Inflation Accounting

Contents :
  1. Meaning of Inflation Accounting.
  2. Objectives and Need of Inflation Accounting.
  3. Advantages and Disadvantages of Inflation Accounting.
  4. Methods/Techniques of Inflation Accounting.

What is Meant by Inflation Accounting ? 

Introduction :

The basic objective of Accounting is the preparation of financial statements is a way that they give a true and fair view of the operating results and the financial position or the business to its various users, namely investors, creditors, management Government, trade unions, research institutions etc. These financial statements are prepared based on certain accounting concepts and conventions. The money measurement concept is a basic attribute of accounting. The money measurement concept states that only those business transactions that are capable of being expressed in terms of money can be recovered in the books of account. It also assumes that the monetary unit used for recording the transaction is stable in nature. 
However, this is not true in practice as many countries, developed as well as developing, have been experiencing inflation of high magnitude in recent times. Inflation refers to state of continuous rise in prices. It brings downward changes in the purchasing power of monetary unit. Thus, financial statements prepared without taking into account the change in purchasing power of the monetary unit lose their significance. There is a demand that business enterprises should prepare inflation adjusted financial statements. The different ways through which financial accounts can be adjusted for changing prices is studied under the subject "Inflation Accounting". Given that price changes can also be downward, it is more appropriately called "Accounting for price level changes".

History of Inflation Accounting :

Inflation accounting was practiced in the Us by the American Institute of Certified Public Accountants for over 50 years. During the period of Great Depression many companies reconstructed their financial reports recording the inflation in them. During those 50 years many companies were encouraged to record the price-level adjusted statements in place of cost-based financial statements. The FSAB or the Financial Accounting Standards Board raised a proposal of publishing the price-level adjustment statements which was withdrawn by them later due to certain problems.

Meaning of Inflation Accounting :

Inflation accounting is a term describing a range of accounting models designed to correct problems arising from historical cost accounting in the presence of high inflation and hyperinflation.Inflation accounting may be described as an attempt to portray financial performance of business enterprises on the basis of current prices. Special accounting techniques, which can be used during periods of high inflation. Inflation accounting requires statements to be adjusted according to price indexes, rather than rely solely on a cost accounting basis. Companies operating in countries experiencing hyperinflation may be required to update their statements periodically, in order to make them relevant to current economic and financial conditions.

Explain the Need and Objectives of Inflation Accounting.

Objectives of Inflation Accounting :

Inflation accounting aims at infusing the element of realism in the process of compilation of the financial statements, by making the necessary adjustments (in the figures of the historical costs) to the best possible extent, with a view to representing the currently prevailing prices of the various items in the market, caused by the effect of inflation. It reflects, in a true and fair manner, the financial position and performance, profitability and prospects, of the enterprise, during the respective accounting periods. In other words, it aims at convening the monetary units, having different purchasing powers, into one single monetary unit, whose purchasing power is uniform for various valuations and computations. The resultant effects of the inflation accounting adjustments are :
  1. To enhance the meaning and measurement of the income and expenditure of the enterprise, keeping in view the ever-changing purchasing power of the momentary unit, the specific currency.
  2. This, in turn makes the intra-firm comparison of the financial results of the company more realistic, rational and meaningful.
  3. To highlight and specify the effect of inflation on different enterprises, depending upon their different nature of business as also the operating features.
  4. To provide a meaningful and reliable database, facilitating a realistic and rational decision-making process in the organisation.

