Professional Documents
Culture Documents
Diff. Between Capital Receipt and Revenue Receipt
Diff. Between Capital Receipt and Revenue Receipt
(b) Appears as capital or liabilities in the (b) Credited as revenue to Trading and Profit &
Balance Sheet Loss Account
© Examples: receipts of cash brought in by © Examples: receipts from sales of goods and
partners, shareholders, debenture services, rent, commission and interest on
holders and bank loans bank deposits received by the business.
The main causes of depreciation may be divided into two categories, namely:
Internal Causes:
Depreciation which occurs for certain inherent normal causes, is known as internal depreciation.
The main causes of internal depreciation are:
Some assets physically deteriorate due to wear and tear in use. More and more use of an asset,
the greater would be the wear and tear. Physical deterioration of an asset is caused from
movement, strain, friction, erasion etc. An obvious example of this is motor car which rapidly
wears out. Other assets like this are building, plant, machinery, furniture, etc. The wear and tear
is general but primary cause of depreciation.
Depletion:
Some assets declines in value proportionate to the quantum of production, e.g. mine, quarry etc.
With the raising of coal from coal mine the total deposit reduces gradually and after sometime it
will be fully exhausted. Then its value will be reduced to nil.
External Causes:
Depreciation caused by some external reasons is called external depreciation. The main external
causes are as follows:
Obsolescence:
Some assets, although in proper working order, may become obsolete. For example, old machine
becomes obsolete with the invention of more economical and sophisticated machine whose
productive capacity is generally larger and cost of production is therefore less. In order to survive
in the competitive market the manufacturers must must install new machines replacing the old
ones. Again, it may happen that the articles produced by old machine are no longer saleable in
the market on account of change of habit and taste of the people. In such a case the old machine,
although in good working condition, must be discarded and the new one purchased.
Efflux of Time:
Some assets diminish in value on account of sheer passage of time, even though they are not
used e.g., leasehold property, patent right, copyright etc. Suppose we take a lease of a house for
10 years for $10,000. Its annual depreciation will be $1,000 (10,000/10), irrespective of the the
whether the house has been used or not. Because with the end of lease after 10 years, the house
will go out of possession.
Accident:
Assets may be destroyed by abnormal reasons such as fire, earthquake, flood etc. In such a case
the destroyed asset must be written off as loss and a new one purchased.
Depreciation is a loss. So Unless it is considered like all other expenses and losses, true profit or
loss cannot be ascertained. In other words, depreciation must be considered in order to into out
true profit or loss of a business.
Goods are produced with the help of plant and machinery which incurs depreciation in the
process of production. This depreciation must be considered as a part of the cost of production of
goods. Otherwise, the cost f production would be shown less than the true cost. Sales price is
fixed normally on the basis of cost of production. So, if the cost of production is shown less by
ignoring depreciation, the sale price will also be fixed at low level resulting in a loss to the
business.
Value of assets gradually decreases on account of depreciation, if depreciation is not taken into
account, the value of asset will be shown in the books at a figure higher than its true value and
hence the true financial position of the business will not be disclosed through balance sheet.
Replacement of Assets:
After sometime an asset will be completely exhausted on account of use. A new asset must then
be purchased requiring a large sum of money. If the whole amount of profit is withdrawal from
business each year without considering the loss on account of depreciation, necessary sum may
not be available for buying the new asset. In such a case the required money is to be collected by
introducing fresh capital or by obtaining loan or by selling some other assets. This is contrary to
sound commerce policy.
Cost: This principle states that the company has to consider the
original cost of fixed assets like building and machinery, rather than
market value. But today most of the companies report only the market
value.
There are, however, many key differences between internal and external audit and these
are matters of basic principle that should be fully recognized:
1. Both the external and internal auditor carry out testing routines and this may
involve examining and analyzing many transactions.
2. Both the internal auditor and the external auditor will be worried if procedures
were very poor and/or there was a basic ignorance of the importance of adhering
to them.
3. Both tend to be deeply involved in information systems since this is a major
element of managerial control as well as being fundamental to the financial
reporting process.
