Inflation

Accounting
Inflation = Bubble
 Inflation: 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
• 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.
 Inflation
• 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 growth
Inflation kills the Economy
Inflation & Politics
Illusion
Gift on Festival
 Meaning : 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.
• 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 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.
• 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
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 Accounting – Conceptual
Issues contd…
• 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…
 Inflation Accounting – Conceptual
Issues contd…
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 Changes
1. 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
described 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
 Methods
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 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 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 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)
Method
• 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.
• 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.
• 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.

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
CPP 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)
Method
• 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.

• 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
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.
• 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.

• Surplus or deficit due to changes in

value of assets and adjustments in
profit and loss account should be
adjusted to revaluation reserve account