Need for Inflation Accounting :

Inflation, especially when it is prolonged and high, reduces considerably the meaningfulness and use of the corporate accounts because the various amounts in current rupee values may not signify proportionate real amounts, as the real worth of the rupee varies in different years. Moreover, arithmetical operations involving different amounts in rupees having different real worth become quite misleading. To make the accounts more meaningful, all items should be expressed in values relating to common year. This is attempted through inflation accounting, the following reasons usually being advanced in its favor.
  1. It helps to correct the usually distorted picture of the financial operations and condition of a company presented by the conventional system of accounts.
  2. It facilitates inter-company comparisons since inflation hits different firms in different degrees.
  3. It also facilitates inter-period comparisons of the performance of firm.
  4. Correct measurement of income is possible only with inflation accounting.
  5. When some nominal value in the accounts forms the basis of government action, e.g., taxation based on profits, MRTP Act measures based on nominal value acting as proxy for relevant variables, determination of controlled price on the basis of nominal profits and so on, inflation may cause unfair decisions by the government, unless the relevant nominal value is adjusted for inflation.

Explain the Advantages and Disadvantages and Inflation Accounting.

After going through the various techniques of inflation accounting it is useful to analyse the advantages and disadvantages of the practice of recognising the effect of inflation on accounts.

Advantages of Inflation Accounting :

The approach offers following advantages :
  • It enables the maintenance of capital intact which is essential in a limited liability business like companies.
  • Profit/loss is determined by matching the cost and the revenue at current values which are comparable. This enables a realistic assessment of performance of the business.
  • The assets are shown at real values uniformly instead of at distorted values as in historical rupee values.
  • Trade unions, employees, shareholders and public are not misled by giving an exaggerated profit figure. "The profit earned is taken as a guide to prosperity by actual and potential investors and quite often trade unions base their wage claims on the assumption that a company can afford to pay higher wages because profits are higher."
  • By showing the current values of fixed assets it enables the establishment of a realistic price for the company's shares.

Disadvantages of Inflation Accounting :

The approach suffers from the following disadvantages too :
  • Depreciation being the process of distribution on original cost over the effective life, charging anything in excess does not fit into the concept of depreciation.
  • 'Replacement cost' is an indefinite figure colored by future technological developments and the time period at which the asset will be scrapped. Hence even the best estimate cannot give an accurate estimate of replacement costs.
  • Charging depreciation on replacement cost basis will not be acceptable to income-tax authorities and hence there is no use of doing this exercise.
  • The calculators are so involved that an average shareholder will not be able to understand the financial statements easily. Despite some obvious conceptual weaknesses and practical difficulties, the technique of inflation accounting is very useful. Due to rapid changes in price-levels, it has become rather a basic necessity to adjust accounts at current prices. How the various difficulties involved in it are resolved, is a challenge to the accountants.

Explain the Methods/Techniques of Inflation Accounting.

Number of techniques has been developed by professional institute and accountants to deal with inflationary conditions. The important among them are as follows.

Methods/Techniques of Inflation Accounting :

1) Replacement Cost Method :
The replacement cost method, also called replacement value method, is based on the principle that sufficient provision should be made in the profit and loss account for the amount needed to meet the cost of replacement of all fixed assets as and when they wear out. Under this method, therefore, charges to profit and loss account would be made to provide for replacement cost instead of depreciation cost which is designed to amortise the cost of fixed assets over their useful life.

2) Writing-up of Fixed Assets :
Under this method, a portion of the value of fixed assets should be written off annually from the income statement of the company in addition to its normal depreciation charges. The amount to be written off will be determined on the basis of obsolescence in fixed assets as we do in the case of internal reconstruction of a company. The main problem in this method is this that the amount to be written off is a subjective decision; and secondly, this technique cannot be applied to all types of assets.

3) Replacement Cost Method Covering Fixed Assets and Inventories :
This method is an improvement over the first method as it includes inventory valuation problem too. The replacement cost of inventories consumed is kept in mind in the computation of the cost of goods sold. The replacement cost approach covers a number of variants (such as maintenance of real capital approach, anticipated cost approach, current cost approach and purchasing power approach), though all of them have one thing in common: they specifically allow for the effects of changes in prices and cost levels and relate depreciation, stock valuations and other cost computations to current replacement costs.

