28

Chapter - 2

ORIGIN AND DEVELOPMENT OF INFLATION ACCOUNTING

Origin of Inflatipn Accountiny s

The problem of inflation, affecting accountiny is neither

new nor confined to some specific countries or reyions. It is an
age old and universal problem. Under conditions of inflation when

accounts are maintained under the "Orthodox" or historical system

the financial statements give virtually a distorted picture. The

reason for such a 'distortion' lies in that the historical

accounting is based on the monetary convention which implies that

the value of the monetary unit will remain stable.

Since Paciolo's "Summa" (1494) until the mid sixties of

our century the dominant school of accountiny thought both in

theory and practice has been the historical cost accountiny

(H.C.A) school. Doubts about its theoretical consistency were

raised first in Sweeney (1936) and to a lesser extent in

Bonbright (1937). Inflation Accountiny has gathered Steadily

through the forties, but very rapidly in later decades. The

proponents of historical accountiny whose number though not

inconsiderable is fast diminishing.

"The challenge of inflation accountiny is directed at the

theoretical foundation of historical accounting."1

1. Rajas Parchure, Inflation and Accounting Theory. 1987. Times

Research Foundation, Pune. Page - 2.
 29

The inflation accounting school (I.A.S) has gathered a large

number of committed supporters, staunch converts, reluctant

converts spread all through academia, business, Government and

legal bodies. The inflation accounting school itself is neither

homogenous nor unanimous but their front against HCA is a united

one. There are two major conflicting approaches within the

inflation accounting school. These are the Current Purchasing

Power Approach (CPPA) or General Purchasing Power Approach (GPPA)

and the Current Cost Accounting Approach (CCA).

Inflation accounting and the principles underlying it

have been discussed in some form or the other for the last 50

years. The discussions remained more or less academic and

confined to accountants. During the runaway inflation in the

'forties in Germany, it was discussed quite a great deal but no

concrete proposal or action emerged. The issue was revived this

time in the U.K and the U.S.A about 25 years ago. Other countries

where it became a live issue very early were Latin American

Countries like Chile, Argentina and Brazil, and the Netherlands

in Europe.

Need for inflation accounting ;

An inflationary environment has a profound effect on the

reporting of business operations. When inflation 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

 30

worth of rupee varies in different years. One economic Pundit has

described the situation as - -"trying to measure the width of a

room with a ruler that is getting constantly smaller." Moreover

arithmetical operations involving different amounts in rupees

having different real worth become quiet misleading.

During inflationary periods, historic accounting is

inadequate in four respects as follows

i) Depreciation provisions are not realistic, since they are

based on the original cost of an asset, not its current

inflated value.

ii) Profits appear larger than they actually are to the

extent that stock profits arise from general price

increases.

iii) Holding cash becomes a liability, as high interest rates

are offset by the decline in value of the money held.

iv) No accounting credit is given for the appreciation

derived from borrowed money when the liability has been

effectively reduced by inflation.

"Inflation accounting, by linking each year's figures to

a recognized index, spotlights this discrepancy
and presents a
2
much truer picture of a firm's continuing progress". To make the

2. Howe. C. Stidger & Ruth. W. Stidger. Inflation Management,

100 Practical techniques for Business and Industry.
Robert. E. Krieger Publishing Company, INC 645 NEW YORK
Avenue Huntington, New York 11743. Page.179 & 180.
 31

accounts more meaningful, all items should be expressed in values

relating to a common year. 'This is, attemptedthrough inflation

accounting. The following reasons are advanced in its favour -

i) It helps to correct the usually distorted picture of the

financial operations and condition of a company presented

by the conventional system of accounts.

ii) It facilitates inter company comparisons since inflation

hits different firms in different degrees.

iii) It also facilitates inter period comparisons of the

performance of a firm.

iv) Correct measurement of income is possible only with

inflation accounting and

v) When some nominal value in the accounts forms the basis

of Government action, e.g. taxation based on profits, -

MRTP Act measures based on a nominal value acting as a 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.

There seems to be a general consensus that inflation is

going to be a persistent economic phenomenon and that it is no

 32

less important that accounting in its present form is totally

inadequate to the job of reporting the impact of inflation. It is

generally contended that reported earninys is the best indicator

of future profitability and cash availability of the enterprise

which would help meet the enterprise its obligation for dividend

payment and debt repayment without er oding its operating

capabilities. From the current accounting statements it is

difficult to say how much the company's revenue increases have

been due to greater physical volume and how much due to increased

selling prices. Analysis through inflation accounting helps us to

improve our idea regarding following decision making areas

i) Whether selling prices and the costs increased more or

less than the overall rate of inflation.

ii) Affect of profit margins due to inflation.

iii) Amount of additional capital required to finance

inflation and to replace, expand or modernise productive

capacity.

iv) Affect on debt / equity ratio, rate of return on equity

and capital employed caused by inflation.

v) The rate of inflation adjusted taxation.

vi) Management's streategy for counteracting the effects of

inflation through price increases, cost reductions,

 33

improved productivity and increased reliance on

borrowings.

vii) Whether shareholders being adequately compensated,

keeping the general inflation rate in view.

