Inflation Accounting: Need, Limitation and Objections

In this article we will discuss about the Inflation Accounting:- 1. Need for Inflation Accounting 2. Limitations of Historical Accounting in a Period of Inflation 3. Objections 4. Role 5. Current Purchasing Power Method 6. Constant Dollar Accounting.

Contents:

  1. Need for Inflation Accounting
  2. Limitations of Historical Accounting in a Period of Inflation
  3. Objections to Inflation Accounting
  4. Role of Inflation Accounting
  5. Current Purchasing Power Method for Inflation Accounting
  6. Constant Dollar Accounting



1. Need for Inflation Accounting:

This shows that if the effect of inflation is ignored, one will have an unrealistic and exaggerated view of the profit earned or return on investment achieved. Hence, the need for “Inflation Accounting.”

To illustrate this point, let us consider the steel plants in India. The plants of various steel companies were established at various points of time. TISCO’s plant was erected earlier than even the First World War. The Indian Iron and Steel Company was established in the pre-independence period. The various plants of HSL were established in 1960’s.

If the performances of these plants are compared through ratio analysis, erroneous and misleading results will be shown because of the following two reasons:—

(i) The investment base of all the plants would be different. It is obvious that the plants which were established earlier had a much lower capital cost — the same facilities established by other firms at a later period would have a much higher cost.

The investment base of the later companies would be much higher than the investment base of the companies established earlier. Therefore, companies which are established later will show a lower rate of return on investment.

(ii) The return showed by the old companies would be unduly high. This is due to the fact that the depreciation charge of such companies would be much lower than warranted by the real present day value of the assets.

A point of great significance, apart from proper measurement and comparability, is that if only historical costs are considered, the amounts collected by way of depreciation charge will be totally inadequate to replace the fixed assets when their life is over. If physical assets are to be maintained, as indeed must be the aim, inflation must be kept fully in view.

It is, therefore, important that proper adjustments on account of price level changes are made in the financial statements. A number of studies have been conducted, especially in U.K., to devise a practical method to adjust accounts for price level changes. There are basically two methods by which price level changes can be recognised.



2. Limitations of Historical Accounting in a Period of Inflation:

The example given on the previous page shows clearly that when prices have risen substantially, the profit and loss account and the balance sheet drawn up on the basis of historical costs do not permit a proper appraisal of the performance of the concern and its financial position.

This is because of the facts that though the sales revenue is in terms of current rupees some of the important charges against revenue are in terms of old rupees.

The chief example of this is depreciation; another is the cost of goods sold. Further, the real capital employed is much more than that shown by the balance sheet. Thus, the first limitation is that a meaningful appraisal is not possible if financial statements are drawn up in the traditional manner even though there has been a great increase in prices.

Due to inflation, the matching principle, vital to preparation of proper financial statements, is violated. If sales are entered in the Profit and Loss Account in terms of 2010 rupees, it is but proper that the relevant costs should also be in terms of 2010 rupees.

That obviously is not so in the case of depreciation, but will the matching principle be satisfied if the goods sold were purchased say in 2008? To satisfy this principle, it will be necessary to restate the 2008 purchases in terms of 2010 prices. From another angle also, it is important.

An important function of the profit and loss account is to show up the factors that have led to the year’s profit or loss. This will not be possible unless operating profits are separated from holding gains.

The former is the profit earned through the firm’s operations of production and sale of goods and the latter from rise in prices (which is a windfall for the firm). Inflation accounting should help in clearly differentiating operating profit from holding gain. In another way, one can say that profit should be computed only in items of physical units and not merely rupees in times of inflation.

A buys 100 grams of gold at Rs 14,400 per ten grams on 1st January, 2009, he sells the entire quantity on 31st December, 2009 at Rs 14,600 and immediately buys the same quantity again at Rs 14,600, how much profit has he made Monetarily Rs 2,000, but really nothing since he had 100 grams of gold and still has only 100 grams.

