Inflation Accounting

By: Sruthi R Nair & Arun S Nair

Definition

A term describing a range of accounting systems designed to correct problems arising from historical cost accounting in the presence of inflation.

Significance of Inflation Accounting

Its significance emerges from the limitations of historical cost accounting system. Limitations of historical cost accounting are:

1.Historical accounts do not consider the unrealised holding gains arising from the rise in the monetary value of the assets due to inflation. 2. 3.The objective of charging depreciation is to spread the cost of the asset over its useful life and make reserve for its replacement in the future. But it does not take into account the impact of inflation over the replacement cost which may result into the inadequate charge of depreciation.

Significance contd.
3. 4.

Under historical accounting, inventories acquired at old prices are matched against revenues expressed at current prices. In the period of inflation, this may lead to the overstatement of profits due mixing up of holding gains and operating gains. Future earnings are not easily projected from historical earnings.

5. 6.

Origin

First was suggested in 1936 by Henry Sweeny of USA through his book Stabilized Accounting. USA and England are the two countries that made prominent inroads to Inflation Accounting.

Indian Scenario

ICAI realised the importance of Inflation Accounting very late (Feb 1982). Indian corporate sector does not follow this method, as there is no fiscal law governing the presentation of company accounts in this basis. Ashok Leyland Ltd., Carborandum Universal Ltd. & Tube Investment of India Ltd. were the first 3 companies who presented CPP accounts in 1973-74 annual reports.

BHEL and Tata Chemicals Ltd. are considered to be the pioneers in the presentation of inflation adjusted accounts. But both discontinued after following for a long period. NTPC, MMTC & OIL are still following inflation accounting (CCA).

Techniques

To measure the impact of inflation on financial statements, following are the techniques used.
1) 2)Current Purchasing Power (CPP) Method 3) 4)Current Cost Accounting (CCA) Method

Current Purchasing Power (CPP) Method

All items in the financial statements are restated in terms of a constant unit of money i.e. in terms of general purchasing power. For measuring changes in the price level and incorporating the changes in the financial statements we use General Price Index, which may be considered to be a barometer meant for the purpose. This method takes into account the changes in the general purchasing power of money and ignores the actual rise or fall in the price of the given item.

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.

Value of asset as per CPP = Historical Cost of Asset x Conversion Factor Conversion Factor = Price Index at the date of conversion Price at the date of transaction

Illustration

X Ltd. purchased machinery on1st 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 from150 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:

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.

Current Cost Accounting (CCA) Method

The CCA method matches current revenues with the current cost of the resources which are consumed in earning them. Under this method, asset are valued at current cost which is the cost at which asset can be replaced as on a date.

Limitations of Inflation Accounting

1)Change in the price level is a continuous process. 2) 3)This system makes the calculations a tedious task because of too many conversions and calculations. 4) 5)This system has not been given preference by tax authorities.

CPP Vs. CCA

CPP scores over CCA on account of its:

Verifiability Comparative

simplicity

International Accounting Standards Committee is also in favour of CPP method to be adopted in hyperinflationary economies. CPP is the only method, in force in Latin American countries, where inflation accounting is mandatory.

Conclusion

Despite a right method of presenting financial statements, Inflation Accounting is still not widely prevalent due to certain limitations. But with more research and development of accounting software in this field, there is no doubt that Inflation adjusted accounting is the future of Financial Accounting.