INFLATION ACCOUNTING

Accounting records are no longer maintained to meet the requirements. Today the financial statements are also prepared to meet the 2 following additional objectives:

To meet the information needs of the owners, potential investors and the parties having stake in the organization; and

To provide information to the management to control the business.

Thus, accounting as a service function aims to identify, measure and communicate economic transactions and events relating to a particular period to its internal & external users. The financial statements so prepared are required to reflect a true & fair view of the state of affairs of the business entity at the balance sheet date.Money measurement concept is a basic attribute of accounting. It is also assumed that monetary unit recording the business transactions, is stable in nature. This is however not true as the inflation is effecting on a high magnitude to all spans of businesses. Inflation brings downward changes in the purchasing power of the monetary unit thus makes its stability a myth. It is much obvious that statements prepared without any regard to the current purchasing power of the monetary unit lose much of their significance.

Inflation accounting is the technique of such accounting methods as are designed to mirror the impact of rising prices on economic magnitudes through adoption of inflation adjusted accounts.The objectives of inflation accounting are:

To ensure that the capital invested is maintained intact in real terms; and

To reflect a true & fair view of the results of operations and financial position for the period concerned.

Inflation-It refers to the general increase in the prices of all goods & services. It is fundamentally caused by an undue increase in the quantity of money in proportion to buying power, or the amount of money in circulation in relation to the goods or wealth created. It results in the fall of the value of money.

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IMPACT OF INFLATION UPON BUSINESS

The impacts of inflation upon a business are distorting its profit performance and valuations of its capital. This in turn affects the judgments and decisions of its management, shareholders, etc. Assets recorded at historical cost will have a lower real value as the purchasing power of money falls within inflation. On the other hand, liabilities such as loan are recorded in the financial statements at historical cost and that is the amount to be repaid despite the fact that the rupees we repay have a lower real value than the rupees that were borrowed.Some of the distorting facts are:

The assets that are stated in the balance sheet are reported at values that are much lower than their current values. Due to the understatement of the values, the business is more vulnerable to take-over bids and the shareholders may not realize a fair value for their shares at the time of such takeover.

The profits and return on investment under historical cost accounting are overstated as revenue is recorded at increasing price levels & expenses such as depreciation and cost of sales are charged off at the historical cost.

Therefore accounts that haven’t adjusted the impact of inflation can prove vulnerable to the users of accounts.

INFLATION ACCOUNTING

Definition-It is a technique of accounting by which the transactions are recorded at current values and the impact of changes in the prices on the accounting transactions is neutralized or at least such impact is pointed out along with transactions recorded at historical cost concept. Price level accounting is mostly known as ‘inflation accounting’ for the reason that prices are usually changing on the higher side.

Objectives: The following are the objectives of inflation accounting-1. To improve the quality of financial information for

decision-making.2. To give effect to the changes in the purchasing power

of money while measuring the incomes & expenses during an accounting period.

3. To provide a better basis for inter period comparison of financial statements.

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Methods: The following are the generally accepted methods used to reflect the effects of changing prices in financial accounts:

(a) Current Purchasing Power (CPP) method(b) Current Cost Accounting (CCA) method(c) Hybrid method

(a) Current Purchasing Power (CPP) method

Under this method all items in the financial statements are to be restated for changes in the general price level. This method does not take into account the price change in specific asset thus specific price index is not used. It adjusts historical costs for changes in the general level of prices as measured by general price level index. Increase in the general level of prices (inflation) reduces the general purchasing power & vice-versa. Under the method the adjusted financial statements would reflect the original amounts in terms of current purchasing power. Current Purchasing Power method makes all the accounting nos. comparable in terms of general purchasing power by removing the mixed purchasing power element from historical financial statements. CIMA defines current purchasing power accounting as: “Inflation accounting is a method of accounting for inflation in which the values of the non-monetary items in the historical cost accounts are adjusted using a general price index to show the change in the general purchasing power of money. The current purchasing power balance sheet shows the effect of financial capital maintenance.”

