INFLATION ACCOUNTING

Accounting records are no longer maintained to meet the requirements. Today

the financial statements are also prepared to meet the 2 following additional
objectives:
• To meet the information needs of the owners, potential investors and
the parties having stake in the organization; and
• To provide information to the management to control the business.
Thus, accounting as a service function aims to identify, measure and
communicate economic transactions and events relating to a particular period
to its internal & external users. The financial statements so prepared are
required to reflect a true & fair view of the state of affairs of the business
entity at the balance sheet date.
Money measurement concept is a basic attribute of accounting. It is also
assumed that monetary unit recording the business transactions, is stable in
nature. This is however not true as the inflation is effecting on a high
magnitude to all spans of businesses. Inflation brings downward changes in the
purchasing power of the monetary unit thus makes its stability a myth. It is
much obvious that statements prepared without any regard to the current
purchasing power of the monetary unit lose much of their significance.

Inflation accounting is the technique of such accounting methods as are

designed to mirror the impact of rising prices on economic magnitudes through
adoption of inflation adjusted accounts.
The objectives of inflation accounting are:
• To ensure that the capital invested is maintained intact in real terms; and
• To reflect a true & fair view of the results of operations and financial
position for the period concerned.

Inflation-It refers to the general increase in the prices of all goods &
services. It is fundamentally caused by an undue increase in the quantity of
money in proportion to buying power, or the amount of money in circulation in
relation to the goods or wealth created. It results in the fall of the value of
money.
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IMPACT OF INFLATION UPON BUSINESS

The impacts of inflation upon a business are distorting its profit performance
and valuations of its capital. This in turn affects the judgments and decisions
of its management, shareholders, etc. Assets recorded at historical cost will
have a lower real value as the purchasing power of money falls within inflation.
On the other hand, liabilities such as loan are recorded in the financial
statements at historical cost and that is the amount to be repaid despite the
fact that the rupees we repay have a lower real value than the rupees that
were borrowed.
Some of the distorting facts are:
• The assets that are stated in the balance sheet are reported
at values that are much lower than their current values. Due
to the understatement of the values, the business is more
vulnerable to take-over bids and the shareholders may not
realize a fair value for their shares at the time of such
takeover.
• The profits and return on investment under historical cost
accounting are overstated as revenue is recorded at
increasing price levels & expenses such as depreciation and
cost of sales are charged off at the historical cost.
Therefore accounts that haven’t adjusted the impact of inflation can prove
vulnerable to the users of accounts.

INFLATION ACCOUNTING

Definition-It is a technique of accounting by which the transactions are

recorded at current values and the impact of changes in the prices on the
accounting transactions is neutralized or at least such impact is pointed out
along with transactions recorded at historical cost concept. Price level
accounting is mostly known as ‘inflation accounting’ for the reason that prices
are usually changing on the higher side.

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Objectives: The following are the objectives of inflation accounting-
1. To improve the quality of financial information for decision-
making.
2. To give effect to the changes in the purchasing power of
money while measuring the incomes & expenses during an
accounting period.
3. To provide a better basis for inter period comparison of
financial statements.

Methods: The following are the generally accepted methods used to reflect
the effects of changing prices in financial accounts:
(a) Current Purchasing Power (CPP) method
(b) Current Cost Accounting (CCA) method
(c) Hybrid method

(a) Current Purchasing Power (CPP) method

Under this method all items in the financial statements are to be restated
for changes in the general price level. This method does not take into account
the price change in specific asset thus specific price index is not used. It
adjusts historical costs for changes in the general level of prices as measured
by general price level index. Increase in the general level of prices (inflation)
reduces the general purchasing power & vice-versa. Under the method the
adjusted financial statements would reflect the original amounts in terms of
current purchasing power. Current Purchasing Power method makes all the
accounting nos. comparable in terms of general purchasing power by removing
the mixed purchasing power element from historical financial statements.
CIMA defines current purchasing power accounting as:
“Inflation accounting is a method of accounting for inflation in which the
values of the non-monetary items in the historical cost accounts are adjusted
using a general price index to show the change in the general purchasing power
of money. The current purchasing power balance sheet shows the effect of
financial capital maintenance.”