The second limitation is regarding faulty decisions that are likely to be made if the costs and profits are not properly ascertained. In the example given earlier the profit shown is Rs 9 lakh whereas in reality it is only Rs 7 lakh. If Rs 9 lakh is distributed, it will only result in a reduction in the capital of the firm.

If prices are to be fixed, they are likely to be fixed at an unduly low figure if only historical costs are taken into account. The result will be either very low profits or even losses in real terms. For decision-making purposes, it is essential to consider present day or current costs.

The third, and perhaps the most important is that due to faulty measurement of profit and depreciation charge and decisions based thereon, it is very likely that when the time comes to replace fixed assets, the available funds will not suffice to carry to carry out the replacement.

This will force the firm to operate at a very much reduced level of operations. Operational capability is affected by non-replacement of fixed assets of equal efficiency: it is further affected by the fact that due to higher prices larger and larger amounts will be required for working capital. If such large funds are not available, operations will be adversely affected.

Another point, important from the point of view of financial management, is that inflation will require large funds for maintenance of the working capital, both for inventories and book debts, etc. If inventory consists of 10,000 units and if the cost rises from Rs 40 to Rs 45, Rs 50,000 more will be required for maintaining the inventory.

Maintenance of operational capability is the most important objective of inflation accounting. The points made above are all relevant to the maintenance of operational capability of the firm.

It must think of its capital in physical terms and arrange to retain sufficient funds in the business to replace fixed assets fully when the time is due and also to maintain the working capital required to carry on the operations of the business at their present level. The method followed for inflation accounting should ensure this as well differentiation of operating profits and holding gains.



3. Objections to Inflation Accounting:

There are still some people who object to inflation accounting. Their grounds mainly are the following:

(1) Inflation accounting, involving a write-up of assets, violates the cost concept and destroys objectivity. In a way it is true but what is cost — Rupees spent 20 years ago or the cost that would have been incurred today? Prices are generally fixed in terms of current costs of inputs; there is no reason why such costs, if ascertainable, violate the cost principle.

Objectively must certainly be maintained as, otherwise, the financial statements will lose their credibility. This is a problem which inflation accounting must satisfactorily solve before it can be accepted. The use of official statistics relating to price should go a long way towards a satisfactory solution.

(2) Profits disclosed by revaluation are capital profits — any distribution among shareholders will certainly dissipate financial strength of the firm. This is valid, but no one proposes that profit on revaluation should be treated as distributable; the profit is capital profit.

(3) Maintenance of capital or operational capability is the duty and function of management. It must adopt suitable financial policies to discharge this duty; there is no need to change accounting principles.

It is quite true to say that there must be suitable financial policies but accounting always had the extremely important duty of conveying to the management what the real profit is and how much can be safely distributed among the shareholders. In present times, without inflation accounting, it is impossible to ascertain the correct and real profit.

(4) Inflation accounting may lead to revision of cost of production and hence may lead to increase in prices and a further dose of inflation. There are two fallacies to the argument. It presupposes that prices are generally based on costs; that is not so really since the principle that may operate is “what the traffic will bear”.

Secondly, for fixing prices firms always take into account current costs and not historical costs as is assumed under the argument. In any case, it is for the society to combat inflation; it cannot do so by refusing to know the facts.

(5) Tax authorities so far have refused to recognise depreciation based on replacement costs and, therefore, even if an inflation-adjusted profit and loss account is prepared. The tax will still be on the basis of profit as per historical profit and loss account.

This is quite true but two points can be made. The survival of the firm is paramount and hence the behaviour of tax officers should not stop the firm from ascertaining the real situation. Secondly, it is quite possible that when an agreed scheme of inflation accounting is adopted.

Government agreeing, the tax authorities will also agree to make the necessary changes. In U.K., for example, 100% depreciation allowance is made in the very first year.



4. Role of Inflation Accounting:

The definition of Accounting given by AICPA is: “Accounting is the art of recording, classifying, and summarizing in a significant manner and in terms of money, transactions and events which are, in part at least, of a financial character, and interpreting the results thereof.