Policy making would improve as awareness of changing

prices and economic evnironment increases. Though the Government

of India has not officially accepted the "replacement cost", a

very significant pointer has been the case very closely argued

for it in no less anauthoritative publication than the Economic

Survey t 1975 - 76, according to which - "there is now

considerable evidence that the steep increase in costs of

machinery and equipment in recent years is affecting not only new

investment but also modernisation and replacement of existing

equiment. In a period of rapidly rising prices, depreciation

formulae based on historical costs cease to provide adequate

resources for the replacement of the existing worn out

3
equipment."

Scope of the Study s

Developmeht and utilisation of technology of inflation

accounting, to provide managers c x f enterprises and administrators

of Government operations under the existing environments of

3. Economic Survey 1975 - 76.

Office of the Economic Adviser, Government of India.
Page i 12 Para : 3.12.
 34

inflationary trends, appears to be one of the most uryent and

immediate problem.

It appears necessary that accountants should develop

tools of inflation accounting for maximisation of productivity of

all factors of production. The tools of inflation accounting will

have to be evolved to take, Simultaneously in to consideration

i) Domestic changes in the purchasing power of the currency

unit.

ii) International chanyes in the relative purchasing powers

of the currency units in respect of international,

transnational and multinational trade and commerce.

iii) Evolution of suitable modifications of financial

statements so as to make them more realistic models of

productivity, profitability and financial health of the

enterprise.

iv) Evolution of accounting methods for indentification of

factors responsible for significant inflationary trends

and to measure the impact on financial statements.

v) Development of appropriate information technology and

management information system (MIS) to highlight the
problems of enterprise in the liyht of inflationary
treands so that financial documents forminy the basis of

managerial decisions reflect a realistic model of the

physical situation.
 35

vi) Development of tools of inflation accounting as

applicable to business* and non Governmental organisations
of a few selected corporate enterprises over a period of

seven years from 1988 to 1994.

vii) In the matter of social accounting as well as various

types of National accounts such divergences between

physical facts and their accounting models create serious

distortions.

A detachment of practical daily experiences of the

'people' under such inflationary conditions from the

experience based on such documents which accountants

prepare as realistic models, on the basis of historical

cost system, creates a feeling of "double personality".

viii) Financial statements prepared by cost management and

financial accountants and audited by chartered

accountants and cost accountants have generally enjoyed a

high rate of confidence and credibility by their internal

as well as external users. It is quite likely that in

view of the significant reduction in the purchasing power

of the currency unit the acconts of enterprises and

Government operations compiled and audited on the basis
of historical cost system may no longer reflect a 'true

and fair view' of the affairs of the enterprise. The

indications of productivity, profitability and financial

health based on these historical costs may not reflect a

realistic state of their affairs.
 36

ix) Distortion in financial results is more serious in a

country with higher degree of inflation say 5% and above,

in such cases divergence between the physical facts and

the accounting figures, which are treated as financial

models of these physical facts becomes quite significant.

x) Wide divergences between the physical facts and their

accounting models pose the problem of a serious risk to

the credibility of the accounting profession. In effect

where these divergences are significant, the financial

statements can not be used as reliable documents for

measurement of performance. It was probably this type of

situation which led Bacon to declare - "It is the

distemper of learning when man study words and not

matters".
 37

Development of Inflation Accounting in P.S.A.

"Inflation cannot be vanquished without effort and

sacrifice. There are no simple solutions, no magic wands to wave

inflation away". - Jimmy Carter.

The issues involved in inflation accounting have engaged

serious attention in the United States, the U.K and Australia as

also in other countries for quite some time. We present the

^.viewpoints developed in the United States, the United Kingdom and

Australia as also in India.

In United States the first systematic study of problems

of inflation accounting was done by Henry W. Sweeney. His book

"Stabilised Accounting" contained concepts and procedures for

'General Purchasing Power Accounting' (as CPP was known in USA).

Although over the years the details have changed, the principles

propounded by him have remained unchanged.

In 1951, American Accounting Association's committee on

concepts and standards Underlying corporate Financial Statements

in Supplementary Statements No. 2 - "Price Level changes in

Financial Statements" recommended gereral purchasing power method

of accounting. It recommended the use of general price level

index and comprehensive adjustments in order that each item in

the statements is restated after taking in to account the impact
of inflation.
 38

The American Accounting Association (AAA) sponsored a

study in general purchasing pdwer accounting (GPPA). In 1952, the

study group on 'Business Income' proposed that financial

statements should furnish in formation that will facilitate

determination of income measured in units of approximately equal

purchasing power. In 1961, Accounting Principles Board (APB)

sponsored a project on general purchasing power accounting, which

resulted in Accounting research Study No.6. In a well documented

article published in 'The Accountants' magazine in 1964 Professor

Stephen A. Zeff has provided "a guided tour" covering the last

quarter century of price level developments in the United States.