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The following steps are required to show the statements based on current
costs using Current Purchasing Power method:
• Calculation of Conversion Factor & Mid-Point Conversion
Factor
• Calculation of the Gain or Loss on Monetary items
• Calculation of Cost of Sales and Inventory at current prices
• Calculation Of Profits
• Construction Of Balance Sheet

Calculation of Conversion Factor & Mid-Point Conversion Factor

Conversion Factor:
As the Financial statements prepared on historical cost accounting basis
are to be restated considering the current prices, the value of assets in
historical cost accounts are multiplied by conversion factor. Conversion factor
is calculated as under:
Conversion factor = Price index at the date of conversion
Price index at the date of the item arose

Mid –Point conversion Factor:

For translating the transactions to current prices occurring throughout
the period conversion factor can’t be used. Here Mid Point conversion factor is
used. It could be calculated by taking the average of the index that is at the
beginning of the year and at the end of the year.

Calculation of the Gain or Loss on Monetary items

Monetary items are those items that are fixed by contract or otherwise
remain fixed irrespective of any change in the general price level.
e.g.cash, debtors, loan etc.
On the other hand the value of non-monetary items cannot be stated in fixed
monetary amounts as they change with the changes in the price level.
e.g. land, building, equity shares etc.

Changes in purchasing power of money affects both monetary & non-

monetary items. In case of non-monetary items adjustment is made by

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restating their value in the balance sheet. While for monetary items, i.e.,
monetary assets and liabilities, fixed amounts to be paid or received but
holding such assets or liabilities results in gain or loss in terms of real
purchasing power known as general price level gain or loss.
The general price level gain or loss is shown in the restated income
statement to arrive at the overall profit or loss. However such gain cannot be
used to pay dividend.

Calculation of Cost of Sales and Inventory at current prices

Cost of Sales and Inventories:

The value of cost of sales & inventories will depend upon the method
followed for valuation of inventories,i.e., LIFO or FIFO or any other method.
This will also effect the conversion of historical accounts to current price level
adjusted financial accounts. In the FIFO(first in first out) method inventories
first purchased are assumed to be issued first to the production department
or are assumed to be sold first. On the other hand the LIFO(last in first out)
methods inventories purchased in the last are assumed to be issued first to
the production deptt. or are assumed to be sold first.
In order to convert the historical based financial statements to financial
statements prepared considering the current purchasing power method the
following indices are used:
Current purchases : Average index of the year
Opening stock : Index at the beginning of the year
Purchases of previous year(s) : Relevant index

Determination Of Profits

For determining the profits under the current purchasing power method
any of the following two methods can be used:

(i) Net Change Method

Under this method profit is the change in equity over the period. Thus
both the opening balance sheet & the closing balance sheet are converted to

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reflect the changes in price level and any increase in equity is taken as profit
and any reduction is taken as loss. It may be noted that while converting the
figures of the opening balance sheet both monetary & non-monetary items
except equity are to be converted and while converting the closing balance
sheet only non-monetary items are converted as they are already are reported
at current values. Monetary items are not to be converted.

(ii) Conversion or restatement of Income Statement Method

Under the second method all items of profit or loss are converted. Sales
and operating expenses are converted using the average index. The index to be
used for conversion of cost of sales and inventory will depend upon the method
used for valuation of inventory, i.e., LIFO or FIFO. Fixed assets are converted
on the basis of the indices prevailing on the dates they were purchased. The
same principle applies fir-charging depreciation on them. Taxes and dividend
paid are to be converted using the indices of the date on which they were paid.
Gain on account of monetary items should be calculated and stated separately
in the restated income statement.

Advantages of Current Purchasing Power Accounting

 Comparisons over time are enhanced as the financial

statements are constantly restated in current terms.
 The relative price index adjustments when applied to the
historical cost financial statements is objective.
 The method gives an estimate of the money value of the
business that needs to be retained in order to maintain the
purchasing power of the capital.

Disadvantages of Current Purchasing Power Accounting

 Current purchasing power accounting recognizes the shareholder as

the main user of the financial statements. Using the relative price index
is only relevant to the shareholders and consumers in the general
economy.