Though Statement 4 issued by the Accounting Principles board of the AICPA talks of the utility of accounting in making economic decisions, really Financial Accounting has confined itself more or less, to portrayal, in a significant manner, of the profit earned or loss suffered during a period and of the financial position at the end thereof [Decision-making functions have been left to Management Accounting].

The approach to inflation accounting also has kept this objective mainly in view. In other words, it is considered enough if the reported profit and the balance gh6et conform to reality.

This is important but equally important is the question of survival which is bound up intimately with replacement of assets at the end of their life. This means that the firm must have funds to carry out the replacement when due.

This is one of the important functions of accounting for depreciation and is quite adequately performed if there is no increase in prices; also if increases in prices are constantly kept in view while providing depreciation, at least partially.

The point is that inflation accounting must specifically keep this objective in view; otherwise there is danger that the firm will become sick simply because it does not have adequate funds to acquire new assets when the old assets have yielded all their utility.

Some people argue that finding funds for replacement of assets is the function of financial management, may be through a judicious use of profits. Some of them, therefore, even deny any need for inflation accounting.

If ascertaining real profit and maintenance of operational capability or capital physically are to be viewed separately, this approach may be quite valid but to do so will be to take a partial view of the state of affair to the detriment of not only the various interested parties but also the firm itself.

That the firm should not eat up its capital, that is, it should keep its ability to replace assets by new ones of equal efficiency, when the time comes, is a duty and function of Financial Accounting as well as Financial Management. Perhaps Financial Accounting has a greater responsibility in this regard since it alone can provide the necessary information for the required decisions.

Another question that needs some consideration is: whose viewpoint is to be paramount? — the firm’s or the shareholders’? It appears that the shareholders may be interested in maintaining their purchasing power in general.

Shareholders as a class have no attachment to any particular industry; they are, therefore, more interested in profits from a general point of view and hence they may not rely on profits reported by a firm using the specific inflation adjustment factors.

The firm on the other hand, may be interested in ascertaining profits taking into consideration the price changes that are relevant and specific to its business — the Current Cost Accounting Method, which has now found general acceptance, accepts this view. But in this case also the assumption is that the firm will continue in the same industry as hitherto.

Should the management decide to move into another industry as and when funds are released from the present investment, the available funds, even though inflation-adjusted on the basis of CCA, may not be adequate.

Suppose prices in general rise by 20% but those pertaining to a particular industry rise by only 10%. How would the share market value the shares of a firm in the industry? Will it take at face value, the profits of the firm as disclosed by the Profit and Loss Account drawn up on taking into account the 10% increase in prices?

Or will it discount the reported profit because of a greater fall in the purchasing power in general? Suppose the firm takes care to husband all its profits and depreciation funds in order to be able to move into more promising industry. Will not the firm be interested in knowing what the available funds mean in terms of investment opportunities in real terms?

One may summarise this discussion by stating that inflation accounting should have the following objectives:—

(1) To portray the real profit or loss for the period under consideration as against the profit or loss on the basis of historical costs;

(2) To set out the real financial position, in present day terms rather than the conventional position on historical costs basis and to indicate the real capital employed;

(3) To ensure that sufficient funds will be available to replace the various assets when the replacement becomes due; and

(4) To indicate profits in constant rupees, i.e., having regard to the general movement in prices for the guidance of shareholders as well as of management.

The system of inflation accounting should be such that, with minor modifications, it will yield the necessary information to moderate proper management action. Basically new methods have been recommended to adapt financial statements for inflation accounting.



5. Current Purchasing Power Method for Inflation Accounting:

The Institute of Chartered Accountants in England and Wales recommends that changes in the price level should be reflected in the financial statements through the Current Purchasing Power Method (CPP Method).

Under this method any established and approved general price index is used to convert the values of various items in the balance-sheet and the profit and loss account. The main argument is that a change in the price level reflects change in the value of the rupee.

This change is denoted by a general price index. In India, we may take a general price index like the Wholesale Price Index of the Reserve Bank of India which would show the changes in the value of the rupee in the past years.