The following steps are required to show the statements based on current costs using Current Purchasing Power method:

Calculation of Conversion Factor & Mid-Point Conversion Factor

Calculation of the Gain or Loss on Monetary items Calculation of Cost of Sales and Inventory at current

prices Calculation Of Profits Construction Of Balance Sheet

Calculation of Conversion Factor & Mid-Point Conversion FactorConversion Factor:

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As the Financial statements prepared on historical cost accounting basis are to be restated considering the current prices, the value of assets in historical cost accounts are multiplied by conversion factor. Conversion factor is calculated as under:

Conversion factor = Price index at the date of conversion Price index at the date of the item arose

Mid –Point conversion Factor:For translating the transactions to current prices occurring

throughout the period conversion factor can’t be used. Here Mid Point conversion factor is used. It could be calculated by taking the average of the index that is at the beginning of the year and at the end of the year.

Calculation of the Gain or Loss on Monetary itemsMonetary items are those items that are fixed by contract or

otherwise remain fixed irrespective of any change in the general price level.e.g.cash, debtors, loan etc.On the other hand the value of non-monetary items cannot be stated in fixed monetary amounts as they change with the changes in the price level.e.g. land, building, equity shares etc.

Changes in purchasing power of money affects both monetary & non-monetary items. In case of non-monetary items adjustment is made by restating their value in the balance sheet. While for monetary items, i.e., monetary assets and liabilities, fixed amounts to be paid or received but holding such assets or liabilities results in gain or loss in terms of real purchasing power known as general price level gain or loss.

The general price level gain or loss is shown in the restated income statement to arrive at the overall profit or loss. However such gain cannot be used to pay dividend.

Calculation of Cost of Sales and Inventory at current pricesCost of Sales and Inventories:

The value of cost of sales & inventories will depend upon the method followed for valuation of inventories,i.e., LIFO or FIFO or any other method. This will also effect the conversion of historical accounts to current price level adjusted financial accounts. In the FIFO(first in first out) method inventories first purchased are assumed to be issued first

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to the production department or are assumed to be sold first. On the other hand the LIFO(last in first out) methods inventories purchased in the last are assumed to be issued first to the production deptt. or are assumed to be sold first.

In order to convert the historical based financial statements to financial statements prepared considering the current purchasing power method the following indices are used:

Current purchases : Average index of the year Opening stock : Index at the beginning of the year Purchases of previous year(s) : Relevant index

Determination Of Profits

For determining the profits under the current purchasing power method any of the following two methods can be used:

(i) Net Change MethodUnder this method profit is the change in equity over the period.

Thus both the opening balance sheet & the closing balance sheet are converted to reflect the changes in price level and any increase in equity is taken as profit and any reduction is taken as loss. It may be noted that while converting the figures of the opening balance sheet both monetary & non-monetary items except equity are to be converted and while converting the closing balance sheet only non-monetary items are converted as they are already are reported at current values. Monetary items are not to be converted.

(ii) Conversion or restatement of Income Statement MethodUnder the second method all items of profit or loss are converted.

Sales and operating expenses are converted using the average index. The index to be used for conversion of cost of sales and inventory will depend upon the method used for valuation of inventory, i.e., LIFO or FIFO. Fixed assets are converted on the basis of the indices prevailing on the dates they were purchased. The same principle applies fir-charging depreciation on them. Taxes and dividend paid are to be converted using the indices of the date on which they were paid. Gain on account of monetary items should be calculated and stated separately in the restated income statement.

Advantages of Current Purchasing Power Accounting

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Comparisons over time are enhanced as the financial statements are constantly restated in current terms.

The relative price index adjustments when applied to the historical cost financial statements is objective.

The method gives an estimate of the money value of the business that needs to be retained in order to maintain the purchasing power of the capital.

Disadvantages of Current Purchasing Power Accounting

Current purchasing power accounting recognizes the shareholder as the main user of the financial statements. Using the relative price index is only relevant to the shareholders and consumers in the general economy.

