meaning : Inflation Accounting Contd.

• There is no general agreement regarding the term “inflation accounting”.

• In short, feasibility of accounting for price level changes is termed as “Inflation Accounting”.

Effects on Financial StatementsEffects on Financial Statements• Implied assumption: The value of money

will remain stable but the value of money has been fluctuating violently in all most all the parts of the world.

• Revenue Statements:• Some expenditures are shown at Current

Price Level :• e.g. wages, rent, lighting charges, etc.• Some expenditures are shown at Historical

Price Level :• e.g. depreciation, amortization, depletion, etc.

Contd.Contd.

• Balance Sheet:

• Acquisition cost of various assets purchased at different time intervals are added together.

• Some Assets are shown at Current Price Level :

• e.g. Current assets

• Some Assets are shown at Historical Price Level:

• e.g. Fixed assets

Inflation Accounting – Conceptual Inflation Accounting – Conceptual Issues contd…Issues contd…

Impact of inflation on financial statements• Understated Assets Values.

• Overstated Income and overpayment of Taxes.

• Demands for higher Dividends.

• Differing impacts across companies resulting in lack of comparability…


• Inflation creates two basic reporting “mistakes” when traditional accounting methods are alone employed:

– Purchasing power gains/losses are not detected and reported.

– Historical cost numbers lose their relevance…


Impact of inflation on financial statements• Historical cost ignores purchasing power gains and

losses.

– Purchasing power losses result from holding monetary assets, such as cash and accounts receivable.

– Purchasing power gains result from holding monetary liabilities, such as accounts payable…

Effects of Price Level ChangesEffects of Price Level Changes1. P & L A/c will show more profit than actual as

depreciation is inadequate and closing stock is valued at higher amount.

2. More amt. of income tax and dividend. So acute shortage of working capital.

3. Balance Sheet won’t show “True & Fair view”.

4. Depreciation is inadequate so when required to replace another source of long term fund is required to seek.

Change in the price level is Change in the price level is described by indexesdescribed by indexes

Change in the price level is Change in the price level is described by indexesdescribed by indexes

• General indexes/indices– Price Index of Gross Domestic Product– Cost-of-living Index– Consumer Price Index– Wholesale Price Index– Production Price Index

• Special indexes/indices– Industry indexes– Commodity group indexes– Commodity indexes

MethodsMethods

1. Only Putting a Note in Accounts

2. Replacement Reserve Method

3. Partial Change Method

4. Current Purchasing Power (CPP) Method

5. Current Cost Accounting (CCA) Method

1.Only Putting a Note in Accounts1.Only Putting a Note in Accounts

• Accounts will be prepared on historical cost basis only as acceptance of the assumption value of money remains stable.

• A note should be appended to show changing price level in accounts presented.

Thus, no changes are made in the accounts. So, profit is in excess and enough amount is not available for replacement of the assets.

2.Replacement Reserve Method2.Replacement Reserve Method

• Accounts prepared on historical basis only.

• Depreciation is calculated on historical cost only.

• But replacement amount is inadequate when the asset is discarded.

• So, additional amount required for replacement purpose should be transferred to Replacement Reserve A/c every year.

• Replacement cost is estimated and will be spread over future period.

3.Partial Change Method3.Partial Change Method

• Fixed assets are generally written-up and Stock is valued on the basis of LIFO method.

• Link-up fixed assets in accordance with a legally established index. Thereafter, charge depreciation on written-up value.

• Stock and issue of material priced on LIFO basis which resembles the current price of goods.

• As a result, profit won't be higher it will reflect true profit or loss on price level change.

4.Current Purchasing Power (CPP) 4.Current Purchasing Power (CPP) MethodMethod

• On 15th May , 1974 the major UK and Irish accounting bodies issued a provisional statement of standard accounting practice recommending that companies listed on recognized stock exchanges should publish accounting statements adjusted for changes in the purchasing power of money.

Contd.Contd.• A general price index is used for this purpose

as it reflects the changes in purchasing power of money as a whole.

• For converting historical value of money into purchasing power value as at the end of the period , Two index numbers are required :

1.Showing general price level at the end of the period and another

2.showing general price level at the date of the transaction.

Contd.Contd.• X Ltd. purchased machinery on 1st Jan. 2003

for Rs. 1,50,000. This machinery is to be expressed in current purchasing power terms at the end of 2006. The approved general index has increased from 150 in Jan. 2003 to 250 at the end of Dec. 2006.

The value of machinery as on 31-12-2006 by CPP method will be calculated as under:

Contd.Contd.

1,50,000*250/150 = Rs.2,50,000

Thus, Rs.2,50,000 being the new cost of machinery represents the current purchasing power at the end of 2006 of Rs. 1,50,000 paid out in the beginning of 2004.

Important points while using Important points while using CPP MethodCPP Method

• Continue to keep the records and present their basic annual accounts in normal form.

• Publish supplementary accounting statements expressed in CPP Method.

• Convert the figures with aid of a general index of the purchasing power rupee.

• In CPP Accounting all assets are revalued on basis of the general price index and value of individual asset is not taken into account.

5.Current Cost Accounting (CCA) 5.Current Cost Accounting (CCA) MethodMethod

• Gain acceptance in academic and business world.

• Importance increased after the report of Sandilands Committee in U.K.

• Defects of CPP method – all assets are valued on general price index. Change in the value of individual asset is not taken into account.

• To remedy the defects of CPP method, CCA method shows assets the ‘value to business’.

Contd.Contd.

• Such valuation may be only approximation but it is a reasonable estimate.

• The asset cost is shown at their current cost and the difference between historical cost and current cost should be charged to Re-valuation Reserve A/c.

Recommendations of ASC of Recommendations of ASC of U.K.U.K.

• Show :

• Fixed Assets = ‘Value to the business’

• Land & Building = M.V.+ Acquisition cost

• Plant & Machinery, Furniture & Fittings, Vehicles, etc. = Net current replacement cost

• Investments = Cost to the business

Contd.Contd.

• Stock-in-trade, Work-in-progress = Lower of Current Replacement Cost or Net Realizable Value

• Debtors, cash and current liabilities = Net Realizable Value

• P & L a/c should be prepared on the basis of CCA. Depreciation and cost of sales are shown at historical cost

Contd.Contd.

• Surplus or deficit due to changes in value of assets and adjustments in profit and loss account should be adjusted to revaluation reserve account

Documents

ACCOUNTING: Inflation Accounting