Accounting for Inflation
Accounting for inflation is otherwise known as “Revaluation Accounting”, “Replacement value theory” or “Stabilized accounting”. The method of accounting which takes into account the recorded book value to be adjusted owing to change in prices is known as accounting for inflation. In other words, the system of accounting, which pays due regard to the money value and real value of assets and liabilities is known as accounting for inflation.
Aspects involved in Inflation accounting & related problems:
1) The Problem of replacement of fixed assets: - As depreciation is made on historical cost method, it accounts more for cost than for values. Only on the date of purchase the cost or value of an item would be the same. Subsequently, cost remains the same but the value changes. If depreciation is charged on historical cost method, the ploughing back of profit due to charging of depreciation would be less than what it would have been if it was made on current values. So there is less retention of profit. Also, the total fund arising out of depreciation does not permit the company to replace the assets such as machines at current values. Hence, the replacement becomes more and acute during the period of inflation. Employment of additional capital is an alternative in such situations.
2) Problem of Inventory Valuation: - Conventional method of valuation of inventory is either at cost price or market price whichever is lower. But trading usually takes the valuation at latest purchase which is higher than the previous purchases. Hence profit is inflated. The retention of profit is higher in the case where closing inventory is valued at cost or market prices whichever is lower. It is lower in the case were closing inventory is valued at the latest purchase price. The sufficiency of retained profits to replace the stock is another problem associated during the period of inflation.
3) Problem of proper Interpretation of Financial Statements: - Changes in the purchasing power of money will definitely affect accounting for real value. Value may be of two types: real value and money value. The assets and liabilities which are reassessed owing to rise in price levels are known as real value items and which do not permit reassessment under similar situations are known as money value items. There is no uniformity as to the techniques used for inflation accounting. For example, in the Income Statement, in some cases, it may happen that the reported profit shown is a higher figure due to charge of depreciation based on historical cost.
4) Erosion of Real Capital: - Because of inadequate provision for depreciation and improper valuation of closing stock, the profit of the business may tend to be inflated.
5) Problem of disparity of the rate of dividend: - The investors in long-term debt and preference shareholders, who are entitled to a fixed interest/dividend at every period, suffer during the period of inflation due to their depreciation of capital and income.
6) Problem of proper Managerial Decision: - The problem arises due to the fact that the top management has to reconcile between the past, present and uncertain future.
7) Problem of distribution of dividend and payment of taxes against profit:- Under-statement of assets and over-statement of profit due to inflation involves the problem of high dividend and tax payments.
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