The current purchasing power method takes the historical cost accounts as the starting part and so subjectivity in the estimates of historical cost accounts due to the accruals method is also prevalent in the current purchasing power accounts.

The selection of a suitable price index is again a difficult and subjective task.

(b) Current Cost Accounting Method

Current Cost Accounting Method measures the effect of individual rates of price changes on all assets & liabilities, i.e., stocks, plant & machinery, investments, loans, creditors and so on. It recognizes that there may be great differences in the rates of inflation of various items and by using specific indices for items or group of items the method attempts to match the current cost of assets used against current incomes generated by them. The objective is to maintain operating capital at current price level. Assets are valued at current cost considering specific price index of the relevant asset and not general price index as is used in Current Purchasing Power Method.

Objectives of Current Cost Accounting

The following are its main objectives: To show assets and liabilities at current replacement

value; To ascertain the profit or loss by matching current

costs with revenue;6

To remove distortions caused by summing up rupees of different values; and

To provide more useful information for decision-making on issues such as price policy, return on investment etc.

Features of Current Cost Accounting System:

Fixed Assets are to be shown at their value to the business and not historical cost less depreciation.

Inventories are to be valued at the price prevailing on the balance date and not at the market price or cost price which ever is less.

Depreciation is charged on the basis of the current value of the relevant fixed asset.

Cost of goods sold are calculated based on the price prevailing on the date of sale and not on the historical cost basis.

The effect of loss or gain will be computed and set off against interest.

The Following is the process of converting the historical cost based financial statement into the financial statement taking into account inflation factor using the Current Cost Accounting Method:

1. Valuation of fixed assets2. Depreciation adjustment3. Cost of sales adjustment4. Monetary working capital adjustment5. Gearing adjustment

Valuation of Fixed Assets: The fixed assets in the balance sheet are valued at their value to the business that is defined as the amount that the company will loose if it were deprived of these assets. The value of an asset to the business could be either of the following:-

1. Replacement cost value2. Net Realisable value3. Economic value

Replacement Cost: It refers to the money now required to buy a new asset of the type similar to the existing asset. The amount of

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depreciation has also got to be deducted from the same considering the fact that the true replacement of the asset would not be a new asset but an asset that has the same remaining useful life as the existing asset.

Net Realisable value : The value the asset will realize if the asset is sold now.

Economic value : It refers to the discounted (present) value of the net income that will be earned from using the existing assets during the remaining life of the asset. Thus, it is the net present value of the future anticipated net income that the asset is likely to generate. Thus it indicated that the replacement cost value is the purchasing value, net realizable value is the sale value and the economic value is the holding value.

Economies Experiencing Inflation will find that the balance sheets prepared under current cost accounting methods may show the fixed assets at a higher value than their purchase value. This increase will be credited to the capital reserve named as current cost accounting reserve.

Depreciation Adjustment:

The charge to the profit and loss account to for depreciation under this method should be equal to the value of fixed assets consumed during the period. Thus depreciation should be provided at the current cost of the asset and not at historical costs. Depreciation provided under current cost will differ from the amount of depreciation calculated considering historical costs.

A suitable depreciation adjustment is required as under:Depreciation required under current cost accounting ___________Less: Depreciation charged as per Historical Cost accounting ___________Depreciation adjustment ___________

Cost of sales Adjustment

Current cost accounting method is based on the important principle that current cost must be matched against current revenue for

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determining the true operating profit or loss. The amount of sales requires no adjustment as it is already at current rate.

Items that enter into the computation of cost of sales have to be taken at the present value that is required to replace them if consumed or sold. The difference in values is termed as cost of sales adjustment that is debited (in case of inflation) before deriving profit.

Monetary working Capital Adjustment

The cost of sales adjustment only takes into account the impact of inflation on stock consumption. An organization also requires additional resources to meet working capital requirements due to the increase in the prices. This extra amount of required working capital is known as additional monetary working capital.