Professor Zeff notes that "like other countries in the United

States also there was some sort of a craze in terms of an

unquestioned axiom in financial circles that the handsomer the

balance sheet, the more prosperous the corporation for both

tangible and intangible assets were assigned value higher than

cost in balance sheet of some of the most respected

corporations".4

4. P. Chattopadhyaya, Inflation Accounting Tools and Techniques

1975. Institute of cost and works Accountants of India,
Calcutta, Page. 14.
 39

"In 1969, Accounting Principles Board (APB) issued

statement No. 3 recommendirfg that business concerns should

furnish "Supplementary financial statements in general purchasing

. 5
power unit". The statement gave detailed guidelines, although it

was not mandatory. This was followed by a discussion memorandum

on general purchasing power accounting and an

draft exposure
6
issued by Financial Accounting Standards Board (FASB) in 1974.

However, around the same time security and Exchange Commission

(SEC) issued Accounting Series Release No.190 (ASR 190) requiring

corporations to include current replacement cost disclosures in

7
the financial statements. With a view to aboid dichotomy, action

on FASB exposure draft was deferred. The Business community did

not welcome the issue of Accounting Series Release No.190. It

would be interesting to note that continental oil in its report

made to SEC stated that "It is the opinion of management that

these data are of limited, if any, value because of substantial

conceptual difficulty and imprecision inherent in the estimate

process".

5. APB statement No.3 Financial Statements Restated for General

Price Level Changes, June 1969.
6. FASB Exposure Draft, Financial Reporting in Units of General
Purchasing Power, December 31, 1974.
7. SEC Accounting Series Release 190, Notice of Adoption of
Amendments to Regulation S-X Requiring Disclosure of Certain
Replacement Cost Data, March 23, 1976.
 40

Later, AICPA constituted a Task Torce to Study various

proposals of inflation accounting. Four models were adopted, and

with the help of about 25 participant companies, these models

were applied to the financial statements. Taking in to account

reactions and responses of the participating companies, FASB

issued an Exposure Draft which resulted into issue of SFAS 33 :

8
Financial Reporting and Changing Prices. It applied to only

certain large companies. It required presenting information

regarding income from continuing operations on the constant

dollar basis as well as current dollar basis. Purchasing power

gains/loss, increase or decrease in current cost amount of

inventory and fixed Assets and effect of general inflation and

current cost on inventory had to be disclosed. Information in

summary form for last five years was also required to be

furnished.This statement was mandatory.

SFAS No.33 was superceded by SFAS No.82. The new SFAS is

not mandatory but encourages supplementary disclosures. The

statement itself was adopted only by a majority and not

unanimously. The main dissent was on account of supercession of

SFAS No.33 and in the process loss of the data that was being

built up while complying with SFAS.33 SFAS-82 provides for a five

years summary of selected financial data.

8. FASB, statement No.33 Financial Reporting and Changing

Prices, September 1979.
 41

It also requires disclosure of income from continuing

operations on current cost/constant purchasing power basis. It

requires income from continuing operations on current cost basis

applying the same constant purchasing power used in the

presentation for the five years summary. It. also requires

disclosure of the following.

i) Current cost or lower recoverable amount in respect of

inventory and fixed assets.

ii) Increase or decrease in current cost or lower recoverable

amount before and after adjusting for inflation in

respect of above items.

iii) Information used in calculations of current cost.

iv) Difference between depreciation method, estimates of

useful life and salvage value of assets used for

calculation of current cost/constant purchasing power

depreciation.

The disclosure suggested in respect of the five years

summary is meaningful and will develop methods and know - how for

interpreting financial statements adjusted for inflation and

changes in specific prices. In December, 1984 the Board again

brought out an exposure draft which says that if an enterprise

presents the minimum information as per the proposed statement,

the five years summary of selected financial data would be stated

 42

in average of the current year units of purchasing power. The

option to use the base year 'for the U.S consumer price index

stands eliminated, thus improving the comparison of disclosures

across enterprises.^

From the discussions that have gone on during the period

of last twenty five years or more in the United States, it

appears that the debate is still inconclusive. No one method of

adjustment of historical amouhts to current prices has had a

backing of consensus while the realisation that such adjustments

are necessary to reflect the reality has, of course been on a

much larger scale now than ever before. However, even the

supporters of the contention that such adjustments are necessary

have stressed only the requirement of having to supplement the

historical values with a statement of current prices

corresponding to them. How near the adjusted historical values to

reality are however, yet undetermined.

9. B.M. Lall Nigam, 'Accounting for Changiny Prices', Presented

at the XII All India Accounting Conference of the Indian
Accounting Association held in Jaipur on October 5 and
6,1985.
 43

Development: of Inflation Accounting in D.K.

"If inflation continues to be soar, you are yoiny to have to

work like a dog to live like one" - George Gobel.

The professional accounting bodies in the U.K and the

accountants in business and industry also showed a similar

concern about the problem of having to accommodate changes in the

price level in the structure of accounts. The trends of thouyht

noticed in the U.K have been on similar lines as in the U.S.A.

However, the experience of the second World War was more severe in

the case of U.K than of the U.S.A and as such inflationary

conditions in the U.K were more pronounced than in the U.S.A

after the War.