4) Present Value Accounting Method :
This method is also known as current value method. This method refers to a variety of valuation alternatives that focus on reflecting the current as opposed to past (or historical) values of financial statement items. By present value we simply mean the replacement cost as a concept of valuation. In respect of certain types of assets, we use the net realisable value as a basis of valuation (for the assets which are not essential to the continuance of the operations of the enterprise) on the other hand for comparatively permanent assets we use the discounted present value of the assets.

5) Continuously Contemporary Accounting Method :
This method also belongs to the family of replacement cost accounting. It involves the adjustment or modification of financial statements expressed in units of money so that relevant information is given in terms of existing purchasing power of money. Such general purchasing power adjustments can be applied under both historical cost and a current value system. 
The method requires adjustment to every item in financial statements prepared on a historical cost basis. Each item is expressed in a single unit of purchasing power. The gain or loss on account of holding monetary items is determined and included in income measured on a purchasing power basis. These general purchasing power adjusted financial statements are proposed as supplementary information and they are presented in summarised form together with the historical cost statements. Obviously, the method involves more accounting work.

6) Current Purchasing Power Method :
This method is based on the assumption that capital should be maintain in terms of the same monetary purchasing power. The accounts are duly adjusted for changes in the price level by restating all items appearing in the financial statements in terms of a constant unit of money. The constant unit of money referred to above Is known as the general purchasing power. A general price index is used as a multiplier. 
The reason underlying this is that the general price index is perhaps the best indicator of changes in the purchasing power of money. Under this method, the actual movements i.e. rise or fall in the price of a given item is ignored and only changes in the general purchasing power of money is considered. The proponents of this use the historical values and convert the same into the value of purchasing power as at the end of a specified period. In order to do so two index numbers are used one showing the general price level on the date of the transaction while the other portrays the general price level at the end of the period specified. The current purchasing power method of accounting for price level changes measures profit as the increase in the current purchasing power of equity i.e., net assets. The valuations of all items are made in terms of current purchasing power.

A) Features of Current Purchasing Power Method :

  • All items in the balance sheet and the income statement are adjusted in terms of current rupees.
  • Items appearing in historical cost accounts are classified into monetary and non-monetary groups. Monetary items are simply related in current rupees they do not require adjustment. Non-monetary items on the other hand are adjusted in accordance with changes in the purchasing power of money.
  • Transactions, both capital and revenue are assumed to have taken place evenly throughout the year at the average price level of the year.

B) Adjustment of Profit and Loss Account :

  • Items such as sales, purchases, expenses, taxes, dividends etc. are adjusted in terms of the year and rupee by applying the average index for the year.
  • Opening and closing stock are adjusted by the price index of the average date of their acquisition.
  • For computing adjusted depreciation, the fixed assets are first aged and grouped according to the date of their acquisition and then their cost, in current rupees is obtained. The depreciation charges are computed with reference to such adjusted cost either by applying regular rates of depreciation or on a proportionate basis.

C) Adjustment of Balance Sheet :

  • Fixed assets are adjusted in accordance with the index numbers of the dates of their acquisition or if deemed satisfactory, with reference to the index number of the avenge date of their acquisition.
  • The method of conversion of inventory is the same as stated above in 2.
  • The remaining current assets and all liabilities (i.e., monetary assets and liabilities) need no adjustment as they are already stated in current rupees.
  • The index number at the date of issue or if deemed satisfactory, the average index of the year; is used to adjust equity capital. The preference capital is treated as a monetary item and is simply restated.

D) Groups of Current Purchasing Power Method :

The method seeks to classify items into two broad groups in order to provide an understanding of the effect of inflation. They are :

1) Monetary Items :
A monetary item is an asset or liability, the amount in respect of which is fixed by contract or statute and are stated in rupees regardless of variations in general price level. Thus, debtors, cash, creditors' loans etc. are examples of monetary assets and liabilities. When there is inflation, persons holding monetary assets would stand to lose as their value in terms of current purchasing power will decline. 
For instance, a person holding cash of Rs. 1,000 when the annual inflation is 10% would find its purchasing power fall to Rs. 900 (Rs. 1,000-10% of Rs 1,000) at the end of the period. Similarly, in the case of credit sales, by the time the money is received from the custom, the purchasing power of the same would fall. Monetary liabilities display opposite behavior with a fall in the value of money there would be a decline in the value of such items in terms of current purchasing power. For instance a person who purchases Rs.500 worth of goods on credit when the rate of inflation is 6% would find that when he repays the sum, the value of money has fallen by 6% i.e., he is paying a lower sum in real terms thus, persons incurring monetary liabilities gain during inflation.

