SHARFA HASSAN South campus, KU
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INFLATION ACCOUNTING
Introduction: Money is the medium of expression of values in modern life. Effects of various economic activities are measured and expressed in terms of money. For measuring anything, it is mandatory that the measure itself is constant. Money as a medium of expression of value and measure of economic activity is expected to have a constant value. But this expectation has been belied. “Constant value of money” has remained a very unrealistic assumption. Changing value of money has resulted in chaos and distortion while reporting the results of the economic activities of the business enterprises. Inflation has become a global phenomenon in present day world. And it has hardly come as a surprise to the people of the world because history of mankind has been more or less a history of rising prices. Corporate accounting is always done in money terms and one of the underlying assumptions is that the value of unit of money does not change over time. Thus, the accounts contain entries in money terms, the real values of which are supposed to remain unchanged for as many as fifteen years or more. Accounts and auditors certify financial statements as a ‘true and fair view’ of the financial position. But do these financial statements carried out during period of inflation give a ‘true and fair view’ of the results of the operations during the period or of the state of affairs on the balance sheet date? The answer is a big ‘No’. A search for a possible solution to the problem of preparing accounts in an inflationary period thus began. The search resulted in a protracted and inconclusive debate on the methods of presenting accounts in an inflationary period. This provided the way for “Inflation Accounting”. It may, therefore, be defined as that technique of accounting by which the financial statements are restated to reflect the changes in the general price level.
Brief History: Inflation accounting and the principles underlying it have been discussed in some form or the other for the last 80 years or so, although the discussions remained more or less academic and confined to accountants. During the runaway inflation in the 'forties in Germany, it was discussed quite great deal but no concrete proposal or action emerged, and the discussion subsided once the economy resumed functioning on more or less even keel. The issue was revived, this time in the UK and the USA, about 25 years ago. Other countries where it became live issue very early were Latin American countries like Chile, Argentina and Brazil, and the Netherlands in Europe. In United States the first systematic study of problems of inflation accounting was done by Henry W. Sweeney. His book "Stabilised Accounting"(1936) contained concepts and procedures for 'Constant Purchasing Power Accounting' (as CPP was known in USA). Although over the years the details have changed, the principles propounded by him have remained unchanged. This Model of Sweeney was used and seriously advocated
for the first time by the American Institute of Certified Public Accountants (AICPA) in 1963 in study entitled “ Reporting the Financial Effects of Price Level Changes”. About six years later, the Accounting Principles Board (APB) brought out similar proposal as Statement 3. The Financial Accounting Standards Board (FASB) was formed in 1973. It prepard few exposure drafts, the most notable of which was FAS 33, issued in 1979. Meanwhile, the Securities and Exchanges Commission (SEC) also contributed to the discussion by issuing Accounting Series Release (ASR) 190. However, despite these expository papers and the tremendous amount of discussion that they have pro voked, there is no consensus on the exact method of inflation accounting to be adopted. In the UK, the first full-scale discussion is found in report on inflation accounting by the Inflation Accounting Committee (1975) appointed by government and chaired by F.E.P. Sandilands. There were, of course, several expository papers issued by accounting bodies already existing. Hard on the heels of the Sandilands Committee Report (1975) came Exposure Draft (ED) 18 by the Inflation Accounting Steering Group, also known as the Morpeth Group. Unlike most other propo sals, where inflation-adjusted accounts were to be added as sup plementary information to the conventional accounts, ED 18 required companies to give inflation-adjusted accounts in the primary financial statements. This sparked off revolt among the U.K. accountants and led to an unprecedented formal vote by the Institute of Chartered Accountants in 1977 against this kind of imposition. As result, ED 18 was shelved and