INFLATION ACCOUNTING

ASSIGNMENT-2

         INFLATION ACCOUNTING       

INTRODUCTION

Inflation accounting is a term describing a range of accounting systems designed to correct problems arising from historical cost accounting in the presence of inflation. Inflation accounting is used in countries experiencing high inflation or hyperinflation. For example, in countries experiencing hyperinflation the International Accounting Standards Board requires corporate financial statements to be adjusted for changes in purchasing Alteration of a firm's financial statements to account for changes in the purchasing power of money. With inflation accounting, gains and losses from holding monetary items during periods of changing prices are recognized. Likewise, long-term assets and liabilities are adjusted for changing price levels. Inflation accounting is used to supplement regular financial statements in order to illustrate how changing price levels can affect a firm. Also called general price level accounting power using a price index.

DISCUSSION

OBJECTIVES

Following are the objectives of accounting for price level changes

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* To show the true result of the operations i.e. real profit or loss.
* To show the true financial position in current values.
* To show the realistic value of fixed assets in financial statement.
* To provide sufficient depreciation to generate funds for the replacement of fixed assets.
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* To indicate the real capital employed.
* To make distinction between holding gain or loss and operating gain or loss.
* To make accounting records reliable for the various users.

Methods Of Accounting For Price Level Changes
There are many methods of adjustments for the effects of changes in prices. The generally accepted methods of accounting for price level changes are as under..
1. Current purchasing power method or general purchasing power method(CPP or GPP).
2. Current cost accounting method (C CA method).
3. A hybrid method i.e mixture of CPP and C CA method.

TECHNIQUES OE INFLATION ACCOUNTING

1.Replacement Cost Accounting Technique

Replacement Cost Accounting Technique (RCA) is an

improvement over CPP technique. In the Replacement Cost

Accounting Technique, the index used, are those directly relevant

to the company 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. 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

2.Current value Accounting Technique

In the Current value Accounting Technique of price level accounting all assets and liabilities are shown in the balance sheet at their current values. The value of the net assets at the beginning and at the end of the accounting period is ascertained and the difference in the value in the beginning and the end is termed as profit or loss, as the case may be. In this method also, like replacement cost accounting technique, it is very difficult to determine relevant current values and there is an element of subjectivity in this technique.

3.Current Cost Accounting Technique

The crux of the Current Cost Accounting Technique is the preparation of financial statements (B/S andP&L account) on the current values of individual items and not on the historical or original cost.

The Current Cost Accounting Technique (CCA) has been preferred to the CPP technique of price level accounting as it is a complete system of inflation accounting.

The financial statements prepared under this technique provide more realistic information and make a distinction between profits earned from business operations and the gains arising from changes in price levels. As depreciation under CCA is provided on current cost, the method prevents overstatementof profits and keeps.

A.Current Cost of Sales Adjustment (COSA):Under the CCA technique, cost

of sales are to be calculated on the basis of cost of replacing the goods at the time they are sold. The important principle is that current costs must be matched with current revenues. As for sales are concerned, it is current revenue and out of the costs, all operating expenses are current costs. But in case of inventories,

certain adjustments will have to be made, known as cost of sales adjustment.

B. Depreciate Adjustment : under the CCA method, assets are shown in the balance sheet on current replacement costs after allowing for depreciation. This will require an adjustment in depreciation also. Current year depreciation under CCA can be

calculated with the help of following formula:

= Opening Current Value of Assets + Closing Current Value of Assets

2xLife of Asset

And, Depreciation Adjustment = Current Years Depreciation of CCA ± Depreciation of Historical Cost .

iii).Backlog Depreciation : whenever an asset is revalued, the profit on revaluation is

transferred to Revaluation Reserve Account. But, the revaluation also gives rise to a  backlog depreciation. This backlog depreciation should be charged to Revaluation Reserve Account.

iv). Monetary Working Capital Adjustment (MWCA):Working capital is that

part of capital which is required to meet the day to day expenses and for holding current assets for the normal operations of the business. It is referred to as the excess of current assets over current liabilities. The changes in the price levels disturb the working capital position of a concern. CCA method requires a financing adjustment reflecting the effects of changing prices on net monetary items, leading to a loss from holding net monetary assets or to a gain from holding net monetary liabilities when prices are rising, and vice-versa, in order to maintain the monetary

Advantages of price level accounting:

1. In the price level accounting, current revenues are matched with current costs.

2.Depreciation charged on current values of assets in inflation accounting

Further enables a firm to show accounting profits more nearer to economic

profits and replacement of these assets when required.

3.It enables a company to maintain its real capital by avoiding payment of Dividends and taxes out of its capital due to inflated profits in historical accounting.

. 4.Balance sheet reveals a more realistic and true and fair view of the financial position of a concern becausethe assets are shown at current values and not on distorted values as in historical accounting.

5.When financial statements a represented ,adjusted to the price level changes, it makes possible to compare the profitability of two concerns set up at different times.

Disadvantages of price level accounting

1.Adjusting accounts to price level changes is a never-ending process. It involves constant changes and alterations in the financial statements

2.Price level accounting involves many calculations and makes financial statements so complicated and confusing that it becomes very difficult for man of ordinary prudence to understand, analyze and interpret them.

3.The concept of price level accounting appears to have more theoretical importance than practical because adjusting the accounts to the changes in the price levels may lead to window dressing of accounts due to the element of subjectivity in it.People may adjust the accounts according to the values most

suited to them, thereby, making the financial statements more inaccurate.

4. Depreciation charged on current values of fixed assets is not acceptable under the Income Tax Act, 1961 and hence adjusting it to price changes does not serve any

practical purpose.

Conclusion.

Price level accounting states that financial statements are represented and adjusted to the price level changes, it makes it possible to compare the profitability of two concerns set up at different times. It is used in countries experiencing high inflation and hyper inflation.