In order to trace the impact of inflation on the financial statements, it becomes necessary to pin-point the limitations of the conventional statements conveying historical financial information for end-users within an organisation and also outsiders.
1. Changes in the price level are not taken into account. The financial statements prepared under the conventional system are merely statements of historical facts. They fail to give realistic and correct picture of the state of affairs of a concern. Because monetary unit is never stable under inflationary conditions. This instability has resulted in a number of distortions in the financial statements and is the most serious limitation of historical accounting.
2. Fixed assets are shown in the position statement at the cost at which they were acquired. Further purchase of assets at different points of time are clubbed together as additions to the existing assets, without any regard to change in the purchasing power of rupee. For example, we constructed a building at a cost of Rs. 1, 00,000 in 1999 and constructed a similar building in 2003 at a cost of Rs 2, 50,000. The rupee value in 1999 is not the same as in 2003. The value is significantly less in 2000.
These buildings are shown as follows:
3. Depreciation is charged on the historical cost of the asset. It is the charge of cost of the used up value of the asset against revenue. It is a mechanism of generating funds for the replacement of fixed assets when the replacement becomes due. The charge of depreciation of fixed assets is based on the original purchase price, and not the price at which the same asset could be acquired. The cost of replacement of an asset far exceeds the original cost at which the asset is acquired. The provision made by way of depreciation charge on the original cost will be insufficient for the purpose, on account of inflation. And the profit is overstated.
4. Financial statements contain non-comparable figures because of inflation.
For example:
The price index at the end of 2004 is 325.
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By looking to the above, one will say that there is an increase in sales over the 3 years.
But if they are adjusted for change in price level, the real situation would be different as shown below:
When adjusted for price level changes, the sales are constantly declining.
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5. Tax is levied on money profits. The money profit under conventional accounting does not represent real profit. Since money profit is taken for taxation, a portion of capital is taken away by taxation. The reported profits are overstated and assets are understated under inflationary conditions.
6. In conventional accounting gains (or losses) on account of holding inventories may be mixed up with operating gains (or losses). To determine the true operating performance, holding gains (or losses) should be segregated from operating profits (or losses). The operating profit should be available for distribution while holding profit should not. For example, a businessman purchased 100 grams of gold @ Rs 350 in 2003 and sold 50 grams of gold in the year.
In 2004, purchased another 100 grams of gold @ Rs 400 and sold all 150 grams of gold @ Rs 450. In such case, the profit in 2004 is:
The holding profit is (50 gms x Rs. 50) Rs.2, 500 and the operating profit is Rs. 7.500. This is because if all the units sold have been purchased in 2004, the profit would have been only 150 gms x Rs. 50 = Rs. 7,500.
7. Balance Sheet consists of monetary as well as non-monetary items. Monetary items-cash, debtors, creditors etc., are shown at their current money value. Non-monetary items—building, inventories etc. are shown at their unexpired historical cost, and not at real current value. In other words, the non-monetary items are understated. Thus Balance Sheet fails to present a fair value of financial position.