In the United Kingdom, Accounting Standards committee

(ASC) representing various accounting institutes in Great Britain

and Ireland is the Standard setting body for the accounting

profession. The awareness about inflation accounting generated a

lengthy debate in the 1970's and 1980's about the appropriate

method for reporting results of business enterprises in a period

of inflation. Chronological developments in U.K can be briefly

discussed as under.

In January, 1973 Exposure Draft No.8 (E.D.8) was issued

by the Accounting Standards committee (ASC). Before a standard

could be issued, the Government announced that an independent

 44

committee of enquiry would be appointed to consider various

methods of inflation accounting. The issue was thus politicised.

ASC went ahead and finalised the standard which was issued in

May, 1974. The standard - Accounting for changes in purchasing

Power of Money (SSAP-7) as the name denotes, recommended CPP

method of accounting."1'® Unlike other standards this was a

provisional standard and was not mandatory. Paragraph 11 of this

standard clarified that accounting for changes in purchasing

power of money should be distinguished from replacement cost

accounting or current value accounting which dealt with mixture

of changes in relative value and changes due to movements in

general price level.

The Government appointed a committee headed by F.E.P

Sandilands which submitted its report in September, 1975.^ The

report recommended revolutionary changes in the method of

accounting. Its main findings and recommendations were as under :

a) It accepted money as unit of measurement.

b) Each one has a personal rate of inflation based on spending

habits. A single index is not useful to any one.

10. ASC, SSAP - 7, Accounting for changes in Purchasing Power of

Money. May, 1974.

11. F.E.P. Sandilands, Inflation Accounting, Report of the

Inflation Accounting Committee H.M.S.O. London 1977.
 45

c) The companies total yains can be classified in to

realised and unrealised; and holding and operating yains.

d) Profit is an individual and subjective concept.

However,'operating profit' is a useful concept for many

users of accounts.

e) The dominant requirement of users of account is of

information on value to business.

f) Operating profit is arrived at by charging against the

amounts realised 'the value to the business' of the

assets consumed in generating those amounts.

g) It rejected CPP method of accounting on various grounds.

Replacement cost accounting can legitimately be described

as a method of accounting for inflation. It is suitable

for periods of both rising and falling prices.

h) The committee gave detailed guidelines about the

procedures to be followed.

The consultative Committee of Accounting Bodies

(CCAB) welcomed the report of the Sandilands committee but it

also pointed out that CCA does not deal 'at all' or 'adequately'

with changes in value of monetary assets and liabilities problems

of comparability of accounts between different periods and effect

of inflation on proprietors interest.

 46

Pendiny the report of Sandilands Committee, procedures to

be followed during the interim period were recommended. These

came to be known as Hyde Guidelines. It recommended that along

with primary historical cost accounts, a supplementary statement

should be attached. If the companies were following CPP method,

they were recommended continuation of the same. In the absence of

precedent of CPP accounts, the guidelines gave option to follow

either CPP or CCA method of accounting. A detailed note was

required to be given explaining the method followed.

SSAP-7 was withdrawn with effect from January 1978. The

Morpeth committee was appointed to formulate a standard based on

the report of the Sandilands committee. This resulted in to

Exposure Draft No.18. However, this was never converted in a

standard. A^ second Exposure Draft No.24 was issued. This was

followed by SSAP-16 : standard on current cost Accounting. This

created strong difference of opinion in the accounting

profession. The method recommended by SSAP-16 was strongly

criticised. The standard was therefore suspended in June 1985 and

ultimately withdrawn in April, 1990.

A review of SSAP-16 was carried out. This included

consideration of the report of CCA Monitoring Working Party

proposals of the sub-committee of ASC on inflation accounting,

submissions of council of the Institute of Cost and Management

Accountants, Surveys by the Association of Certified Accountants

and the Institute of Chartered Accountants in Ireland, Studies

 47

sponsored by the Institute of Chartered Accountants in England

and wales and the Institute of 'Chartered Accountants of Scotland.

The review resulted in the issue of Exposure Draft 35

dealing with Accounting for the Effects of Changing prices. The

Exposure Draft mentions that Current Cost Information is the most

appropriate method to use in acconting for the effects of

changing prices. This information is to be given either in a note

Or as part of full current cost accounts. ASC proposed that the

draft standard may not provide appropriate method in case of

value based companies and small companies. It assured about the

introduction of necessary amendments.

Inflation Accouftfcing in India :

"Inflation is like sin. Every Government

denounces it and every Government

practises it." - Frederick Leith - Ross.

There has not been much debate or discussion in India on

the subject of inflation accounting, although even the Government

of India has realised the problem. Economic Survey : 1975-76 Para

3.12 stated as under j

"there is no w considerable evidence that the steep increase

in costs of machinery and equipment in recent years is

affecting not only new investment but also modernisation and replace­

ment of'existing equipment. In a period of rising prices, depreciation formulae

based on historical costs cease to provide adequate reasources for the

replacement of the existing worn out equipment. Moreover, in

 48

industries under price control, so long as the calculations

of permissible rate of return continue to be based on

historic cost for fixed capital in use, there is a built in

disincentive to new investment......The problem of steep

escalation in capital costs is, however, today a general

problem facing Indian industry, and ways and means have to be

12
found to deal effectively with the same."