4. Both are based in a professional discipline and operate to professional standards.
5. Both seek active co-operation between the two functions.
6. Both are intimately tied up with the organization’s systems of internal control.
7. Both are concerned with the occurrence and effect of errors and misstatement that
affect the final accounts.
8. Both produce formal audit reports on their activities.
The 3 Key Models Of Organization Activities Involves Internal And External Audit
[b]. Overall risk management arrangements are the main preoccupation of the internal
auditor who is concerned with all those controls fundamental to the achievement of
organizational objectives.
[c]. The final accounts are the main preoccupation of the external auditor who is
concerned that the data presented in the accounts present a true and fair view of the
financial affairs of the organization:
1. It should be clear that the external audit role is really much removed from the
considerations of the internal auditor both in terms of objectives and scope of
work.
2. External audit is a legal requirement for limited companies and most public
bodies, while internal audit is not essential for private companies and is only
legally required in parts of the public sector.
3. Internal audit may be charged with investigating frauds and, although the external
auditors will want to see them resolved, they are mainly concerned with those that
materially affect the final accounts.
4. Internal auditors cover all the organization’s operations whereas external auditors
work primarily with those financial systems that have a bearing on the final
accounts.
5. Internal audit may be charged with developing value-for-money initiatives that
provide savings and/or increased efficiencies within the organization. This applies
to some external auditors in the public sector (e.g. Audit Commission and
National Audit Office).
6. The internal auditor reviews systems of internal control in contrast to the external
auditor who considers whether the state of controls will allow a reduced amount
of testing.
7. Internal audit works for and on behalf of the organization whereas the external
auditor is technically employed by and works for a third party, the shareholders.
8. The internal audit cover is continuous throughout the year but the external audit
tends to be a year-end process even though some testing may be carried out
during the year.
The accounting profession is something that can cover many types of activities. These activities include the
protection of investors, organizations and the economy as a whole. There are very real dangers involved in this
changing profession. Fraud is perhaps the most obvious and most dangerous activity for auditors to detect. The
second most dangerous is not their job. The external auditors open to legal liability when conducting audits, and
not perform their tasks effectively can be devastating. This article discusses these dangers, and the roles and
responsibilities of internal and external auditors, including the many career opportunities available in these
professions.
Compare and contrast the roles and responsibilities of internal and external auditors, and discussing the vast
amount of career opportunities that comes with more internal or external auditor, we must first define what they
mean. The Institute of Internal Auditors (IIA) describes an internal auditor as one who uses an independent,
objective assurance and advice designed to add value and an organization for the activities. The internal auditor is
to help the organization its objectives through a systematic and disciplined approach to evaluate the effectiveness
of risk management, control and improve governance. “Alternatively, an external auditor is defined as the carrying
out periodic inspections for specific purposes or to determine, among other things, whether the records are correct
and complete, prepared in accordance with the provisions of GAAP, and review of financial statements prepared
uit the accounts present fairly the financial position and organization of the results of its financial operations. Now
that we have the difference between what the external auditor in relation to an internal auditor, we know can begin
to describe the roles and responsibilities in the field of accounting.
External auditors have a major impact on the audit of internal controls through their audit activities, including
providing the management and their recommendations for improving internal controls. They provide important
information on the effectiveness of internal control. Especially for the external auditors on an experimental
research, transactions and supporting documents to the financial statements and related information. They review
the accounting principles used and significant estimates made by management and evaluating the overall financial
statement presentation of an organization. Before an external auditor, the performance of its duties, they must
comply with generally accepted auditing standards. The most important is the independence of the auditor should
regards operators’ organizations in which he / she is the control and implementation of appropriate training and the
power to carry out an audit.
Internal auditors, on the other hand, to assess a reasonable degree of certainty of the risk and decides whether the
internal-control systems performed as planned zijn om the organizing objectives are achieved. A report of the
deficiencies in internal controls, risk management issues, and recommendations on how these areas. Safety is
another area of expertise of an internal auditor may have when used by an organization. An internal auditor must
assess the security of sensitive information that must be kept within the organization. Other responsibilities include
communication with management and external auditors, who monitor their studies to continue and support to an
organization controls against fraud.