fresh discussions started with the Hyde Guidelines issued in 1978. In 1979 it was proposed that disclosures under Hyde Guidelines should be mandatory. In 1980, Statement of Standard Accounting Practice (SSAP) 16 was issued, by the Accounting Standards Committee (ASC), requiring most large companies to give inflation-adjusted accounts, in both the balance sheet and the profit-and-loss account. SSAP 16 was slated to be reviewed in 1983. A working group under the chairmanship of Tom Neville pointed out the limited usefulness of SSAP 16 after consulting various users, preparers and auditors of SSAP 16 accounts. Meanwhile, the urgency of the issue has declined due to fall in the rate of inflation. As result, no successor to SSAP 16 has yet emerged. However, it is almost certain that the new standard would be simpler, less rigorous and will require fewer adjustments. The Netherlands allows inflation accounting for companies; and Philips, a big multinational based in that country, has been giving such accounts for number of years now. At least two Latin American countries practise inflation accounting —Brazil and Chile. Inflation has been rampant in these countries and naturally, they were the first to practise inflation accounting. Argentina also has been facing a very high rate of inflation and has been on the verge of accepting infla tion accounting for number of years now, but somehow has not taken the plunge yet. Canada, Australia and India seem to be simply following the U.K. in this matter. In Canada, some exposure drafts have been issued which do not propose anything new and
India and Australia have made few attempts each to discuss the issue by instituting committees. The Australian Committee was chaired by R.L. Mathews and the Indian one was chaired by R.M. Honaver. Again, there is nothing original with respect to the principles of inflation accounting in the reports of these committees. Some companies have been giving inflation-adjusted accounts in India on their own. Examples from the public sector are Bharat Heavy Electricals Limited (BHEL) and Hindustan Machine Tools Limited (HMT). The inflation-adjusted accounts, of course, are supplied in addition to the conventional accounts. The Institute of Cost and Works Accountants of India sponsored two publications in 1975 to familiarise Indians with this issue. Later, in December, 1979, the Federation of Indian Chambers of Commerce and Industry (FICCI) organised workshop in Bombay to discuss the issue and published Report on the Workshop (1979). Recognising the importance of the effect of changing prices on the financial statements of business enterprises, the Research Committee of the Institute of Chartered Accountants of India (ICAI) has brought out a Guidance Note on Accounting for Changing Prices in 1982. In preparing the Guidance Note, the Research Committee of ICAI has drawn heavily on the various publications on the subject by various international professional bodies and more particularly those by the Accounting Standards Committee in the U.K. The main objective of the Guidance Note is to encourage the adoption of accounting for changing prices, and to suggest a methodology relevant in the prevailing economic environment in India. The Institute of Chartered Accountants of India has not given its own clear opinion as to which method of accounting for price changes should be adopted by business enterprises in India. However, the Research Committee of ICAI is in favour of Current Cost Accounting (CCA) of UK.
Definitions:
‘Inflation Accounting’ connotes adjustment of financial statements to show a firm's real financial position in inflationary times. It aims to indicate how rising prices and lower purchasing power of the currency affect a firm's cost of refinancing its productive assets, and of its ability to maintain an adequate level of profit on the capital employed. One method is to adjust every figure in the balance sheet on the basis of a price index (such as consumer price index) which reflects the current purchasing power of the currency. Another method suggests to re-value tangible assets at their replacement cost. In valuation of an inventory, inflation accounting treatment can affect the firm's taxable income, cash position, and reported earnings, depending on whether the firm uses FIFO1 or LIFO2 methods.3 FIFO method, shows a higher profit, therefore higher tax 1
First-In, First-Out : In Accounting it means a method of inventory valuation based on the assumption that
goods are sold or used in the same chronological order in which they are bought. Hence, the cost of goods
burden and a decrease in net cash flow. LIFO method lowers the profit and tax burden and increases the net cash flow.