2) Non-monetary Items :
Assets or liabilities whose value is not fixed by contract arc known as non-monetary items. Thus, plant and machinery, land and buildings and other fixed assets, stock and shareholders equity are examples of non-monetary items. Non-monetary items are unaffected by changes in the value of money.

E) Merits Current Purchasing Power Method :

i) Measurement of Profit in Real Terms :
The profit figure is duly adjusted to exclude the effect of inflation. As a result, the same is stated in real terms. This would enable the firm to make sound forecasts of future.

ii) Trend Analysis and Inter-firm Comparisons :
The assets appearing in the financial statements are restated in stable money value and as a result comparisons of data from year to year can be carried out for judging the trend. Similarly, it would facilitate inter-firm comparisons.

iii) Ease of Understanding and Application :
The method is easy to understand. Apart from this, the general price index can be easily obtained and the method is easy to use.

iv) Avoids Subjective Valuation :
The method uses a single price index in valuing non-monetary items and this leads to the avoidance of subjective valuations.

F) Demerits Current Purchasing Power Method :

i) No Practical Significance :
The general price index which is used for carrying out the adjustments is an index of wide variety of goods and services purchased and consumed by the general public. As a result, it does not reflect the effect of inflation on individual companies. To quote T.A. Lee, Generalized purchasing power has no relevance to any person or entity because no such thing exists in reality, except as a statistician's computation.

ii) Weakness in impact :
Since it has been recommended that the statements prepared under current purchasing power method should form supplements to the statutory accounts reduces the efficacy of the system and shows signs of weakness.

iii) Less Meaningful than Current Value Financial Statements :
It is argued that the value of assets appearing in financial statements prepared under current purchasing power method is not as meaningful as a current value balance sheet. It is wrong to presume that the value of net assets shown under this method is a reflection of the foregoing of consumption of general goods and services in order to replace those assets; it also does not show the value of general goods and services that could be purchased provided the assets were released.

7) Current Cost Accounting Method :
Current cost accounting is a system of inflation accounting in which each item of financial statements is restated in terms of current value of that item. This method recognises the changes in the prices of individual assets irrespective of the quantum and direction of changes in the general price level. It takes into account the price changes relevant to particular firm or industry rather than the economy as a whole. 
This method seeks to ensure that adequate provisions or adjustments are made for the maintenance and replacement of the operating assets of the company. Assets are shown in terms of what such assets would currently cost. Similarly, profits are computed on the basis of what the cost would currently cost. Similarly, profits are computed on the basis of what the cost would have been at the date of sale rather then the actual amount paid. In other words, it seeks to arrive at a profit which can be safely distributed as dividend without impairing the operational capacity of the firm. In addition to adjustment for depreciation and cost of sales it deals with the working capital and also loan raised.

A) Features of Current Cost Accounting Technique :

  1. The accounts will continue as at present to be drawn-up in terms of monetary units.
  2. The accounts should show the value to the business of the company's assets at the balance sheet date.
  3. It measures the income after matching current costs with current revenues. It is based on the concept of operational capability. This method seeks to achieve this by substituting the current cost of assets consumed in place of corresponding historical cost.
  4. Depreciation for the year is to be calculated on the current value of the relevant fixed assets.
  5. The cost of stock consumed during the year is to be calculated on the value of the stock of business at the date of consumption and not at the date of purchase.
  6. The effects of loss or gain from loans will be computed and set-off against interest.
  7. The Current cost operating profit is arrived at by making three adjustments to trading profits before interest is calculated on historical cost basis, i.e. depreciation adjustment, cost of sales adjustment and monetary working capital adjustment. The current cost attributable to shareholders is obtained by making gearing adjustment.
  8. Profit for the year should consist of the company's operating gains, and should exclude all holding gains.
  9. The current cost balance sheet includes a new reserve 'current cost reserve which is created to take the credits relating to the revaluation of fixed assets and stock as also those relating to the depreciation adjustment, cost of sales adjustment, the working capital adjustment and the gearing adjustment.