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  The current purchasing power method takes the historical cost
accounts as the starting part and so subjectivity in the estimates of
historical cost accounts due to the accruals method is also prevalent in
the current purchasing power accounts.
 The selection of a suitable price index is again a difficult and
subjective task.

(b) Current Cost Accounting Method

Current Cost Accounting Method measures the effect of individual rates

of price changes on all assets & liabilities, i.e., stocks, plant & machinery,
investments, loans, creditors and so on. It recognizes that there may be great
differences in the rates of inflation of various items and by using specific
indices for items or group of items the method attempts to match the current
cost of assets used against current incomes generated by them. The objective
is to maintain operating capital at current price level. Assets are valued at
current cost considering specific price index of the relevant asset and not
general price index as is used in Current Purchasing Power Method.

Objectives of Current Cost Accounting

The following are its main objectives:

 To show assets and liabilities at current replacement value;
 To ascertain the profit or loss by matching current costs
with revenue;
 To remove distortions caused by summing up rupees of
different values; and
 To provide more useful information for decision-making on
issues such as price policy, return on investment etc.

Features of Current Cost Accounting System:

 Fixed Assets are to be shown at their value to the business

and not historical cost less depreciation.

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  Inventories are to be valued at the price prevailing on the
balance date and not at the market price or cost price which
ever is less.
 Depreciation is charged on the basis of the current value of
the relevant fixed asset.
 Cost of goods sold are calculated based on the price
prevailing on the date of sale and not on the historical cost
basis.
 The effect of loss or gain will be computed and set off
against interest.

The Following is the process of converting the historical cost based financial
statement into the financial statement taking into account inflation factor
using the Current Cost Accounting Method:

1. Valuation of fixed assets

2. Depreciation adjustment
3. Cost of sales adjustment
4. Monetary working capital adjustment
5. Gearing adjustment

Valuation of Fixed Assets: The fixed assets in the balance sheet are valued
at their value to the business that is defined as the amount that the
company will loose if it were deprived of these assets. The value of an
asset to the business could be either of the following:-
1. Replacement cost value
2. Net Realisable value
3. Economic value

Replacement Cost: It refers to the money now required to buy a new asset of
the type similar to the existing asset. The amount of depreciation has also
got to be deducted from the same considering the fact that the true
replacement of the asset would not be a new asset but an asset that has the
same remaining useful life as the existing asset.

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Net Realisable value : The value the asset will realize if the asset is sold now.

Economic value : It refers to the discounted (present) value of the net income
that will be earned from using the existing assets during the remaining life
of the asset. Thus, it is the net present value of the future anticipated net
income that the asset is likely to generate. Thus it indicated that the
replacement cost value is the purchasing value, net realizable value is the
sale value and the economic value is the holding value.

Economies Experiencing Inflation will find that the balance sheets prepared
under current cost accounting methods may show the fixed assets at a
higher value than their purchase value. This increase will be credited to the
capital reserve named as current cost accounting reserve.

Depreciation Adjustment:

The charge to the profit and loss account to for depreciation under this
method should be equal to the value of fixed assets consumed during the
period. Thus depreciation should be provided at the current cost of the asset
and not at historical costs. Depreciation provided under current cost will differ
from the amount of depreciation calculated considering historical costs.
A suitable depreciation adjustment is required as under:
Depreciation required under current cost accounting ___________
Less: Depreciation charged as per Historical
Cost accounting ___________
Depreciation adjustment ___________

Cost of sales Adjustment

Current cost accounting method is based on the important principle that

current cost must be matched against current revenue for determining the

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true operating profit or loss. The amount of sales requires no adjustment as it
is already at current rate.
Items that enter into the computation of cost of sales have to be taken at
the present value that is required to replace them if consumed or sold. The
difference in values is termed as cost of sales adjustment that is debited (in
case of inflation) before deriving profit.