According to the American Institute of certified P ublic Accountants (AICPA), “Inflation Accounting is a system for accounting which purports to record as a built-in mechanism in all economic events in terms of current costs”. Inflation and its Impact on Corporate Financial Statements : The monetary postulate underlying historical cost accounting does not hold good during the period of changing prices. Consequently, a host of problems begin to creep into the accounts with the movement - upwards or downwards - in prices. Such problems have the effect of distorting the accounting results in various ways. These distortions are manifested in the form, among others, of an overstatement of profits and an understatement of assets during inflation conversely there is an understatement of profits and an overstatement of assets when there is deflation. Mainly two types of assets are included in the Balance Sheet. One is current assets and the other is fixed assets. Fixed assets are the main victims of inflation or in other sense the effect of inflation is more pronounced in the case of these types of assets: The depreciation is calculated on the historical cost basis which is usually lower than that of those calculated at replacement value. Second the operating expenses and incomes are taken at current prices, stock shows at cost or market price whichever is lower. Purchasing power gains, losses occur simply because the firm is holding some monetary liabilities and assets which gain or lose purchasing power during inflation. Since nominal values of assets, profits and other items from corporate accounts form the basis of many other decisions having important effects, like calculation of tax liability, action under MRTP Act, actions regarding various controls imposed by the Government and so on. "The distortion in corporate accounts introduced by inflation may have a much wider effect than a mere misrepresentation of purchased first (first-in) is the cost of goods sold first (first-out). During periods of high inflation-rates, the FIFO method yields higher value of the ending inventory, lower cost of goods sold, and a higher gross profit (hence the higher taxable income) than that yielded by the last-in first-out (LIFO) method. The 'in' office basket is an illustration of FIFO method. 2
Last-In, First-Out : In accounting it means a method of inventory valuation based on the assumption that the
goods purchased most recently (the last in) are sold or used first (the first out). The remaining items are assumed to have been purchased at successively-earlier periods. In this method, value of the inventory at the end of an accounting period is based on the value of items purchased earliest. During periods of high inflation rates, the LIFO method yields lower value of the ending inventory, higher cost of goods sold, and a lower gross profit (hence lower taxable income) than that yielded by the application of the first-in, first-out (FIFO) method. During prolonged inflationary periods, however, LIFO method can seriously understate the value of inventory because the cost of replacing it would be much higher than the value shown in accounts. The 'Out' officebasket is an illustration of LIFO method. 3
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accounts"4. This malady may be corrected only by inflation accounting.
Advantages of Inflation Adjusted Financial Statements (I.A.F.S) over Historical Cost Financial Statements (H.C.F.S ) [or Differences between the two statements]: The main difference between historical cost financial statements and Inflation adjusted financial statements is that historical cost financial statements shows real or original cost of assets and liabilities while inflation adjusted financial statements represents the cost prevailing at the reporting date of time. The difference can be analysed from the following angles (i)
(ii)
(iii)
(iv)
(v)
In a situation of inflation the figure based on historical cost financial statements (H.C.F.S) never exhibits a true and fair view of the financial position of a firm. Only the Inflation adjusted financial statements (I.A.F.S) shows the current values of assets and gives the picture of the financial position in true sense. Depreciation based on historical cost financial statement is usually lower and shows more profit/ which misleads the firm's profitability or the return on its investment. If this profit is distributed as dividend, it will lead to erosion of capital. While the inflation adjusted financial statements correct this mistake by charging the depreciation on current values of assets. By matching the cost and revenue at current values ‘the inflation adjusted financial statements’ (I.A.F.S) reveal s the actual profit in rupees of the same purchasing power. This is an aid to decision making process. The comparison of financial statements based on historical cost of the two plants set up at different dates may mislead any person. While the inflation accounting gives the correct values, it helps in making better comparison of financial position. I.A.F.S based on current values provides more meaningful information at the time of financial analysis. It helps not only the internal staff but also the outsiders like investors, common public, creditors etc.
Objections to Inflation Accounting:
There are still some people who object to inflation accounting. Their grounds mainly are the following:
4
Tapas Kumar Sen, Inflation Accounting and Corporate Taxation 1987. National Institute of Public Finance and policy, New-Delhi. P.7.
