Impact of Inflation on the

Financial Statements
Objective: Explain the
impact of inflation on the
financial statements
Historical Cost
Accounting
A measure of value used in
accounting in which the price of an
asset on the balance sheet is based on
its original cost when acquired by the
company.
The historical-cost method is used for
assets under generally accepted
accounting principals (GAAP).
Drawbacks of historical
cost accounting
Historical costs is only interested in cost
allocations and not in the market value
of an asset.
While it tells the user the acquisition
cost of an asset and its depreciation in
the following years, it ignores the
possibility that the current market value
of that asset may be higher or lower
than it is on the books.
Inflation and Financial
Statements
Historical cost accounting practices
reflect results of prices and costs in
effect at the time the transactions
occurred.

This approach does not account for the
fact that the purchasing power
diminishes during periods of inflation.

Therefore, another main
criticism of historical
accounting method is its
obvious flaws in times of
inflation.
The validity of historic accounting rests
on the assumption that the currency in
which transactions are recorded
remains stable, i.e. its purchasing power
remains the same over a period of time.

An asset purchased at a point in time
may be more expensive in the future.

The traditional accounting principles
record all assets at an original cost and
continue to use these historic figures
throughout the asset's life, but money
has a time-value attached to it.
In addition, effects of inflation may not
be the same for all the companies
because they may operate in different
countries with different levels of inflation
and historical cost accounts become
almost unhelpful when comparing
corporate performance.
FYI - What is inflation?
Inflation is defined general rise
in prices for goods and services.
It is measured as an annual
percentage increase.
As inflation rises, every dollar
you own buys a smaller amount
of goods or services.
Solution to historical
cost accounting
Alternatives to historical cost
accounting.
Current cost accounting
Fair value

An alternative approach to
measurement that seeks to capture
changes in asset and liability values
over time.
The International Accounting Standards
Board (IASB) defines fair value as "...
an amount at which an asset could be
exchanged between knowledgeable and
willing parties in an arms length
transaction".



Under the fair value measurement
approach, assets and liabilities are re-
measured periodically to reflect
changes in their value, with the resulting
change impacting net income.
The result is a balance sheet that better
reflects the current value of assets and
liabilities.
The cost is greater volatility in periodic
reported performance caused by
changes in fair value.

Current Cost Accounting
Current costing accounting (CCA)
approach recognizes the changes in the
price of individual items due to the
change in general price level (inflation).
This is the method which includes the
process of preparing and interpreting
financial statement in such a way that
relevant change in the price is
considered significantly.
In CCA method, the assets are valued
on a current cost basis. It does not
consider the retail price index.

This method considers the replacement
value of the assets for its accounting
records.
The value of assets at which it is to be
replaced in future is called the
replacement value.
Sometimes it is known as replacement
cost accounting approach.
Under this method, each financial
statement is to be restated in terms of
the current value of such items.

1. The fixed assets are recorded at
replacement cost value in the balance
sheet.
2. Inventories are shown at market
value rather than cost price whichever
less
3. Revaluation surplus are transferred to
current cost accounting reserve but not
distributed as dividend to shareholders.


4. Depreciation of fixed assets is to
be calculated at replacement value.
5. Two types of profit i.e. profit from
operation and profit from
revaluation are calculated.
6. Liabilities are recorded in their
original value because there is no
change in monetary unit.
Summary
Historical cost - the financial statements
reflects the original costs in effect at the time
of the transactions occurred
Fair value - assets and liabilities are re-
measured periodically to reflect changes in
their value- (Revaluation of assets)
Current cost accounting - the financial
statements are restated in terms of the
current value of items. (Replacement Value)

See cases:
Lladnar Ltd revenue earning
capicity of assets
And comparison of income
statements

Case - Eskom
In an attempt to eliminate the effects of changing
prices on assets and income, and to ensure that
funds needed to maintain the operating capacity are
preserved, historical costs have been restated by the
preparation of current value financial statements
based on IAS 15, Information reflecting the effect of
changing prices.
In reflecting the impact of inflation, Eskom has
adjusted the most significant of these effects by
revaluing the property, plant and equipment and
charging the related additional depreciation to the
income statement.
To the extent that further adjustment is necessary,
especially as regards the effect of inflation on future
fuel supplies and maintenance and consumables
inventory and the relief provided by funding assets
with monetary liabilities, additional adjustments have
been made.
The following summary shows the fully adjusted
performance and financial position of Eskom prepared
in terms of the
principles contained in IAS 15.
Summarised income statement Eskom
` 2000 1999
$ $
Historic cost of net profit for the after
tax
1 759 2 062
Inflation adjustments ( 3 253) (3 483)
Addition depreciation (3 635) (4 233)
Cost of sales (263) (203)
Gearing adjustment 645 953
Inflation-adjusted net loss for the
period
(1 494) (1 421)