Thus, if we want to add up the values of certain assets purchased in 2002, to those of some other assets purchased in 2010, we can do so only after we have converted the rupee values of 2010 in terms of rupees of 2002.

The CPP Method accounts for changes in the value of money. It does not account for changes in the value of the individual assets. Thus, a particular machine may have become cheaper over the last few years, whereas the general price level may have risen; the value of the machine will also be raised in accordance with the general price index.

This is because we are not trying to work out the current values of the various assets in the possession of the business. What we are trying to achieve is that the financial statements should be stated in terms of rupees of uniform value.

In 1974, the English Institute of Chartered Accountants recommended that companies should continue to prepare financial statements on historical cost basis but should also prepare supplementary statements showing the various items of the financial statements in terms of the value of the pound as at the end of the period to which they relate.

The following extracts from this statement would indicate the basic aspects of the CPP Method:

1. Inflation, which is the decline in the purchasing power of money as the general price of goods and services rises, affects most aspects of economic life, including investment decisions, wage negotiations, pricing policies, international trade and government taxation policy.

2. It is important that managements and other users of financial accounts should be in a position to appreciate the effects of inflation on the businesses with which they are concerned — for example, the effects on costs, profits distribution policies, dividend cover, the exercise of borrowing powers, returns on funds and future cash needs.

The purpose of this statement is the limited one of establishing a standard practice for demonstrating the effect of changes in the purchasing power of money on accounts prepared on the basis of existing conventions.

It does not suggest the abandonment of the historical cost convention, but simply those historical costs should be converted from an aggregation of historical pounds of many different purchasing powers into approximate figure of current purchasing power and that this information should be given in a supplement to the basic accounts prepared on the historical cost basis.

11. The method proposed in this statement (the ‘current purchasing power’ as ‘CPP’ method) is concerned with removing the distorting effects of changes in the general purchasing power of money on accounts prepared in accordance with established practice. It does not deal with changes in the relative values of non-monetary assets (which occur also in the absence of inflation).

It should therefore be distinguished from methods of “replacement cost” and “current value” accounting which deal with a mixture of changes in relative values and changes due to movements in the general price level.

Summary of the principal aspects of the statement of standard accounting practice:

12. The main features of the standard are:

(a) Companies will continue to keep their records and present their basic annual accounts, in historical pounds, i.e., in terms of the value of the pound at the time of each transaction or revaluation;

(b) In addition, all listed companies should present to their shareholders a supplementary ^ statement in terms of the value of the pound at the end of the period to which the accounts relate;

(c) The conversion of the figures in the basic accounts into the figures in the supplementary statement should be by means of a general index of the purchasing power of the pound;

(d) The standard requires the directions to provide in a note to the supplementary statement an explanation of the basis on which it has been prepared and it is desirable that directors should comment on the significance of the figures.

13. The form of the supplementary statement is a matter for the directors of the company to decide, provided that they conform to the standard accounting practice. There are a number of ways in which the information required may be shown.

An example of a possible presentation is given in Appendix 2 (not reproduced). This example includes some ratios as the effect of changes in the purchasing power of the pound on them may be even more significant than on the underlying absolute figures.

Monetary and Non-Monetary Items:

14. In converting the figures in the basic historical cost accounts into those in the supplementary current purchasing power statement a distinction is drawn between:

(a) Monetary items; and

(b) Non-monetary items.

15. Monetary items are those whose amounts are fixed by contract or otherwise in terms of numbers of pounds, regardless of changes in general price level. Examples of monetary items are cash, debtors, creditors and loan capital.

Holders of monetary assets lose general purchasing power during a period of inflation to the extent that any income from the assets does not adequately compensate for the loss; the converse applies to those having monetary liabilities.

A company with a material excess on average over the year of long, and short-term debts (e.g., debentures and creditors) over debtors and cash will show, in its supplementary current purchasing power statement, a gain in purchasing power during the year.

This is a real gain to the equity shareholders in purchasing power but it has to be appreciated that there may be circumstances in which it will be accompanied by a dangerously illiquid situation or by excessively high gearing and for this reason any such gain should be shown as a separate figure.

