Inflation Accounting

Meaning Inflation accounting is a term describing a range of accounting systems designed to correct problems arising from historical cost accounting in the presence of inflation. Inflation accounting is used in countries experiencing high inflation or hyperinflation.For example, in countries experiencing hyperinflation the International Accounting Standards Board requires corporate financial statements to be adjusted for changes in purchasing power using a price index

 Inflation Accounting is a financial reporting procedure which records the consequences of inflation on the financial statements that a company prepares and publishes at the end of the financial year. It is based on the assumption that the currency is stable. But in certain countries this assumption is not valid specially for certain countries which are experiencing hyperinflation and the adjustments are done according to the changes in the purchasing power of the masses.

 Under a historical cost-based system of accounting inflation leads to two basic problems
Many historical numbers are not economically relevant

The rise in the average price level for all goods and services produced in an economy
Historical numbers are not additive

Impact of inflation on financial statements

Understated asset values. Overstated income and overpayment of taxes. Demands for higher dividends. Differing impacts across companies resulting in lack of comparability

 Historical cost ignores purchasing power gains and losses. Purchasing power losses result from holding monetary assets, such as cash and accounts receivable. Purchasing power gains result from holding monetary liabilities, such as accounts payable. The two most common approaches to inflation accounting are general purchasing power accounting and current cost accounting.

Purchasing Power Gains & Losses

State of the Enterprise Net Monetary Asset Position Inflation Purchasing Power Loss Deflation Purchasing Power Gain

Net Monetary Liability Position

Purchasing Power Gain

Purchasing Power Loss

 Current Cost Accounting Method Under this method non monetary assets like fixed assets, inventories are shown at their value to the business , which is called as replacement value (calculated on the basis of general price index ).Gearing benefit is taken to adjusted P & L account.

 Methods Current Purchasing Power Accounting This method was intended to remove distortions in the financial statements due to changes in general purchasing power of money.CPP Method divides items of bal. Sheet into monetary and nonmonetary items.Change in the monetary items is not stated in the balancesheet , but changes in nonmonetary items caused by CPP of money is stated in inflation adjusted P & L Account.Items of Income statements are adjusted at average rate of inflation.