(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. However, there are two fallacies to the argument: firstly , 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”; and 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 in this respect. 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.
Methods of Inflation Accounting: Number of methods have been suggested for measuring the impact of changing prices on the profitability and financial position of the business units, however, no single method has gained universal acceptance. The most important of these techniques are explained as follows: 1. Current Purchasing Power Method [CPP method]. 2. Current Cost Accounting Method [CCA method].
1. Current Purchasing Power method [CPP Method] or Constant Rupee Method: The CPP method attempts to restate all items in t he financial statements in terms of units of equal purchasing power. It seeks to eliminate the effects of changes in the general price levels or in the value of money itself. Money as a measuring rod is somewhat defective, because its value keeps on changing due to inflation or deflation. The CPP method basically attempts to remove the distortions in financial statements, which arise due to change in the value of rupee. For this purpose, any approved price index depicting the changes in the purchasing power of rupee is used to convert the various items of the financial statements. For example, an asset purchased in 2000 for Rs.5, 000 would be valued in 2005 based on the change in the general price index in 2005 as compared to that in 2000. Suppose the general price index was 200 in 2000 and it was 300 in 2005. The asset would be valued at Rs.7,500 [i.e., Rs.5,000 x 300/200], It implies that the current purchasing power of a sum of Rs. 5,000 spent in 2000 is equivalent to Rs.7 500 in 2005. That is, the purchasing power of rupee in 2005 is 1.5 times [300/200] more than that in 2000. It is important to note that under CPP method only the changes in the general purchasing power of money is relevant and not the value of individual asset. For example a particular asset has become cheaper over the period of time as against the increase in the general price index. In such a case, the value of such an asset will be raised in accordance with the general price index. Mechanism of preparing Financial statement under CPP method: a. Conversion Factor: For converting historical rupees into equivalent uniform rupees [current purchasing prices] as at the date of balance sheet an index
depicting the changes in the power of rupee is required. The consumer price index or the wholesale price index prepared by the Reserve Bank of India can be taken for conversion of historical costs. For this purpose, historical figures must be multiplied with the conversion factor. This is done through a conversion factor, which is calculated as follows:
And , Converted Figure = Historical Figure x Conversion factor Or,
=Historical figure x
Price Index at the date of conversion Price at the date of transaction
For this purpose most broad-based retail or consumer price is used. And in case of transactions occurring throughout a period, an average price index of the period is used. Such transactions include items like sales, purchase of goods, payment of expenses, etc. The average price index may be calculated by taking the average of the opening and end of the period price index numbers. Example 1: A company purchased a plant on 1-1-2005 for a sum of Rs.45 000. The consumer price index on that date was 125 and it was 250 at the end of the year. Restate the value of the plant as per CPP method as on 31st December 2005. Solution:
Thus, Value of the Plant on 31st December 2005 after conversion (i.e., converted figure) Conversion Factor ]
= [ Value of the plant on 1 – 1 – 2005 x = Rs. 45 000 x 2 = Rs. 90 000]
(b) Mid-Period Conversion: There are several transactions which take place throughout the year such as purchases, sales, expenses, etc. For conversion of such items, average index of the year can be taken
as the one index for all such items. If such an average is not available, the index of the mid-year is taken for this purpose. And, if the index of the mid year is also not available, then the average of index at the beginning and at the end of the period may be taken. (c) Monetary and Non-Monetary Accounts (Gain or Loss on Monetary items): For the conversion of historical costs in terms of current purchasing power of currency, it is useful to make a distinction between: (a) Monetary accounts, i.e., money value items; (b) Non-monetary accounts, i.e., real value items. Monetary accounts are those assets and liabilities which are not subject to reassessment of their recorded values owing to change of purchasing power of money. The amounts of such items are fixed, by contract or otherwise in term of