16. It has been argued that the gain on long-term borrowing should not be shown as profit in the supplementary statement because it might not be possible to distribute it without raising additional finance. This argument, however, confuses the measurement of profitability, with the measurement of liquidity.

Even in the absence of inflation, the whole of a company’s profit may not be distributable without raising additional finance for example because it has been invested in, or earmarked for, investment in non-liquid assets.

17. Moreover, it is inconsistent to exclude such gain when profit has been debited with the cost of borrowing (which must be assumed to reflect anticipation of inflation by the lender during the currency of the loan) and with depreciation on the converted value of fixed assets.

18. Non-monetary items include such assets as stock, plant and buildings. The retention of the historical cost concept requires that holders of non-monetary assets are assumed neither to gain nor to lose purchasing power of the pound (but see paragraphs 21 and 22 below).

19. The owners of a company’s equity capital have the residual claim on its net monetary and non-monetary assets. The equity interest is therefore neither a monetary nor a non-monetary item. The conversion process

20. In converting from basic historical cost accounts to supplementary current purchasing power statements for any particular period

(a) Monetary items in the balance sheet at the end of the period remain the same;

(b) Non-monetary items are increased in proportion to the inflation that has occurred since their acquisition or revaluation (and conversely, reduced in times of deflation).

21. In the conversion process, after increasing non-monetary items by the amount of inflation, it is necessary to apply the test of lower of cost (expressed in pounds of current purchasing power) and net realizable value to relevant current assets, e.g., stocks, and further to adjust the figures if necessary.

Similarly, after restating fixed assets in terms of pounds of current purchasing power, the question of the value of the business needs to be reviewed in that context and provision made if necessary.

Other matters that will need to be considered include the adequacy of the charge for depreciation on freehold and long leasehold properties and whether it may be necessary to include in the deferred tax account in the supplementary statement, an amount for the corporation tax (in the Republic of Ireland, income tax and corporation profits tax) on any chargeable gain which would arise on sale of the assets at the date of the balance sheet at the amount shown in the supplementary statement.

22. In applying these tests, and during the whole process of conversion, it is important to balance the effort involved against the materiality of the figures concerned. The supplementary current purchasing power statement can be no more than an approximation, and it is pointless to strive for over-elaborate precision.

Index to be used:

23. In the United Kingdom there are a number of indices which might be taken as indicators of changes in the general purchasing power of the pound.

24. On the basis of a recommendation from the Central Statistical Office, the use of the following indices is specified for the relevant periods:

for periods up to end-1938, the Ministry of Labour cost of living index;

for periods between end-1938 and end-1961, the consumers expenditure deflator;

for periods from 1962 onwards, the general index of retail prices.



6. Constant Dollar Accounting:

The Securities and Exchange Commission has christened the CPP method as “Constant Dollar Accounting”. The SEC now requires inflation-adjusted statements and it permits use of either the Current Cost Accounting Method (discussed below) or the Constant Dollar Accounting.

In the latter case, the adjustments to be made are based on movements in the consumer price index for all urban consumers. An important point to be noted is that adjustments may be made either on the basis of “average for the year” or of “end of the year” prices.

In the latter case revenue items are adjusted on the assumption that the amounts recorded in the income statement are in terms of prices prevailing in the middle of the year. Further, loss or gain on monetary items, resulting from movements in prices, must also be computed and shown (Under the CPP method as enunciated in U.K. such losses or gains were to be ignored.)

Example 1:

A company bought investments at a cost of Rs 6,00,000 on July 1, 2011 when the price index stood at 300. On 31st March, 2012 the index had moved to 320 and the market value of the investments was Rs 6,10,000. On CPP basis, what is the loss or profit on the investment?

Illustration 1:

A firm had Rs 2,00,000 as cash at bank on April 1, 2011. The consumer price index on that date was 200. During the year ended 31st March, 2012 the receipts and payments were stated below:

Illustration 2:

PQ Ltd. prepared the following (summarised) final statements of account for the year ended 31st March, 2012:


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