So far, the main differences between the internal and external auditors, the sum of the experience and expertise of
each property. Internal auditors prove specific knowledge about the organizations in which they operate. This
knowledge and experience can be carried with them from job to job, however, different organizations use different
accounting methods that may be materially different from the one they previously worked. External auditors have
established guidelines and laws to respect, which requires large amounts to acquire knowledge about different
types of accounting methods, controls and, more importantly, entities and unusual surroundings.
In discussing the roles and responsibilities of internal and external auditors, we can point out the many career
opportunities available for both professions. Firstly, the external auditors have an immense advantage over the
internal auditors when it comes to job prospects. As previously mentioned, the external auditors appear on the
knowledge and skills that enable them to move in different accounting areas more easily than an internal auditor.
The external auditors, private CPA with less effort, working as an internal auditor for a sum of different
organizations has become a business and progress faster. These assumptions are not true all the external
auditors, but the roles and responsibilities for each profession seems a higher standard for external auditors to.
According to www. BLS. gov, “Employment of accountants and auditors is expected to grow 18 percent between
2006 and 2016, faster than the average for all occupations. This occupation will have a very large number of new
jobs occur in the vicinity of 226,000 during the ten screenings. A growing number of businesses, changing financial
laws and rules of corporate governance and increased accountability for protecting an organization’s stakeholders
will drive growth. “After a review of the current economy, the previous statement does not hold much truth, but it is
probably Admittedly, the accounting profession will continue to grow, especially the audit.
The following statement on the same site, must be made during treatment of career controllers. “An increased
need for accountants and auditors will arise from changes in legislation on taxation, financial reporting standards,
business investments, mergers and other financial events. Following the accounting scandals at several large
companies, Congress passed the Sarbanes-Oxley Act of 2002 in a attempt to curb corporate accounting fraud.
This law requires public companies to maintain well-functioning internal controls to ensure the accuracy and
reliability of financial reporting rights. He is also the CEO of the company personally responsible for false financial
information .
The growth of the accounting industry as a whole is something that can not be neglected. Given the amount of
fraud that has occurred over the years, it is impossible not to project an enormous need for more listeners over the
next decade. For example, Bernie Madoff Ponzi scheme, it will take hours and hours, day after day, month by
month sort out the damage he and his investment company. “There will be numerous, external auditors werken
with the internal auditors of the firm does not know what exactly happened, and trying to get money back claim for
injured investors. Another example is Texas Stanford investment firm which is currently being studied to continue
in a Ponzi scheme. This form of fraud is the most dangerous for investors because of its nature.
Fraud and the evolution of the law because of the fraud are the main reasons for the enormous growth in the field
of accounting, auditing specific. It is the personal responsibility of internal and external auditors to actively
investigate fraud in their organization or the organization of their customers. Not to be proactive in detecting fraud
is only half of their work. Auditors are required to analyze and interpret financial statements, internal controls, and
more so, detect fraud, a requirement of employment or appointment to an organization as a listener.
The importance of detecting fraud, and its role in employment, especially for internal auditors, the following quote
is from an article on a study entitled “The importance of internal audit fraud detection” by Paul Coram, Colin
Ferguson and Robyn Moroney. “In recent years the importance of good corporate governance has a huge veel
public attention and regulation. A critical aspect of corporate governance is an entity internal audit function. At the
same time there was great public concern about the level of fraud binnen organisaties. “In their study, they”
ASSESS or organizations with an internal audit function are more prone to fraud detection. “Their results suggest
that” internal audits added value through better monitoring and surveillance environments in organizations for fraud
detection, and that the maintenance of the internal audit function within the organization more effective than the
complete outsourcing of this function. ”
This study leads me to believe that the duties, responsibilities and career opportunities for internal and external
auditors will grow at a rapid pace, and there is no reason to think otherwise. With the amount of financial corruption
in our society more and more, year after year, it is not incorrect to say that the external and internal auditors are
essentially police the financial world. In principle, the accounting profession a depression-proof because the nature
of the fraud, and businesses expanding in the world. Hopefully accounting student looking for an action seeking a
College of Commissioners to become and continue to the hypothesis that the police actually the world of finance
and to strengthen moral ethics.
