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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
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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.
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
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.”
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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
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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.
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 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:
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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.
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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.
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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:
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 value
2. Net Realisable value
3. 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 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.
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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 ___________
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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.
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
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proportion to the borrowings in the capital structure. This adjustment is known
as gearing adjustment.
(c)Hybrid Method
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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.
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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.
h) Inflation accounting also effects the investment market as it
helps to establish a realistic price for the shares of a
company.
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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.
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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.
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Contributed by—
NAME : Abhishek Rathi
REG. NO. : CRO0191775
STAGE : 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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