DEFINITION of 'Inflation Accounting'
Special accounting techniques, which can be used during periods of high inflation. Inflation accounting requires statements to be adjusted according to price indexes, rather than rely solely on a cost accounting basis. Companies operating in countries experiencing hyperinflation, may be required to update their statements periodically, in order to make them relevant to current economic and financial conditions
SIGNIFICANCE of inflation accounting.
The significance of inflation accounting emerges from the inherent limitations of the historical cost accounting system. Following are the limitations of historical accounting:
1. Historical accounts do not consider the unrealised holding gains arising from the rise in the monetary value of the assets due to inflation.
2. The objective of charging depreciation is to spread the cost of the asset over its useful life and make reserve for its replacement in the future. But it does not take into account the impact of inflation over the replacement cost which may result into the inadequate charge of depreciation.
3. Under historical accounting, inventories acquired at old prices are matched against revenues expressed at current prices. In the period of inflation, this may lead to the overstatement of profits due mixing up of holding gains and operating gains.
4. Future earnings are not easily projected from historical earnings.
TECHNIQUES of Inflation Accounting
To measure the impact of inflation on financial statements, following are the techniques used:
Current Purchasing Power (CPP) Method
Under this method of adjusting accounts to price changes, all items in the financial statements are restated in terms of a constant unit of money i.e. in terms of general purchasing power. For measuring changes in the price level and incorporating the changes in the financial statements we use General Price Index, which may be considered to be a barometer meant for the purpose. The index is used to convert the values of various items in the Balance Sheet and Profit and Loss Account. This method takes into account the changes in the general purchasing power of money and ignores the actual rise or fall in the price of the given item. CPP method involves the refurnishing of historical figures at current purchasing power. For this purpose, historical figures are converted into value of purchasing power at the end of the period. Two index numbers are required: one showing the general price level at the end of the period and the other reflecting the same at the date of the transaction.
Profit under this method is an increase in the value of the net asset over a period, all valuations being made in terms of current purchasing power.
Current Cost Accounting (CCA) Method
The Current Cost Accounting is an alternative to the Current Purchasing Power Method. The CCA method matches current revenues with the current cost of the resources which are consumed in earning them.
Changes in the general price level are measured by Index Numbers. Specific price change occurs if price of a particular asset changes without any general price change. Under this method, asset are valued at current cost which is the cost at which asset can be replaced as on a date.
While the Current Purchasing Power (CPP) method is known as the General Price Level approach, the Current Cost Accounting (CCA) method is known as Specific Price Level approach or Replacement Cost Accounting.
LIMITATIONS of Inflation Accounting
Though Inflation Accounting is more practical approach for the true reflection of financial status of the company, there are certain limitations which are not allowing this to be a popular system of accounting. Following are the limitations:
1. Change in the price level is a continuous process.
2. This system makes the calculations a tedious task because of too many conversions and calculations.
3. This system has not been given preference by tax authorities.
CONCLUSION
Historical cost accounting does not take into account the changes in the rise in the value of assets and its impact on Balance Sheet and P&L Account due to inflation and does not reflect the real worth of the business which is very required for effective decision making.
Inflation Accounting has removed this drawback by providing methods for adjusting the figure according to General or Specific Price levels.
Despite a right method of presenting financial statements, Inflation Accounting is still not widely prevalent due to certain limitations. But with more research and development of accounting software in this field, there is no doubt that Inflation adjusted accounting is the future of Financial Accounting
Special accounting techniques, which can be used during periods of high inflation. Inflation accounting requires statements to be adjusted according to price indexes, rather than rely solely on a cost accounting basis. Companies operating in countries experiencing hyperinflation, may be required to update their statements periodically, in order to make them relevant to current economic and financial conditions
SIGNIFICANCE of inflation accounting.
The significance of inflation accounting emerges from the inherent limitations of the historical cost accounting system. Following are the limitations of historical accounting:
1. Historical accounts do not consider the unrealised holding gains arising from the rise in the monetary value of the assets due to inflation.
2. The objective of charging depreciation is to spread the cost of the asset over its useful life and make reserve for its replacement in the future. But it does not take into account the impact of inflation over the replacement cost which may result into the inadequate charge of depreciation.
3. Under historical accounting, inventories acquired at old prices are matched against revenues expressed at current prices. In the period of inflation, this may lead to the overstatement of profits due mixing up of holding gains and operating gains.
4. Future earnings are not easily projected from historical earnings.
TECHNIQUES of Inflation Accounting
To measure the impact of inflation on financial statements, following are the techniques used:
Current Purchasing Power (CPP) Method
Under this method of adjusting accounts to price changes, all items in the financial statements are restated in terms of a constant unit of money i.e. in terms of general purchasing power. For measuring changes in the price level and incorporating the changes in the financial statements we use General Price Index, which may be considered to be a barometer meant for the purpose. The index is used to convert the values of various items in the Balance Sheet and Profit and Loss Account. This method takes into account the changes in the general purchasing power of money and ignores the actual rise or fall in the price of the given item. CPP method involves the refurnishing of historical figures at current purchasing power. For this purpose, historical figures are converted into value of purchasing power at the end of the period. Two index numbers are required: one showing the general price level at the end of the period and the other reflecting the same at the date of the transaction.
Profit under this method is an increase in the value of the net asset over a period, all valuations being made in terms of current purchasing power.
Current Cost Accounting (CCA) Method
The Current Cost Accounting is an alternative to the Current Purchasing Power Method. The CCA method matches current revenues with the current cost of the resources which are consumed in earning them.
Changes in the general price level are measured by Index Numbers. Specific price change occurs if price of a particular asset changes without any general price change. Under this method, asset are valued at current cost which is the cost at which asset can be replaced as on a date.
While the Current Purchasing Power (CPP) method is known as the General Price Level approach, the Current Cost Accounting (CCA) method is known as Specific Price Level approach or Replacement Cost Accounting.
LIMITATIONS of Inflation Accounting
Though Inflation Accounting is more practical approach for the true reflection of financial status of the company, there are certain limitations which are not allowing this to be a popular system of accounting. Following are the limitations:
1. Change in the price level is a continuous process.
2. This system makes the calculations a tedious task because of too many conversions and calculations.
3. This system has not been given preference by tax authorities.
CONCLUSION
Historical cost accounting does not take into account the changes in the rise in the value of assets and its impact on Balance Sheet and P&L Account due to inflation and does not reflect the real worth of the business which is very required for effective decision making.
Inflation Accounting has removed this drawback by providing methods for adjusting the figure according to General or Specific Price levels.
Despite a right method of presenting financial statements, Inflation Accounting is still not widely prevalent due to certain limitations. But with more research and development of accounting software in this field, there is no doubt that Inflation adjusted accounting is the future of Financial Accounting
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