In short, the external and internal auditors are the same that a very important work to save up to protect investors.
They differ, however, that the external auditors to a wider range of knowledge to do than the internal auditors.
Even so, probably accounts for the largest occupations to close today, and the control is only the tip of the iceberg
accounts.
INDIAN A/C Standards
Accounting is the art of recording transactions in the best manner possible, so as to enable the reader to arrive at
judgments/come to conclusions, and in this regard it is utmost necessary that there are set guidelines. These
guidelines are generally called accounting policies. The intricacies of accounting policies permitted Companies to
alter their accounting principles for their benefit. This made it impossible to make comparisons. In order to avoid the
above and to have a harmonised accounting principle, Standards needed to be set by recognised accounting
bodies. This paved the way for Accounting Standards to come into existence.
Accounting Standards in India are issued By the Institute of Chartered Accountanst of India (ICAI). At present there
Objective of Accounting Standards is to standarize the diverse accounting policies and practices with a view to
eliminate to the extent possible the non-comparability of financial statements and the reliability to the financial
statements.
The institute of Chatered Accountants of India, recognizing the need to harmonize the diversre accounting policies
and practices, constituted at Accounting Standard Board (ASB) on 21st April, 1977.
Sub Section(3A) to section 211 of Companies Act, 1956 requires that every Profit/Loss Account and Balance Sheet
shall comply with the Accounting Standards. 'Accounting Standards' means the standard of accounting
recomended by the ICAI and prescribed by the Central Government in consultation with the National Advisory
Committee on Accounting Standards(NACAs) constituted under section 210(1) of companies Act, 1956.
Accounting Standards Issued by the Institute of Chatered Accountants of India are as below:
• Valuation Of Inventories:
• Net Profit or loss For the period, Prior period items and Changes in accounting Policies.
• Depreciation accounting.
• Construction Contracts.
• Revenue Recognition.
• Employee Benefits.
• Borrowing Cost.
• Segment Reporting.
• Discontinuing Operation.
• Intangible assets.
• Impairment Of assets.
• Financial instrument.
Disclosure of Accounting Policies: Accounting Policies refer to specific accounting principles and the method of
applying those principles adopted by the enterprises in preparation and presentation of the financial statements.
Valuation of Inventories: The objective of this standard is to formulate the method of computation of cost of
inventories / stock, determine the value of closing stock / inventory at which the inventory is to be shown in balance
sheet till it is not sold and recognized as revenue.
Cash Flow Statements: Cash flow statement is additional information to user of financial statement. This
statement exhibits the flow of incoming and outgoing cash. This statement assesses the ability of the enterprise to
generate cash and to utilize the cash. This statement is one of the tools for assessing the liquidity and solvency of
the enterprise.
Contigencies and Events occuring after the balance sheet date: In preparing financial statement of a particular
enterprise, accounting is done by following accrual basis of accounting and prudent accounting policies to calculate
the profit or loss for the year and to recognize assets and liabilities in balance sheet. While following the prudent
accounting policies, the provision is made for all known liabilities and losses even for those liabilities / events,
which are probable. Professional judgement is required to classify the likehood of the future events occuring and,
Objective of this standard is to prescribe the accounting of contigencies and the events, which take place after the
balance sheet date but before approval of balance sheet by Board of Directors. The Accounting Standard deals
with Contingencies and Events occuring after the balance sheet date.
Net Profit or Loss for the Period, Prior Period Items and change in Accounting Policies : The objective of this
accounting standard is to prescribe the criteria for certain items in the profit and loss account so that comparability
of the financial statement can be enhanced. Profit and loss account being a period statement covers the items of
the income and expenditure of the particular period. This accounting standard also deals with change in accounting
Depreciation Accounting : It is a measure of wearing out, consumption or other loss of value of a depreciable
asset arising from use, passage of time. Depreciation is nothing but distribution of total cost of asset over its useful
life.