rupees, regardless of change in the general price level. The examples of such items are cash, debtors, bills receivables, outstanding incomes, etc., as assets and creditors, bills payable, loans etc., as liabilities. Such items whose amounts are fixed and do not require reassessment are also known as money value items. Other assets and liabilities, the values of which do change or are subject to reassessment along-with the change in the purchasing power of money are called nonmonetary items or real value assets and liabilities. Non-monetary : items include items such as stocks, land, building, plant and machinery, etc. It must be noted that, in the process of conversion, it is only the non monetary items which are adjusted to the current purchasing power of money. Further, if assets and liabilities are converted as stated above, it may be found that a loss or gain arises from the difference of the converted total value of assets and that of liabilities. This loss or gain arises through monetary items or money value assets and liabilities i.e., cash, debtors, receivables, creditors, bills payable, etc., and not through real value assets and liabilities or non-monetary items. The computation of monetary gain or loss can be followed with the help of the following illustrations. A company has the following transactions at the given dates and price indices for the first quarter of 2008:
(d) Adjustment of Cost of Sales and Inventory: As inventory is purchased in period n and sold in (n + x) period, there is a time gap between purchases and sales. During this time, there might be changes in the price levels. Because of inflation, the selling prices would indicate the value realized in terms of the increased price levels and costs which relate to the earlier periods would imply lower values. This results in over-statement of profits which are often misleading. The same is true is in deflation also, as current revenues are not matched with current costs. Hence, adjustment of inventory and cost of sales is very important. This adjustment depends upon the method adopted for the outflow of inventories, viz., first-in-first-out or last-infirst-out. Under first-in-first out method (FIFO) cost of sales comprise the entire opening stock and current purchases less closing stock. The closing inventory is entirely from current purchases. But under the last-in-fist-out method (LIFO) cost of sales comprise mainly of the current purchases and it is only when the cost of sales exceeds current purchases, opening stock enters into cost of sales. The closing stock enters current purchases opening stock enters into cost of sales. The closing inventory in LIFO is out of the purchases made in the previous year. For adjusting the figures for price level changes the following indices are applied: (a) For current purchases —the average index of the year. (b) For opening stock —the index at the beginning of the year. (c) For purchases of previous year—the average index of the relevant year. This process of adjustment of cost of sales and inventory has been explained in the following illustration. Illustration 6: From the information given below, ascertain the cost of sales and closing inventory under CPP method, if (i) LIFO and (ii) FIFO is followed:
Solution:
(e) Ascertainment of Profit: Profit under Current purchasing Power (CPP) accounting can be ascertained in two ways: (i) Net Change Method: This method is based on the normal accounting concept that profit is the change in equity during an accounting period. Under this method, the openings as well as closing balance sheets are converted into CPP terms by using appropriate index numbers. The difference in the balance sheet is taken as reserves after converting the equity capital also. If equity capital is not converted, it may be taken as the balancing figure. It must be remembered that in the closing balance sheet, the monetary items will remain unchanged. Profit is calculated as the net change in reserves, where equity capital is also converted; and will be equal to net change in equity, where equity is not converted.
(ii) Conversion of Income Method: Under this method, the historical income statement is converted in CPP terms. Purchases, sales and other expenses which are incurred throughout the year are converted at average index. Cost of sales is adjusted as discussed in point (d) above. Depreciation can be calculated on converted values. Monetary gain or loss is also ascertained as explained in point, (c) The process of ascertainment of profit under the CPP accounting can be followed with the help of the following s Illustration 7: Arjun Ltd. furnishes the following income statement for the year ending 31st December 2007, prepared on the basis of conventional accounting. You are required to adjust the same for price level changes under CPP method.