We discuss the development in this context under the

following heading :

a) Professional developments

b) Government actions if any, and

c) Corporate Practices

a) Professional developments :

At the professional level, the developments can be

examined from the viewpoints of the two prime Institutes of the

accounting profession namely,

i) The Institute of Cost and Works Accountants of India

(ICWAI) and,

ii) The Institute of Chartered Accountants of India (ICAI)

The ICWAI published only two books by its Research

Directorate, namely, "Inflation Accounting; Tools and

Techniques", 1975 by P. Chattopadhyaya and "Inflation Accounting

as a Tool to Fight Inflation" 1975 by B. Murao. The ICWAI has

preferred to remain silent so far as any

12. Economic Survey 1975-76. Office of the Economic Adviser.

Government of India. Para : 3.12.
 49

guideline or inflation accounting method, to be followed either

in connection with external reporting or decisional phenomena in

the context of changing price levels is concerned. On the other

hand, realising the urgency and importance of the matter, the

Research committee of the Institute of Chartered Accountants of

India published in its monthly journal, 'The Chartered

Accountant' a discussion paper on 'Treatment of Changing Prices

13
in Financial Statements' in February 1982.

It was only a discussion paper and not a definitive

statement of the Institute. The committee recognised that a great

deal of research and experimentation on the subject has already

been conducted by various professional institutes, accountants

and academics. Hence the main issue was in the opinion of the

committee, "to examine how and to what extent the techniques of

inflation accouning designed in Western Countries are apolicable

to the Indian situation". Out of the many proposals that had been

put forward for accounting for changing prices the following

three were specifically considered :

)

i) Periodical revaluation of fixed assets along with the

adoption of Lifo formula for inventory valuation.

ii) The current purchasing power accounting method.

iii) The current cost accounting method.

Thereafter, the Institute issued in December, 1982 a

'Guidance Note on Accounting for changing Prices' recommended by

the Research Committee of the Institute for the "information and

guidance of members".

13. 'The Chartered Accountant,’ December 1982 PP-492-507.

The Institute of Chartered’ Accountants of India.
 50

The Guidance note issued is not mandatory. The president of the

Institute in his Foreward to the Guidance Note stated :

"I earnestly urge upon the members to experiment with the

methods of accounting for changing prices suggested in

the guidance note, so that more experience can be gained

in this regard".

Except for very few companies, not many business

enterprises have experimented with inflation accounting while

submitting reports to Shareholders. Even the companies who did

publish inflation adjusted accounts did so generally irregularly.

Nevertheless the steps taken by the institute are welcome. In the

absence of any legal provision, the Guidance note, although

recommendatory in nature, will definitely improve the situation

in India.

b) Government actions if any :

The companies Act, 1956, does not contain any specific

provisions which may insure incorporation of the impact of price

level changes in the accounts of a company. On the other hand,

some of the provisions of the Act help maintain accounts in this

sector according to the age-old historic cost accounting.

Accordingly, "the requirements of section 211 of the Act are not

satisfied even when accounts are maintained truly in conformity

with the provisions of the Act and schedules there to".14

14. B.Banerjee, "Inflation and corporate Reporting in India". The

Management Account, April 1982. PP.192-4.
 51

Secondly when accounting profit is overstated as compared to real

profit, dividend paid on the b'asis of inflated accounting profit

may be far in excess of what ought to have been otherwise paid

and ultimately may amount to payment of dividend in the absence

of profit which runs contrary to the provisions of section 205 of

the said Act. In spite of all these no action in the form of

suitable amenchment in the Act to incorporate the impact of rise

in price levels in accounts appears to have been taken by the

Government although the Act has been amended a number of times

since its enactment in 1956.

In 1977 the Government appointed an 11 member committee

known as the Sachar - committee to suggest changes in the

compaines Act 1956 and the MRTP Act 1969, "to make these Acts

simple, easier to undrstand and more effective". The committee

submitted its report in 1978 and of the 600 recommendations made

by it, 460 pertain to the companies Act. One of them was relating

to inflatipn accounting. It suggested that "in view of continuous

increase in the prices, companies should make a provision by

setting aside ten percent of their profits after tax as a

replacement reserve provided that such a reserve should be

treated at par with depreciation under the statutes of the

country."•

It is significant that for the first time a Government

appointed committee made such recommendation on inflation
accounting in India. The responsibility to some extent lies with
 52

the premier professional institutes, the chambers of commerce in

different parts of the country, the Bureau of public enterprises

in particular and the accounting academics in general to make the

Government conscious of the nature of the problems and ask for suitable

amendments in the companies Act to incorporate in accounts the

impact of change in price levels.

The Income Tax Act 1961, also does not provide any

incentive for inflation adjusted accounts. So, the relevant

provisions of this Act should be amended as early as possible to

allow tax-benefits to enterprises when they deviate from historic

cost accounts.