It is required purely on account of increase in price levels and not on account of increase in scale of operations. Monetary working capital normally means aggregate of trade receivables, pre-receivables and trade bills receivables less trade creditors, trade bills payables and accruals. This adjustment should present the amount of additional (reduced in case of deflation) finance needed for monetary working capital as a result of changes in the input prices of goods and services used and financed by the business.

Gearing Adjustment

The profits as calculated after taking into account the foregoing adjustments, i.e., depreciation adjustment, cost of sales adjustment and monetary working capital adjustment reflect the true amount of profits from operations known as current cost operating profit. This operating profit belongs to those who bring in the operating capital for the business. It is also known that many organizations obtain part of their operating capital by loans or other monetary obligations. Therefore a part of the adjustments in respect of above adjustments made is ascribable to the loan funds or borrowings. Thus the net adjustments of the above three factors may be reduced by the proportion to the borrowings in the capital structure. This adjustment is known as gearing adjustment.

Thus to sum up gearing adjustment is necessary because a part of the net operating assets are financed by borrowings which are to be

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repaid in the same monetary amount irrespective of changes in prices. Equity, debts and preference shareholders provide funds. For a debt fixed amount has to be paid thus the gearing adjustment is required.

Gearing adjustment = Operating adjustment * Average Borrowings Average Borrowings + Average EquityThe gearing adjustment in fact reduces the impact of depreciation,

cost of sales and monetary working capital adjustments.

Advantages of Current Cost Accounting

1) Calculating depreciation on the basis of the value to the business of fixed assets will provide a more realistic measure of resources used during the period.

2) Calculating cost of sales on the basis of cost of replacing goods at the same time they were sold with sales revenue. It will also help to maintain the value of entity in real terms.

3) Management is expected to cope with the changes in prices of specific goods and services normally acquired by a business enterprise. This method provides a consistent basis for evaluating management’s actions and performance.

4) It clearly distinguishes between gains made from operations (operating gains) and gains made from holding assets.

5) Current cost balance sheet shows the assets at their current values and therefore provides a more realistic indication of economic values of the assets than do the balance sheet based on historical costs.

Disadvantages of Current Cost Accounting

1) Specific price indices are not available particularly for specialized assets like plant & machinery.

2) Additional difficulties are encountered to measure the current costs of the assets held outside the country.

3) The exclusion of cash and overdraft from working capital adjustment makes current cost accounting method incomplete.

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4) It fails to recognize purchasing power gains or losses on monetary items.

5) It fails to recognize that the value of rupee is not the same overtime.

(c) Hybrid Method

This method is a compromise between Current Purchasing Power Method and Current Cost Accounting Method. Under this method fixed assets and inventories are valued at specific indices-Current Cost accounting. In addition to it purchasing power gains and losses in respect of monetary items are also considered which otherwise are ignored in Current Cost Accounting. It is argued that by combining the two methods, the advantages of both the methods can be obtained. But the critics of this method state that its acceptance may prove difficult because of theoretical objections.

Issues in Inflation Accounting

At present, inflation accounting is one of the most significant, challenging and controversial topics in the field of accounting. Some of them are:

(i) Historical cost accounting Vs. Inflation accounting In the early days when inflation accounting was being developed

there was a controversy on the issue-should firms adjust historical cost accounts for price level changes. As the time passed, the tempo of inflation increased tremendously and business people started to realize the importance of inflation accounting. Therefore it has gained sufficient importance now.

(ii) Adjustment items There are two approaches in this regard. According to first a sound inflation accounting system must cover the adjustment of all financial items. On the other hand the second approach asks for the adjustment of only those items that have direct impact on financial results. But the first approach is more logical & scientific one.

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(iii) Use of Index Number The opinion of experts differs significantly with each other

regarding the use of index numbers for the adjustment of financial accounts. Firm can either use general purchasing power index for this purpose or specific price index. But it is considered better off using general purchasing power index considering the following facts:

It replaces the monetary unit of measurement that ceases to be stable during the changing price level. It provides a uniform measuring rod. It provides a tool for comparison of diverse resources. It advocates its use for restating assets as well as shareholders’ capital. It presents information to the proprietors, showing how their funds have been utilized and the profit derived from such use.