Monetary working Capital Adjustment

The cost of sales adjustment only takes into account the impact of inflation
on stock consumption. An organization also requires additional resources to
meet working capital requirements due to the increase in the prices. This extra
amount of required working capital is known as additional monetary working
capital.
It is required purely on account of increase in price levels and not on
account of increase in scale of operations. Monetary working capital normally
means aggregate of trade receivables, pre-receivables and trade bills
receivables less trade creditors, trade bills payables and accruals. This
adjustment should present the amount of additional (reduced in case of
deflation) finance needed for monetary working capital as a result of changes
in the input prices of goods and services used and financed by the business.

Gearing Adjustment

The profits as calculated after taking into account the foregoing

adjustments, i.e., depreciation adjustment, cost of sales adjustment and
monetary working capital adjustment reflect the true amount of profits from
operations known as current cost operating profit. This operating profit
belongs to those who bring in the operating capital for the business. It is also
known that many organizations obtain part of their operating capital by loans or
other monetary obligations. Therefore a part of the adjustments in respect of
above adjustments made is ascribable to the loan funds or borrowings. Thus
the net adjustments of the above three factors may be reduced by the

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proportion to the borrowings in the capital structure. This adjustment is known
as gearing adjustment.

Thus to sum up gearing adjustment is necessary because a part of the net

operating assets are financed by borrowings which are to be repaid in the same
monetary amount irrespective of changes in prices. Equity, debts and
preference shareholders provide funds. For a debt fixed amount has to be paid
thus the gearing adjustment is required.

Gearing adjustment = Operating adjustment * Average Borrowings

Average Borrowings + Average Equity
The gearing adjustment in fact reduces the impact of depreciation, cost of
sales and monetary working capital adjustments.

Advantages of Current Cost Accounting

1) Calculating depreciation on the basis of the value to the

business of fixed assets will provide a more realistic measure
of resources used during the period.
2) Calculating cost of sales on the basis of cost of replacing
goods at the same time they were sold with sales revenue. It
will also help to maintain the value of entity in real terms.
3) Management is expected to cope with the changes in prices
of specific goods and services normally acquired by a
business enterprise. This method provides a consistent basis
for evaluating management’s actions and performance.
4) It clearly distinguishes between gains made from operations
(operating gains) and gains made from holding assets.
5) Current cost balance sheet shows the assets at their current
values and therefore provides a more realistic indication of
economic values of the assets than do the balance sheet
based on historical costs.

Disadvantages of Current Cost Accounting

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 1) Specific price indices are not available particularly for
specialized assets like plant & machinery.
2) Additional difficulties are encountered to measure the
current costs of the assets held outside the country.
3) The exclusion of cash and overdraft from working capital
adjustment makes current cost accounting method
incomplete.
4) It fails to recognize purchasing power gains or losses on
monetary items.
5) It fails to recognize that the value of rupee is not the same
overtime.

(c)Hybrid Method

This method is a compromise between Current Purchasing Power Method

and Current Cost Accounting Method. Under this method fixed assets and
inventories are valued at specific indices-Current Cost accounting. In addition
to it purchasing power gains and losses in respect of monetary items are also
considered which otherwise are ignored in Current Cost Accounting. It is
argued that by combining the two methods, the advantages of both the
methods can be obtained. But the critics of this method state that its
acceptance may prove difficult because of theoretical objections.

Issues in Inflation Accounting

At present, inflation accounting is one of the most significant, challenging

and controversial topics in the field of accounting. Some of them are:

(i) Historical cost accounting Vs. Inflation accounting

In the early days when inflation accounting was being developed there
was a controversy on the issue-should firms adjust historical cost accounts for

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price level changes. As the time passed, the tempo of inflation increased
tremendously and business people started to realize the importance of
inflation accounting. Therefore it has gained sufficient importance now.

(ii) Adjustment items

There are two approaches in this regard. According to first a sound
inflation accounting system must cover the adjustment of all financial items.
On the other hand the second approach asks for the adjustment of only those
items that have direct impact on financial results. But the first approach is
more logical & scientific one.

(iii) Use of Index Number

The opinion of experts differs significantly with each other regarding
the use of index numbers for the adjustment of financial accounts. Firm can
either use general purchasing power index for this purpose or specific price
index. But it is considered better off using general purchasing power index
considering the following facts:
 It replaces the monetary unit of measurement that ceases to be
stable during the changing price level.
 It provides a uniform measuring rod.
 It provides a tool for comparison of diverse resources.
 It advocates its use for restating assets as well as shareholders’
capital.
 It presents information to the proprietors, showing how their funds
have been utilized and the profit derived from such use.