The statutes Government the financial sector do not also

contain any provision regarding incorporation of the impact of

price level changes in accounts. Similar actions need to be taken

in these statutes as well.

c) Corporate Practices :

The matter may be viewed from two aspects :

(a) External Reporting, and

(b) Use of inflation adjusted data for management

decisions.

In may be mentioned that the existing provisions of the

companies Act do not prohibit the adoption of measures of

inflation accounting as evolved in other advanced countries of

 53

the world, either for external reporting or for internal

decisional purposes. Since accounts under historic cost are

required to be maintained till an amendment is made in this

respect, except some partial adjustments, other measures for

external reporting can be used only in the form of supplementary

statements.

Sorjie of the Indian companies belonging to public as well

as private sector attempts to present their annual accounts

following the recommendations of SSAP-16 or CCA are commendable.

As for example, the Hindustan Machine Tools even in its 26th

Annual Report (1978-79) followed the Hyde Guidelines (P.P. 82-83)

in preparing its annual accounts, similarly, Bharat Heavy

Electricals Ltd, in its 15th Annual Report (1978-79) followed the

principles of CCA as published in ED-18 and also Hyde Guidelines

in presenting its annual accounts.

Bharat Heavy Electricals., Steel Authority of India,

Cement Corporation of India and a few other companies have been

presenting in their annual reports a supplementary inflation

adjusted accounts. Regarding the private sector, it can be stated

that the Indian Institute of Management, Ahmedabad made a Survey

in 1978 of 200 companies. The general picture regarding corporate

practices may be better understood from the findings of'a research

study relating to 80 large private and public sector companies in

. 15
India for the accounting year 1979-80.

15. L.S. Prowal & N. Misra, Inflation Accounting in a Developing

Economy, Allied Publishers Pvt. Ltd. 1985.
 54

All the companies preparing adjusted information followed

either the CCA method or some variant of replacement cost

accounting. Regarding the nature of adjustments, it may bestated

that almost all the companies adjusted the most important factors

affecting the historical cost accounts during inflation viz.

a) fixed assets and depreciation thereon, and

b) cost of inventories consumed. Monetary items, however,

didnot attract due attention of the managers.

It is important to note that many companies in India have

been taking in to account inflation adjusted data for managerial

decisions even though they are not showing supplementary

inflation adjusted accounts for external reporting purposes.

Capital budgeting, working capital management, dividend decision

etc are examples on the point.

In the way of adopting inflation accounting, for external

reporting purpose in India the main obstacles are :

a) Practical difficulties in its implementation.

b) Difficulty in understanding such accounts.

o) Non acceptance of the inflation adjusted accounts for tax

purposes.

There is a general feeling that a high powered committee

on the lines of Sandilands committee of U.K. should be appointed

to study the problem before introducing any solution. The

committee should define objectives, develop concepts and

 55

standards and then finally suggest a suitable system of inflation

accounting.

Development of Inflation Accounting in Australia :

In Australia there has been a lively debate on the

subject of inflation accounting. As a result of the debate

current cost Accounting has been recommended. However, even in

Australia there is no unanimity about the most appropriate method

of accounting for changes in prices. The Australian professional

institutions, industry and academic institutions recorded

response patterns similar to those in the U.K. and the U.S.A.

Attention was focussed on the features of inflation, adoption of

the relevant index numbers for price adjustments and application

of general price level accounting in industry situations.

Professor R.S. Gynther in his book - "Accounting for Price Level

Changes : Theory and Procedures" has taken note of the main

trends of thought expressed in the debate on inflation accounting

in the U.S.A, U.K and Australia and has dealt with practical

problems on brass tacks as to how to accommodate price level

changes in corporate accounts. Professor Gynther has been

emphatic that it is possible to make general price level

accounting a practical reality and he has noted that the Philips

Electrical Industries in Australia and New Zealand have indeed

applied inflation accounting in preparing its annual reports.

Inflation Accounting in Canadia :

In Canada, section 4510 ofthe Canadian Institute of

Chartered Accountants (CICA). Handbook provides for

incorporating, .impact of changes in prices in financial

 56

statements. The British Government started alongside the debate

on ED 8, its own two year enquiry in to accounting for inflation

because, "it has important implications for the efficiency of

company management, the allocation of resources, investment

decision making, industrial competitiveness, corporate taxation

and counter inflationary policy". The Canadian Institute of

Chartered Accountants, has not yet taken an official stand on the

issue. However one of the sponsored research studies of CICA

concluded that "the reporting of price level restated historic

costs of assets and liabilities - appear to have limited

benefit".

Practice of inflation accounting in other countries s

Discussions on the development in U.S.A, U.K, India,

Australia and Canada are comprehensive in the sense that the

inclusion of all the major developments that have taken place

from the beginning has been made possible. Other countries like

New Zealand, France, Argentina and Brazil have been facing a very

high rate of inflation and have been on the verge of accepting

inflation accounting. A brief reference to latest developments of

inflation accounting practice in all these countries are

discussed hereunder.
 57

Development of Inflation Accounting in (a) New Zealand.