However, general purchasing power cannot be applied with reasonable accuracy to any other entity.

Advantages of Inflation Accounting

The major advantages of inflation accounting are as follows:a) It enables the company to present more realistic view of its profitability because current revenues are matched with current costs.b) Depreciation charged on current values in inflation accounting further enables a firm to show accounting profits more nearer to economic profits and replacement of these assets when required becomes easy.c) It enables a company to maintain its real capital by avoiding payments of dividends and taxes out of its capital due to inflated profits in historical accounting.d) Balance sheet reveals a more realistic and true and fair view of the financial position of a concern because the assets are shown at current values and not on distorted values as in historical accounting.e) When financial statements are presented, adjusted to the price level changes, it makes possible to compare the profitability of two concerns set up at different times.f) Investors, employees and the public at large are not mislead by inflated book profits because inflation accounting shows more realistic profits.g) The financial statements prepared by a company adjusted to the price level changes also improve its social image.

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h) Inflation accounting also effects the investment market as it helps to establish a realistic price for the shares of a company.

Disadvantages of Inflation Accounting

Some of the major drawbacks of this accounting are as follows:a) Adjusting accounts to price level changes is a never-ending process. It involves constant changes and alterations in the financial statements.b) Price level accounting involves many calculations and makes financial statements so complicated and confusing that it becomes very difficult for man of ordinary prudence to understand, analyze and interpret them.c) The concept of price level accounting appears to have more theoretical importance than practical because adjusting the accounts to the changes in the price levels may lead to window dressing the accounts due to the element of subjectivity in it.d) Depreciation charged on current values of fixed assets is not acceptable under the Income Tax Act, 1961 , and hence adjusting it to price level changes does not serve any practical purposes.e) During deflation when prices are falling, adjustments of accounts to price level changes will mean charging lesser depreciation and overstatement of profits indicating that dividends could be paid from capital even.

Causes of Non-popularity of Inflation Accounting in IndiaFollowing are the reasons of non-popularity of inflation accounting in India:

1) The most important reason of not using inflation-adjusted accounts is of practical difficulties involved in preparing such accounts and implementations of the system.2) The biggest difficulty if of training accountants, and others, the installation of the system and the preparation and audit of additional current cost accounts.3) Preparation of indices for calculations and the database for the preparations of such indices are inadequate in our country.4) There is lack of agreement as to which method of inflation accounting is most suitable and relevant.

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5) Management of Indian companies have vested interests in maintaining the present system because the system reveals more profit as compared to the inflation adjusted accounting system.6) Even high expenses, absence of guidance from professional Institute and absence of a recognized standard on the subject of inflation accounting acts as barrier to account for changing prices.7) There seems to be an agreement among accountants on the theoretical soundness of an approach. It is criticized for being too complex or costly to implement.8) The government does not accept inflation-adjusted accounts for tax purposes.9) There is no Accounting Standard on Inflation accounting issued by Institute of Chartered Accountants of India.10) The managers of Indian Companies feel that such accounts are too complicated to be understood by the users.11) There is the absence of good leadership, companies do not prepare adjusted accounts because they feel that others are also not preparing it.12) Some finance executives consider it a waste of time and they also look for some monetary benefit for adoption of such inflation accounting system.

In view of the above causes, it is to conclude that we are at crossroads in the accounting professions and must initiate a move to make our accounting statements more relevant and useful reflecting the changing environment. In other words accounts of Indian companies must reflect the fact that prices are not stable.

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Contributed by—NAME : Abhishek RathiREG. NO. : CRO0191775STAGE : CA-FINAL (Due in NOV. 2010)ADD. : 17E/215 Chopasani Housing Board Jodhpur, (RAJ.)PHONE NO. : 0291-2702626 (Landline) 09413591816 (Mobile)E-MAIL : coolabu18@yahoo.co.in

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