2. Current Costing Accounting (CCA) Approach or Replacement Cost Approach: Current costing method is an alternative to current purchasing power (CPP) method. CCA approach was introduced in 1975 to overcome the difficulties of CPP method. One of the major weaknesses of Current Purchasing Power technique is that it does not take into account the individual price index related to the particular assets of a company. So the CPP approach was criticized by the business world. In the Current Cost Accounting technique the index used are those directly relevant to the company’s particular assets and not the general price index. In this sense the replacement cost accounting technique is considered to be an improvement over current purchasing power technique.
Current costing accounting (CCA) approach recognizes the changes in the price of individual due to the change in general price level. This is the method which includes the process of preparing and interpreting financial statement in such a way that relevant change in the price is considered significantly. In CCA method, the assets are valued in current cost basis. It does not consider the retail price index. This method considers the replacement value of the assets for its real accounting records. The value of assets at which it is to be replaced in future is called the replacement value. This is the reason why it is also known as replacement cost accounting approach also. Under this method, each financial statement is to be restated in terms of the current value of such items. But adopting the replacement cost accounting technique will mean using a number of price indices for conversion of financial statements and it may be very difficult to find out the relevant price index to be used in a particular case. Further, the replacement cost accounting technique provides for an element of subjectivity and on this ground it has been criticized by various thinkers.
Features
Of
Current
Cost
Accounting
(CCA):
1. The fixed assets are recorded at replacement cost value in the balance sheet. 2. Inventories are shown at market value rather than market or cost price whichever less as in the historical system is.
3. Revaluation surplus are transferred to current cost accounting reserve but not distributed as dividend to shareholders. 4. Depreciation of fixed assets is to be calculated at replacement value. 5. Two types of profit i.e. profit from operation and profit from revaluation are calculated. 6. Liabilities are recorded in their original value because there is no any change in monetary unit.
Objectives
Of
Current
Cost
Accounting
(CCA)
Approach:
1. To provide correct and reliable financial information based on the current replacement cost. 2. To calculate the profit without changing the historical profit. 3. To protect the business in the event of normal inflationary situation. 4. To keep level of capital in very balance position by making valuation of assets in proper value based on replacement value. 5. To provide realistic information to the management, investors, creditors, government and to other interested parties. 6. To prepare the financial statement at the end of the year on the basis of current value of such items. Depreciation and Replacement of Fixed Assets: Another problem posed by the price level changes (and more so by inflation) is that how much depreciation should be charged on fixed assets. The purpose of charging depreciation is two-fold: (i) To show the true and fair view of the financial statements and the profitability of the concern, and (ii) To provide sufficient funds to replace the assets after the expiry of the life of the asset. Depreciation charged on historical or original cost does not serve any of the two purposes.
Suppose a machine was purchased in 2000 for Rs 1, 00,000 having a life of 10 years. In case depreciation is charged on original cost, after 10 years we shall have Rs 1, 00,000 from the total depreciation provided. But due to inflation the cost of the machine might well have gone up to Rs 2, 00,000 or even more in 2011 when the machine is to be replaced and we may find it difficult to replace the asset. It proves that we have been charging less depreciation which resulted in overstatement of profits and higher payment of dividends and taxes in the past and insufficient funds now to enable the replacement of the asset. Hence, to rectify this, it is necessary that fixed assets are valued at replacement cost values and depreciated on such replacement cost values. But adopting replacement cost method is also not free from difficulties. The main difficulties are as follows: (1) It is not possible to find accurately the replacement cost till the replacement is actually made. (2) The replaced new assets are not of the same type and quality as old assets because of new developments and improved qualities. (3) Income Tax Act. 1961 does not provide for any other method than the actual cost method. (4) The fixed assets should not be written-up in the balance sheet when the prices are not stable. Hence, it may not be possible to charge depreciation on replacement cost basis. However, it is still advisable to retain profits ad restrict dividends so as to enable funds for replacement of fixed assets. For this purpose ‘Specific Capital Reserves’ or ‘Replacement Reserves’ should be provided in addition to the normal depreciation provided on actual cost of the asset.