In April, 1982, New Zealand Society of Accountants issued

Current Cost Accounting Standard No.l (CCA-1) on "Information

Reflecting the Effects of Changing Prices". It closely resembles

U.K's SSAP-16 excepting the calculations of gains on loan

capital. A sample survey report (of 931 companies) published by

Reserve Bank of New Zealand in its Bulletin (May 19835 revealed

that 26 percent of the companies covered by the survey prepared

accounts under the CCA standards.

Development of Inflation Accounting in (b) France

France does not appear to have any accounting guidelines

regarding inflation accounting. The Government did not accept the

recommendations of the Government committee which recommended

supplementary financial statements based on CPP principles and

instead made legislations for revaluation of long term assets at

their use value to the enterprise at the end of 1976. Such

revaluation surplus is taxable.

Inflation Accounting in (c) Argentina

In September, 1980 the Argentina professional council of

Economic Sciences of the Federal District which regulates the

public accounting profession declared that in future the basic

financial statements should disclose historic cost constant

i
dollar figures in one column and historic cost in another.

16. "International Accounting Briefs",

The Management Accountant, January 1984.
ICWAI, Calcutta, Page - 42.
 58

Dei?eIopntbB£..of Inflation Accounting in (d) Brazil

In Brazil the inflation adjusted statements constitute

the basic as opposed to supplementary financial statements. The

amended Brazilian corporation Lav? requires companies to adjust

both permanent assets and equity accounts for changes in general

price level using ORTN (A Brazilian Government treasury bond

index) as deflator. Depreciation is also restated and netted

against the asset adjustment. The price level adjusted

depreciation is permitted as a deduction for tax purposes.

So far as other countries are concerned the Netherlands

and chile have been facing a very high rate of inflation and has

been on the verge of accepting inflation accounting for number of

years.
 5 9

Concept of Inflationary gap

Real inflation, according to keynes comes in to being

only if monetary expansion continues even beyond the point of

full employment. Then every additional expansion of money supply

shall exert- its full effect on prices, raising them to higher and

higher levels. Keynes tried to explain the phenomenon of

inflation in terms of his well known comcept of inflationary gap

in his famous pamphlet entitled - How to pay for the war ?

Keynesian concept of inflationary gap represents the technique of

statistically measuring the pressure of inflation in the economy.

If scheduled investment tends o be greater than full employment

saving, then more goods will be demanded of business than it can

produce, and prices will begin to rise.

Total spending (billions of dollars)

Fig-13.6

Fxg - 13.6 shows how to measure the inflationary gap as vertical

distance. The new C* + I ’ curve lies above the 45° line at the
 60

full employment level by the distance FG' giving us an

inflationary gap of $200 billion. It full employment saving falls

short of scheduled investment at full employment, there is said

17
to be an "inflationary gap". its size being measured by the

excess of the C + I schedule above the 45° limits full employment

level.

17. Ibid. Page t 211.

 61

Effect of the Inflation tax on cash Balances :

Cash halancps are held for the services they provide in

facilitating the completion of transactions. Because money has a

fixed hominal value, an increase in the rate of inflation will

mean that the value of the stock of money held by individuals or

businesses will fall in terms of the quantity of yoods and

•services for which it can be exchanged. For the components "f

this stock of money which includes currency and non-interest

bearing demand deposits held by the public, there is no

compensation for inflation as there is no interest paid on these

items; thus inflation imposes an additional oost or a "tax" on

the holding of these monetary assets.

When inflation exists, the holders of money will have to

add to their stock of nominal cash balances in order to buy and

sell the same quantity of goods and services each period. Because

the banking system creates these additional cash balances at a

very low cost and sells them in exchange for claims on real goods

and services, it is this sector that is initially the principal

beneficiary of the inflationary "tax" on cash. This additional

cost to holding cash that is caused by inflation is illustrated

in figure 4-1.
V 62

Figure - 4-1
Inflation Tax on Cash Balances.

^ Anticipated opportunity cost of I lolding Real Cash Balances.

Percent

' In figure 4-1, the stock of money demanded by a firm is

equal to (M-^) dollars, when the real interest rate is OD and the

anticipated rate of inflation is DE. The inflationary cost of

holding cash balances is then calculated by multiplying the

actual rate of inflation by the stock of real cash balances held

(M^). If the actual rate of inflation is equal to DF then the

cost of inflation on the holding of money is DFHC. This cost of

inflation, which is a transfer between the holders of cash

balances and the banking system, must be differentiated from the

welfare cost of anticipated inflation which is represented by the

triangle with area of M^BAMo in figure 4-1. The welfare cost

represented by M^BAMq is the value of loss in resources to the

economy because people reduce their

 63

holdings of cash balances. It is not a transfer as is the

18
inflation "tax" on cash.

To calculate the amount of the cost of inflation from

holding cash, the current values of the cash balances of the

industrial sector for each year are multiplied by the growth in

the implicit gross national expenditure deflator for the year.

