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(iii) It considers all elements of the financial statements and is not concerned
only with fixed assets or closing stocks.
(iv) Realisation principles are not followed rigidly, particularly, when recording
long-term loans and fixed assets at the current value.
On the basis of the above explanation it is clear that inflation accounting should
not be confused with current cost accounting or current purchasing power
accounting (discussed later). Of course, they are the two important techniques
which are being used for prevention of distortion of the results shown by the
financial statements on account of inflationary tendencies. Accounts all over the
world have still to go a long way before developing a really effective and
acceptable inflation accounting system.
Limitations of Conventional Financial Statements
The income statement and the balance-sheet prepared according to conventional
or historical cost accounting system have been the subject of criticism by
accountants, investors, financial analyst etc. on account of the following reasons :
(i) Fall to disclose current worth of the enterprise: The financial statements
prepared under the conventional system are merely statements of historical facts.
They do show the true current worth of the enterprise.
(ii) Contains non-comparable Items: The financial statements contain items
which comparable since they are usually a composite of historical and current
costs. For a company constructed a building for a sum of Rs 5,00,000 in 1975 and
constructed a similar building in 1989 at a cost of Rs 20,00,000, the total cost of
building will be shown in the balance sheet at the end of 1989 as follows:
Rs.
Building (1975)
5,00,000
Building (1989)
20,00,000
25,00,000
The effect of non-comparative items can also be proved by taking items from the
income statement. For example, the following are the figures of sales for three
years.
Year
Sales
Average price
Index
1989
1,00,000
100
1990
1,50,000
200
1991
2,00,000
275
The price index at the end of 1991 is 300. In case the figures of sales are compared
without the price level adjustment, it appears that there has been a continuous
increase in sales over a period of three years. However, if they are adjusted taking
into consideration the change in the price level, the real situation would be different
as shown below:
Year
Average price index
Unadjusted sales
Conversion factor
Revised sales
1989
100
1,00,000
300/100
3,00,000
1990
200
1,50,000
300/200
2,25,000
1991
275
2,00,000
300/275
2.18,182
The above table shows that the figure of sales, when adjusted for price level
changes, is showing a constant declining trend.
(iii) Creates problems at the time of replacement According to the
conventional method, depreciation is charged on the historical cost of the asset.
Problems, may, therefore, arise when the asset has to be replaced and larger funds
are required on account of inflationary conditions. For example, if machinery was
purchased for Rs 1 lakh and its life was expected to be 10 years, a sum of Rs
10,000 would be charged as depreciation every year. If after ten years, the same
asset can be purchased for Rs 1,50,000, the firm may have to face serious
problems because of insufficiency of funds. The main purpose of providing
depreciation may, therefore, be defeated.
(iv) Mixes holding and operating gains In conventional accounting, gains on
account of holding the inventories may be mixed up with the operating gains. For
example, a business purchased 100 units .of a product at Rs 6 per unit in 1990. It
could sell only 50 of such units in that year. In 1991, it purchases another 100 units
at Rs 8 per unit and sells all 150 units at Rs 10 per unit. In such a case the profit in
1991 as per historical accounting will be as follows:
Rs.
Sales (150 units x Rs 10)
1,500
Less: Cost of sales (50 x 6 + 100 x 8)
1,100
400
As a matter of fact out of the total profit of Rs 400, a sum of Rs 100 (i.e., 50 x 2) is
only on account of holding the inventory. This is because if all the units sold had
been purchased during 1991, the profit would have been only Rs 300 (i.e., 150
units x Rs 2). Thus, Rs 100 is the holding profit while Rs 300 is the operating
profit. The historical accounting system, as seen above, does not make this
distinction.
In general, it can be said that under inflationary conditions the reported profits are
overstated and assets are under-stated when accounts are prepared according to
conventional or historical accounting. Over-reporting of profits gives rise to a
number of problems, viz. heavy taxation, heavy dividend, etc., resulting ultimately
in heavy financial strain on the company. Moreover, it brings heavy erosion in the
interpretative value of financial statements. All this has put more onerous
responsibilities on management as observed Peter Drucker:
There are the costs of today and the costs of tomorrow. I know of no business
today which operates at such a rate of return that it can meet the costs of
tomorrow. With todays rates of inflation businesses are not making profits but
only destroying capital. One of the primary tasks of management is to reduce
the costs of tomorrow and extract the maximum possible out of available
capital.
Methods of Accounting for Changing Prices
The following are the generally accepted methods of accounting for price level
changes:
1. Current Purchasing Power Method or General Purchasing Power Method
(CPP or GPP Method).
2. Current Cost Accounting Method (CCA Method).
3. Hybrid Method, i.e., a mixture of CPP and CCA methods.
asset would be valued at Rs 400 (i.e., 200 x 300/150) as per CPP Method. This is
because the current purchasing power of a sum of Rs 200 spent in 1970 is
equivalent to Rs 400 in 1990.
It should be noted that under the CPP Method, only the changes in general
purchasing power of money are taken into account. It does not consider the
changes in the value of individual assets. For example, a particular machine may
have become cheaper over the last few years, whereas the general price index may
have risen. In such a case, the value of the machine will also be raised in
accordance with the general price index.
Preparation of the financial statements according to CPP Method The following
steps are taken in preparing the financial statements.
(i) Conversion factor: CPP Method requires the restatement of historical figures
as disclosed in the financial statement at current purchasing prices. This is done
by multiplying the historical figures by the conversion factor calculated as follows:
Price Index at the date the item arose
Price Index at the date of conversion
Conversion factor =
The retail price index is considered to be the appropriate price index under CPP
Method.
Illustrations 14.1 A company purchased a machinery on 1990 for a sum of Rs
90,000. The retail price index on that date stood at 150. You are required to
restate the value of the machinery according to CPP Method on 3 1 st December,
1995 when the price index stood at 200.
Solution
Price Index at the date the item arose
Price Index at the date of conversion
Conversion factor =
3
4
150
= 200 =
Value of machinery on 3 1st December, 1995 after conversion
= Existing value Conversion factor
Rs. 1,20,000
3
4
= 9,000 =
Alternatively, Converted value of machinery
Price index at the when item arose
Existing value Price index at the date of conversion
=
344 Accounting Theory
Rs. 1,20,000
150
90,000 200
==
In case one desires to know only the difference between existing value and the
converted value of an item it can directly be known by applying the following
formula :
Difference = Existing value (conversion factor - 1)
Rs. (ii) Mid-period conversion: In case of transactions occurring throughout a
period, it
will be advisable to convert them according to the average index of the period.
Such transactions^ generally include revenue items such as sales and purchases