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Inflation Accounting 123
Inflation Accounting 123
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 power using a price index.
Fair value accounting ( also called replacement cost accounting or current cost accounting) was widely used in the 19th and early 20th centuries, but historical cost accounting became more widespread after values overstated during the 1920s were reversed during the Great Depression of the 1930s.
Most principles of historical cost accounting were developed after the Wall Street Crash of 1929, including the presumption of a stable currency.
Hence, adding cash of $10,000 held on December 31, 2009, with $10,000 representing the cost of land acquired in 1995 (when the price level was significantly lower) is a dubious operation because of the significantly different amount of purchasing power represented by the two numbers. By adding dollar amounts that represent different amounts of purchasing power, the resulting sum is misleading, as would be adding 10,000 dollars to 10,000 Euros to get a total of 20,000. Likewise subtracting dollar amounts that represent different amounts of purchasing power may result in an apparent capital gain which is actually a capital loss. If a building purchased in 1970 for $20,000 is sold in 2006 for $200,000 when its replacement cost is $300,000, the apparent gain of $180,000 is illusory.
Ignoring general price level changes in financial reporting creates distortions in financial statements such as reported profits may exceed the earnings that could be distributed to shareholders without impairing the company's ongoing operations the asset values for inventory, equipment and plant do not reflect their economic value to the business future earnings are not easily projected from historical earnings the impact of price changes on monetary assets and liabilities is not clear future capital needs are difficult to forecast and may lead to increased leverage, which increases the business's risk when real economic performance is distorted, these distortions lead to social and political consequenses that damage businesses (examples: poor tax policies and public misconceptions regarding corporate behavior)
During the Great Depression, some corporations restated their financial statements to reflect inflation.
At times during the past 50 years standard-setting organizations have encouraged companies to supplement cost-based financial statements with price-level adjusted statements.
During a period of high inflation in the 1970s, the FASB was reviewing a draft proposal for price-level adjusted statements when the Securities and Exchange Commission (SEC) issued ASR 190, which required approximately 1,000 of the largest US corporations to provide supplemental information based on replacement cost. The FASB withdrew the draft proposal.
(a) 30,000 x 105/100 = 31,500 (b) 30,000 x 110/100 = 33,000 (c) (30,000 x 105/100) - 30,000 = 1,500 (d) (63,000 x 110/105) - 63,000 = 3,000
Constant dollar accounting is an accounting model that converts non-monetary assets and equities from historical dollars to current dollars using a general price index. This is similar to a currency conversion from old dollars to new dollars. Monetary items are not adjusted, so they gain or lose purchasing power. There are no holding gains or losses recognized in converting values.[
The restatement of historical cost financial statements in terms of IAS 29 does not signify the abolishment of the historical cost model. This is confirmed by PricewaterhouseCoopers: "Inflation-adjusted financial statements are an extension to, not a departure from, historical cost accounting."