However, general purchasing power cannot be applied with reasonable accuracy

to any other entity.

Advantages of Inflation Accounting

The major advantages of inflation accounting are as follows:

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 a) It enables the company to present more realistic view of its
profitability because current revenues are matched with
current costs.
b) Depreciation charged on current values in inflation accounting
further enables a firm to show accounting profits more
nearer to economic profits and replacement of these assets
when required becomes easy.
c) It enables a company to maintain its real capital by avoiding
payments of dividends and taxes out of its capital due to
inflated profits in historical accounting.
d) Balance sheet reveals a more realistic and true and fair view
of the financial position of a concern because the assets are
shown at current values and not on distorted values as in
historical accounting.
e) When financial statements are presented, adjusted to the
price level changes, it makes possible to compare the
profitability of two concerns set up at different times.
f) Investors, employees and the public at large are not mislead
by inflated book profits because inflation accounting shows
more realistic profits.
g) The financial statements prepared by a company adjusted to
the price level changes also improve its social image.
h) Inflation accounting also effects the investment market as it
helps to establish a realistic price for the shares of a
company.

Disadvantages of Inflation Accounting

Some of the major drawbacks of this accounting are as follows:

a) Adjusting accounts to price level changes is a never-ending
process. It involves constant changes and alterations in the
financial statements.
b) Price level accounting involves many calculations and makes
financial statements so complicated and confusing that it

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 becomes very difficult for man of ordinary prudence to
understand, analyze and interpret them.
c) 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 the accounts due to the element of
subjectivity in it.
d) Depreciation charged on current values of fixed assets is not
acceptable under the Income Tax Act, 1961 , and hence
adjusting it to price level changes does not serve any
practical purposes.
e) During deflation when prices are falling, adjustments of
accounts to price level changes will mean charging lesser
depreciation and overstatement of profits indicating that
dividends could be paid from capital even.

Causes of Non-popularity of Inflation Accounting in India

Following are the reasons of non-popularity of inflation accounting in India:

1) The most important reason of not using inflation-adjusted

accounts is of practical difficulties involved in preparing such
accounts and implementations of the system.
2) The biggest difficulty if of training accountants, and others,
the installation of the system and the preparation and audit
of additional current cost accounts.
3) Preparation of indices for calculations and the database for
the preparations of such indices are inadequate in our
country.
4) There is lack of agreement as to which method of inflation
accounting is most suitable and relevant.
5) Management of Indian companies have vested interests in
maintaining the present system because the system reveals
more profit as compared to the inflation adjusted accounting
system.

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 6) Even high expenses, absence of guidance from professional
Institute and absence of a recognized standard on the
subject of inflation accounting acts as barrier to account for
changing prices.
7) There seems to be an agreement among accountants on the
theoretical soundness of an approach. It is criticized for
being too complex or costly to implement.
8) The government does not accept inflation-adjusted accounts
for tax purposes.
9) There is no Accounting Standard on Inflation accounting
issued by Institute of Chartered Accountants of India.
10) The managers of Indian Companies feel that such
accounts are too complicated to be understood by the users.
11)There is the absence of good leadership, companies do not
prepare adjusted accounts because they feel that others are
also not preparing it.
12) Some finance executives consider it a waste of time
and they also look for some monetary benefit for adoption of
such inflation accounting system.

In view of the above causes, it is to conclude that we are at crossroads in

the accounting professions and must initiate a move to make our accounting
statements more relevant and useful reflecting the changing environment. In
other words accounts of Indian companies must reflect the fact that prices
are not stable.

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Contributed by—
NAME : Abhishek Rathi
REG. NO. : CRO0191775
STAGE : CA-FINAL (Due in NOV. 2010)
ADD. : 17E/215 Chopasani Housing Board
Jodhpur, (RAJ.)
PHONE NO. : 0291-2702626 (Landline)
09413591816 (Mobile)
E-MAIL : coolabu18@yahoo.co.in

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