Impact of Inflation on Fiscal Deficits s

Fiscal deficits, as conventionally defined on a cash

basis, measure the difference between total Government cash

outlays, including interest outlays but excluding amortisation

payments on the outstanding stock of public debt, and total cash

receipts, including tax and nontax revenue and grants but

excluding borrowing proceeds. In other words, not all outlays

related to public debt servicing are included in the measure of

the deficit s interest payments are added to non-debt-related

expenditures but amortisation payments are excluded. On the other

hand, current revenues are recorded as Government income -while proceeds from

borrowing are not. in-this -manner, fiscal deficits reflect 'the gap to be covered

by net Government borroydhys, including, direct Government borrowing from

19
the central bank. . Fiscal deficits so defined donot provide,

18. Glenn P. Jenkins, Inflation; its Financial Impact on Business

in Canada, Supply and Services Canada, Ottawa, Canada KIA
059. Page : 25-27.
19. K.S.Ramachardran, "Inflation the critical Issues" Vikas
Publishing House Pvt.Ltd 1991. 567 Masjid Road.Jangpuri New
Delhi. P-100-101.
 64
therefore, a direct measure of monetary expansion nor a measure

of gross Government pressure • on credit markets, as borrowings

required to finance amortisation payments are not included as

part of the deficit.

Under this definition, there are two kinds of Government

financial operations, each involving domestically held debt, that

donot affect the current fiscal deficit. First, any operation

that only involves changes in the composition of Government debt;

for example, the replacement of long terms bond by short term

treasury bills and vice-versa. Second, any operation that

involves the monetisation of existing Government debt. *' The first

type'of operation 'reflects debt 'Management' policy designed to get a particular

maturity -structure:-,of the Government debt. The “second type of operation reflects

open'.m'arket operations by,- th e Central Bank, that is pure monetary

policy. Thus, the conventional definition of fiscal deficit is

independent of the maturity structure of the outstanding domestic

Government debt and of the degree of debt monetisation that the

Central Bank may pursue for purely monetary Policy purposes. This

conclusion is not valid for the long run, as both debt management

policy and open market operations will eventually affect the size

of the deficit.

Inflation has a direct impact on the nominal interest

service of the public debt. To * isolate this effect from the

other consequences of inflation on the Government Budget,

assumption is made that,

 65

(a) non interest expenditures grow pari passu with inflation,

and

(b) through discretionary actions policy makers adjust the

tax system to a new inflationary environment so as to

maintain constant the ratio of tax revenue to qross

domestic product.

The growth of nominal interest payments on existing

domestic debt is generally beyond the control of the fiscal

outhority as it is tied to the evolution of market interest

rates and to indexation clauses. However, sometimes, the increase

in nominal interest payments does not represent a real transfer

of purchasing power from the Government to the debt holders. As

long as the real rate of interest does not change, that increase

tends to compensate the latter for the erosion in the value of

their principal caused by the higher inflation rate. Debt holders

are, therefore, no richer in real terms because of the higher

level of nominal interest rates, although in relative terms, they

might be if inflation has reduced the real incomes of other

groups.

Impact of inflation on taxation :

Inflation plays a significant role among different

taxpayers. Inflation leads to a higher tax burden on certain

taxpayers even when the real tax base remains the same. This

happens when the base is defined wholly or partially in nominal

terms and the tax happens to be progressive. In the case of

 66

specific duties, the Government actually loses real revenue due

to inflation and the real burden of the tax is reduced. The two

distinct ways in which inflation imposes additional tax burden on

tax payers are discussed in brief. It is emphasised that these

effects are not inherent to inflation, but arise due to a

combination of certain tax rules and inflation. 20 A change in the

tax rules can neutralise the effect in so far as these two

specific effects are concerned.

First, a progressive rate structure operates on the

nominal value of the tax base, with inflation, the base increases

in nominal terms and may cross over in to a higher tax-rate slab

even when it remains the same in real terms. Then the effective

tax rate could rise with the real tax base remaining the same.

This may happen in respect of a tax like, say, the personal

income tax. By defining the tax base in real terms, indexing it

to inflation, this effect can be neutralised.

The other way in which the tax base swells only in

nominal terms is as follows : the taxable base is normally

arrived at after certain deductions from a gross base like gross

profits or gross receipts. During inflation the gross base may

increase in nominal terms, but some of the deductions, e.g.

depreciation allowances in the case of corporate income tax,

20. Ibid. Page. 4.

 67

donot increase because they are defined in a way which _ is

invariant to inflation. As a 'result the taxable base in nominal

terms increases faster than that in real terms during inflaion.

Thus this is the method of computation of the tax base

and the tax structure that determine the impact of inflation as

far as tax payers are concerned. Since corporate capital income

is subject to corporate income tax, a brief outline of the

corporate accounting methods and the tax structure would be

relevant.

In the context of inflation and its impact on industry,

it is the effective rate of taxation real as distinct from

historic profits, which is important. This has been demonstrated

21
xn a study of inflation accounting by De Zeote and Bevan. The

basis of the study is that of a 1nilgrowth1 company to which they

apply the current 'imputation1 system of taxation. The conclusion

drawn is that an actual rate of 50% corporation tax at Zero

inflation rises to an effective rate of 80% with inflation at 15

percent.

21. "Inflation Accounting for the Investor" Supplement - No. 3

The Nil-Growth company t De Zeots and Bevan 1973.