Need, Meaning, definition, Importance, Role, Objectives, Merits, and Demerits of Inflation Accounting01/09/2022 0 By indiafreenotes
The basic objective of Accounting is the preparation of financial statements is a way that they give a true and fair view of the operating results and the financial position or the business to its various users, namely investors, creditors, management Government, trade unions, research institutions etc. These financial statements are prepared based on certain accounting concepts and conventions. The money measurement concept is a basic attribute of accounting. The money measurement concept states that only those business transactions that are capable of being expressed in terms of money can be recovered in the books of account. It also assumes that the monetary unit used for recording the transaction is stable in nature.
Inflation accounting is a term describing a range of accounting models designed to correct problems arising from historical cost accounting in the presence of high inflation and hyperinflation. Inflation accounting may be described as an attempt to portray financial performance of business enterprises on the basis of current prices. 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.
- Facilitates reasonable comparison: It facilitates a fair inter-period comparison of business profits by bringing all expenses and income to current value. All financial statements such as Balance sheet and Profit and loss account shows present values in place of historical values which makes comparison a reasonable task.
- Presents true condition: Inflation accounting presents true condition of company by adjusting all price level changes taking place in its financial statements. It depicts fair view of company’s financial position by reflecting all changes as per the current price index.
- Remove distortions: This branch of accounting helps in removing all distortions arising due to historical data. It makes accounting records reliable by updating all the data and matching current revenues with current expenses.
- Check on Mis-leading deeds: Inflation accounting keep an eye over the misleading deeds of Historical cost concepts depicting higher profits and higher taxes, thereby resulting in more wages being demanded by workers seeing the high profits. When all adjustments as per the price level accounting is made, these kind of demand will not arise.
- Improve decision making: It is an efficient tool with management which assist in efficient decision making. Inflation accounting provides reliable from of data that is adjusted to current price level. After adjustments, balance sheet exhibits fair position which helps managers in taking right decisions.
- Inbuilt automatic mechanism: Inflation accounting has an inbuilt and automatic mechanism for making adjustments as per the price level changes in company’s book of accounts. It compares revenues and expenses at current cost for reflecting realistic position.
Importance & Objectives
- Exhibits true position: Inflation accounting exhibits true financial status of company by reflecting all books of accounts at current price. It adjusts all record in accordance with current price index for determining real profitability.
- Avoids profit overstatement: This branch of accounting keeps a check on financial statements of companies for avoiding any overstatements of profits. All expenses and income are mentioned at current values which prevents overstatement of business income.
- Calculate right depreciation: Inflation accounting charges correct amount of depreciation by calculating it on present value instead of historical value. Charging right depreciation facilitates business in easy replacement of assets.
- Easy profit comparison: It enables firms in easy comparison of their inter-periods performance for determining their profitability. Inflation accounting adjust effects of prices changes on all expenses and incomes listed in financial statements that avoids distortion of historical data.
- Provides correct information: Inflation accounting provides correct information to shareholders and workers based on present price level. There may be a chance of higher dividend and higher wages being demanded by these people in absence of such information.
Inflation, especially when it is prolonged and high, reduces considerably the meaningfulness and use of the corporate accounts because the various amounts in current rupee values may not signify proportionate real amounts, as the real worth of the rupee varies in different years. Moreover, arithmetical operations involving different amounts in rupees having different real worth become quite misleading. To make the accounts more meaningful, all items should be expressed in values relating to common year. This is attempted through inflation accounting, the following reasons usually being advanced in its favor.
- It helps to correct the usually distorted picture of the financial operations and condition of a company presented by the conventional system of accounts.
- It facilitates inter-company comparisons since inflation hits different firms in different degrees.
- It also facilitates inter-period comparisons of the performance of firm.
- Correct measurement of income is possible only with inflation accounting.
- When some nominal value in the accounts forms the basis of government action, e.g., taxation based on profits, MRTP Act measures based on nominal value acting as proxy for relevant variables, determination of controlled price on the basis of nominal profits and so on, inflation may cause unfair decisions by the government, unless the relevant nominal value is adjusted for inflation.
- Basis of depreciation. The correct amount of depreciation is when it is charged on the current values (inflated values), and thus the replacement of assets will be more reasonable.
- Realistic view. Inflation accounting enables the company to present a realistic view of its profitability as current revenues are matched to current costs.
- Check on payment of dividends out of capital. Inflation accounting enables companies to maintain capital by checking payment of dividends and taxes out of capital (due to inflated profit calculated based on historical cost accounting).
- Reasonable comparison of profitability. When financial statements consider inflation accounting, the profitability of two plants purchased on two dates can be known concretely. This is because they are calculated based on current value and not on historical cost.
- True and fair balance sheet. The company’s financial position, as shown by the balance sheet, will be true and fair if it keeps a meaningful balance of various effects of inflation accounting in mind.
- Check on misleading deeds. In inflation accounting, higher wage and salary demand is less likely to arise, more and more prospective entrepreneurs will not come to open their units, and unwanted competition will be checked.
- Wrong matching concepts. Assets purchased in the past are depreciated at the original cost or historical cost concept, while all other revenues and expenses are shown on current prices against matching accounting concept.
- Safety of owner’s equity. Inflation accounting records fixed asset values according to their current values. Hence, the owner’s capital valuation will show its correct value.
Inflation accounting is a very complicated technique as it involves a lots of adjustments to be done in financial statements. Too many calculations and unwanted adjustments are to be made which becomes a difficult task for a common man.
Never ending process
Major limitation with inflation accounting is that the price changing is a never ending process and continues for infinity. Adjusting of financial statement at every point of time whenever inflation or deflation occurs becomes a tedious task.
Inflation accounting is merely a theoretical concept as under it window dressing of accounting concepts is done as per the suitability of individuals.
Situation in Deflation
During deflationary periods, it may lead to an overstatement of business profits which is harmful. Prices fall suddenly at the times of deflation, making adjustments to the price level at this time will lead to lesser depreciation being charged by the company thereby causing an exaggeration of profits.
This accounting process is a very expensive technique. Small businesses cannot afford to implement it in their process.