INFLATION ACCOUNTING
Inflation : Inflation means a change in the general prices of goods and services in the upward direction over some defined time period.
Price changes
NEED FOR INFLATION ACCOUNTING
Inflation adjusted profit (depreciation & cost of mat consumed) (high “paper profit”)
Replacement of assets
(dep inadequate to finance replacement of the operating capacity represented by the old asset)
Eg: Asset purchase cost Rs. 1,00,000
Depreciation @ 10% on SLM basis
Thus dep = 10,000 but the replacement cost of the asset at the end of the year is Rs.1,50,000
But dep as per current cost should be 15,000 and not 10,000
Thus accumulated dep would be insufficient to replace that asset.
Maintenance of real value of capital
(financial capital: units of constant purchasing power)
(physical capital: operating capacity)
True and fair view
(Profit & loss a/c and Balance sheet , not inflation adjusted)
(management, employees, creditors, shareholders, government, etc)
Effective comparison
(profits earned under historical a/c are not comparable)
Eg.: Rs.2,00,000 profit in 1980
Rs.15,00,000 profit in 2003
( 2,00,000 had the purchasing power of Rs. 20,00,000 in 2003)
Problem with historical cost accounting
HISTORICAL BACKGROUND
Increase in general price level after 1st world war in Germany and other parts of the world
2 schools of thought emerged
Historical cost accounts should be adjusted for changes in general price level ( CPP)
Advocated replacement cost accounting
Prices stabilized but again increased after second world war
Accounting standards being set in U.S., U.K., Canada, Australia, etc based on General Price Lever (GPP) or Current Purchasing Power method of accounting.
In July 1975, Sandilands committee of U.K. published a report rejecting CPP system and suggested Current Cost Accounting (CCA)
ICAI has issued a guidance note on accounting for inflation and has advocated the use of CCA method
SAIL, BHEL, etc are preparing financial statements under CCA as a supplementary information.
SYSTEMS OF ACCOUNTING FOR INFLATION:
Current Purchasing power (CPP)
Current Value Systems
The current value systems refers to a family of approaches:
Current Replacement Cost (entry values)
Net realizable Value (exit value)
Economic Value
Current Cost Accounting (CCA)
Current Purchasing power (CPP)
In May 1974 the Institute of Chartered Accountants in England and Wales, issued a provisional statement of Standard Accounting Practice No. 7. This is popularly known as CPP method of accounting.
The fundamental aim of CPP accounting is to show the effect of inflation on the purchasing power of the equity interest.
Profit is only recognized after this purchasing power has been maintained in real terms as measured by the general price index.
Steps for preparing CPP accounts
Figures for items in the balance sheet at the beginning of the year are converted in to rupees of purchasing power at the beginning of the year as below:
Non-monetary items are adjusted for changes in the purchasing power of rupee since they were acquired or revalued.
Monetary items : Kept as it is
The items in the balance sheet at the beginning of the year are then updated from rupees of purchasing power at the beginning of the year to the end of that year.
Figures for items in balance sheet at the end of the year are converted in to rupees of purchasing power, at the end of the year in the same manner followed in step 1 above.
The difference between the total equity interest in the converted balance sheets at the beginning and end of the year is the profit or loss for the year measured in the current purchasing power.
The profit and loss account can be prepared by expressing the relevant figures in rupees of purchasing power at the end of the year. The converted profit and loss account should contain a figure of net loss or profit in purchasing power resulting form the effects of inflation in the company’s net monetary assets or liabilities.
CRITICISMS OF CPP
CPP figures not useful for decision making purpose of management
Prices of assets may not move in line with general rates of inflation
Asset specific purchasing power is ignored
Financial statements as per CPP cannot be used for taxation, price control, public policy,etc.
CPP model does not show current economic value of assets since the basis of valuation is historical cost
Current Value Systems
Current Replacement Cost (entry values)
Net realizable Value (exit value)
Economic Value
Current Cost Accounting (CCA)