Unit i c Inflation

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McGraw-Hill/Irwin Copyright 2007 by The McGraw-Hill Companies, Inc. All rights reserved .

UNIT I

Accounting forChanges prices

(Inflation Accounting)


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Inflation

inflation is a rise in the general level ofprices of goods and services in aneconomy over a period of time.

Under a historical cost-based system ofaccounting inflation leads to two basicproblems

Many historical numbers are not economicallyrelevantHistorical numbers are not additive


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Inflation

The rise in the average price level for allgoods and services produced in aneconomy

Under a historical cost-based system ofaccounting inflation leads to two basicproblems

Many historical numbers are not economicallyrelevantHistorical numbers are not additive


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Introduction - Inflation

The Increasing trend in general price levelsIn economic sense it refers to a state in whichthe purchasing power of money goes downDEFINITION

The American Institute of Certified Public Accountants definedAs a system of accounting, which purports

to record as a built-in mechanism, alleconomic events in terms of cost


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Need for Inflation accounting

conventional accounting results in a mix ofattributes being reflected in the assetsection of the balance sheet .

Accounts receivable are reported at the netamount expected to receive in the future.Inventory is carried at the lower of cost ormarket value.Short-term investments are reported eithercost or current market value .Property, plant and equipment is reported atcost less accumulated depreciation


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Cont

Price of most assets fluctuate, oftenincreasing .Reporting assets on the balance sheet at

their historical cost during a period of pricechanges can make the balance sheetinformation irrelevant.

For example, reporting land waspurchased in 1940 in the historical cost atRs.1000 (irrelevant)


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Effects of InflationInflation can have positive and negative effectson an economynegative effects :

A decrease in the real value of money and othermonetary items over time

Uncertainty about future inflation may discourageinvestment and saving.and high inflation may lead to shortages of goods ifconsumers begin hoarding out of concern that priceswill increase in the future

Positive effects A mitigation of economic recessions.debt relief by reducing the real level of debt.


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Measure of Inflation

Inflation is usually estimated by calculatingthe inflation rate of a price index, usuallythe general price level .

The General price level (Consumer PriceIndex) measures prices of a selection ofgoods and services (basket) purchased bya "typical consumer". The inflation rate is the percentage rate ofchange of a price index over time.


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Measure of InflationFor instance, in January 2012, the Indias general pricelevel was 202.416, and in January 2013 it was211.080. The formula for calculating the annual

percentage rate inflation in the general price level overthe course of 2012 is:

The resulting inflation rate for the general price level

in this one year period is 4.28%, meaning the generallevel of prices for typical Indian consumers rose byapproximately four percent in 2012.

211.080 202.416202.416 = 4.28%)(


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Inflation Accounting Conceptual Issues

Impact of inflation on financial statements1. Understated asset values.

Negative impact on ability to borrow.

Can invite hostile takeover to the extent that thecurrent market price of a company's stock doesnot reflect the current value of assets

Learning Objective 1


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2. Overstated income and overpayment of taxesUnderstated assets result in understatedexpensesThis lead to overstated income, thus moretaxes paid and stockholders demand ahigher level of dividends.That may result in high cash outflows so

lead to liquidity problems



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3. Differing impacts across companiesresulting in lack of comparabilityA company with older fixed assets willreport a higher return on assets than acompany with newer fixed assets.Because inflation rates tend to vary acrosscountries, comparison made by parent

company across its subsidiaries located indifferent countries can be distorted



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4.Purchasing power gains and lossesHistorical cost also ignores purchasing power gainsand losses during the period of inflation.For example Rs.202 can purchases one basket ofgood and service, a year later when general pricelevel stated at Rs.211, the same Rs.202 can purchases95.5% percent of the basket, so you need to Rs.211 to

buy the same basket .

The difference between Rs.211 needed to maintainthe purchasing power and 202 result in Rs.9

purchasing power loss .



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Purchasing power losses result from holdingmonetary assets, such as cash and accountsreceivable.Purchasing power gains result from holdingmonetary liabilities, such as accounts payable.The two most common approaches to inflationaccounting are Current purchasing power

accounting and current cost accounting.



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Methods of accounting for changingprices

Two solution have been developed to deal withdistortions caused by historical cost1. Account for in the general price level.

This approach makes adjustments to the historical cost ofassets to update for changes in purchasing power of the

currency and therefore is referred to as general price leveladjusted historical cost (GPLAHC) accounting or, moresimply Current purchasing power accounting

2. Account for specific price changes.By updating the values of assets from historical cost tothe current cost to replace these assets, this is known ascurrent replacement cost (CRC) or simply, current cost(CC) accounting .


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Inflation Accounting -- Methods

General Purchasing Power (GPP) AccountingUnder (GPP) Accounting, nonmonetary assets, liabilities,stockholders equity, and all income statement items arerestated from the GPI at the transaction date to the GPIat the at the end of current period.Fixed assets and intangible assets and the relateddepreciation and amortization would also be restated forchanges in general Purchasing Power .Updates historical cost accounting for changes in thegeneral purchasing power of the monetary unit.

Also referred to as General Price-Level-AdjustedHistorical Cost Accounting (GPLAHC).Requires purchasing power gains and losses to beincluded in net income.



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General Purchasing Power (GPP) AccountingBecause inventory was acquired on January 1, Year 1,when the GPI was 100, and GPI at December 31, Year1, is 120, the cost of sales (inventory) is restated usingthe 120/100 .

Because the sales occurred on December 31, Year 1,when the GPI was 120, there is no need to restate sales(or the restatement ratio can be expressed as 120/120).In addition to restating sales and cost of sales GPPaccounting also requires a net purchasing power gainsand losses to be included in net income


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Current Cost (CC) Accounting

Maintaining the purchasing power of equity does notnecessarily ensure that the company is able to continue tooperate at its existing level of capacity.To determine the amount of income that can be distributedto owners while maintaining the company productivecapacity or physical capital , Current Cost (CC) Accounting must be used.Under Current Cost (CC) Accounting ,historical cost ofnonmonetary assets are replaced with currentreplacement .

Also referred to as Current Replacement Cost Accounting.Nonmonetary assets are restated to current replacementcosts and expense items are based on these restatedcosts.Holding gains and losses included in equity.


Unit i c Inflation

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