B) Groups of Current Cost Accounting Method :

1) Realisable Value :
Realisable value is the value that one can realise on the disposal value of the asset and is measured by (a) the 'forced sale' value of asset, namely the amount which is likely to be obtained in respect of the asset if the same is sold under adverse conditions, or (b) current market sales value of the asset.

2) Replacement Cost :
Replacement cost is the cost that one has to incur in order to replace the asset and the same could be measured in net current replacement cost or gross current replacement cost.

3) Economic Value :
Economic value is the value which may be derived from the use of the asset and the same may be computed as (a) the 'alternative use value namely the value of the asset for a purpose which is prospective excluding the purpose for which it is presently used, or (b) the value which is related to the earnings potential of the asset, or (c) 'going concern' value, namely the value of the asset to a fum on the assumption that the firm will be a going entity.
The prevailing circumstances would determine the choice of deprival value. Generally replacement cost is used. In case it is worthwhile replacing the asset; its deprival value will be replacement cost. Where the asset is not worth replacing, the same might be disposed off or retained till the end of its useful life.

C) Adjustments to Profit/Loss Account :

The following adjustments are to be made in respect of certain items appearing in the profit/loss account in order to derive profit under current cost accounting :

1) Cost of Sales Adjustment :
The CCA method aims at matching current costs against current revenues. We know that sales represents current revenue and so no adjustment is necessary. However, in the case of cost of sales an adjustment is essential provided there are stocks. This is called 'cost of sales adjustment'. Thus, the cost of sales adjustment is the difference attributable to the current cost of inventories on the date on which sales take place and the amount which is shown as the cost of goods sold while calculating profit under historical cost.

2) Depreciation Adjustment :
During a period of inflation, prices of fixed assets also increase. Depreciation which is provided on the historical cost of such assets is inadequate to replace the fixed assets when the need arises. As a result, provision for additional depreciation has to be made. Therefore, depreciation adjustment is the difference attributable to depreciation calculated on the basis of current cost of fixed assets and depreciation used while calculating profit under the system of historical accounts.

3) Monetary Working Capital Adjustment :
The term monetary working capital includes stocks which are not the subject matter of cost of sales adjustment debtors; the figure of creditors should be deducted from them. Monetary working capital adjustment is carried out in order to apply current value to monetary assets. In this manner, the firm is able to give effect to changing prices on the financing arrangements which are necessary for the maintenance of working capital used in the business.

4) Gearing Adjustment :
Gearing adjustment is carried out where a portion of the firm's assets is financed with borrowed funds. This enables the allocation of current cost adjustments in an equitable manner as a result of which the entire burden does not come on equity shareholders.

D) Preparation of Balance Sheet :

While preparing the Balance Sheet valuation under current cost basis the following valuation basis should be followed :

1) Motor vehicles, office equipment's, plant and machinery, aircraft, ships, furniture and fittings :
These should be valued at replacement cost.

2) Land and building (self occupied by owner) :
These should be valued at net realisable value. In case this is not possible, land should be valued at net realisable value and buildings should be valued at replacement cost. This should include estimated acquisition cost.

3) Cash and debtors :
These items should be shown in the balance sheet at net realisable value.

4) Current liabilities :
This should be valued at net realisable value.

5) Quoted investments :
Quoted investments are valued at average prices.

6) Unquoted investments :
This is valued on the basis of present value of future returns from the company.