Construction Contracts : Accounting for long term construction contracts involves question as to when revenue
should be recognized and how to measure the revenue in the books of contractor. As the period of construction
contract is long, work of construction starts in one year and is completed in another year or after 4-5 years or so.
Therefore question arises how the profit or loss of construction contract by contractor should be determined. There
may be following two ways to determine profit or loss: On year-to-year basis based on percentage of completion or
Revenue Recognition : The standard explains as to when the revenue should be recognized in profit and loss
account and also states the circumstances in which revenue recognition can be postponed. Revenue means gross
inflow of cash, receivable or other consideration arising in the course of ordinary activities of an enterprise such
as:- The sale of goods, Rendering of Services, and Use of enterprises resources by other yeilding interest, dividend
and royalties. In other words, revenue is a charge made to customers / clients for goods supplied and services
rendered.
Accounting for Fixed Assets : It is an asset, which is:- Held with intention of being used for the purpose of
producing or providing goods and services. Not held for sale in the normal course of business. Expected to be used
The Effects of changes in Foreign Exchange Rates : Effect of Changes in Foreign Exchange Rate shall be
applicable in Respect of Accounting Period commencing on or after 01-04-2004 and is mandatory in nature. This
accounting Standard applicable to accounting for transaction in Foreign currencies in translating in the Financial
Statement Of foreign operation Integral as well as non- integral and also accounting for For forward
exchange.Effect of Changes in Foreign Exchange Rate, an enterprises should disclose following aspects:
Accounting for Government Grants : Governement Grants are assistance by the Govt. in the form of cash or
kind to an enterprise in return for past or future compliance with certain conditions. Government assistance, which
cannot be valued reasonably, is excluded from Govt. grants,. Those transactions with Governement, which cannot
be distinguished from the normal trading transactions of the enterprise, are not considered as Government grants.
Accounting for Investments : It is the assets held for earning income by way of dividend, interest and rentals, for
Transferee company in case of amalgamtion. This accounting standard is not applicable to cases of acquisition of
shares when one company acquires / purcahses the share of another company and the acquired company is not
dissolved and its seperate entity continues to exist. The standard is applicable when acquired company is
dissolved and seperate entity ceased exist and purchasing company continues with the business of acquired
company
Employee Benefits : Accounting Standard has been revised by ICAI and is applicable in respect of accounting
periods commencing on or after 1st April 2006. the scope of the accounting standard has been enlarged, to include
Borrowing Costs : Enterprises are borrowing the funds to acquire, build and install the fixed assets and other
assets, these assets take time to make them useable or saleable, therefore the enterprises incur the interest (cost
on borrowing) to acquire and build these assets. The objective of the Accounting Standard is to prescribe the
treatment of borrowing cost (interest + other cost) in accounting, whether the cost of borrowing should be included
Segment Reporting : An enterprise needs in multiple products/services and operates in different geographical
areas. Multiple products / services and their operations in different geographical areas are exposed to different
risks and returns. Information about multiple products / services and their operation in different geographical areas
are called segment information. Such information is used to assess the risk and return of multiple products/services
and their operation in different geographical areas. Disclosure of such information is called segment reporting.
Related Paty Disclosure : Sometimes business transactions between related parties lose the feature and
character of the arms length transactions. Related party relationship affects the volume and decision of business of
one enterprise for the benefit of the other enterprise. Hence disclosure of related party transaction is essential for
Accounting for leases : Lease is an arrangement by which the lesser gives the right to use an asset for given
period of time to the lessee on rent. It involves two parties, a lessor and a lessee and an asset which is to be
leased. The lessor who owns the asset agrees to allow the lessee to use it for a specified period of time in return of
Earning Per Share :Earning per share (EPS)is a financial ratio that gives the information regarding earning
available to each equiy share. It is very important financial ratio for assessing the state of market price of share.
This accounting standard gives computational methodology for the determination and presentation of earning per
share, which will improve the comparison of EPS. The statement is applicable to the enterprise whose equity
Consolidated Financial Statements : The objective of this statement is to present financial statements of a parent
and its subsidiary (ies) as a single economic entity. In other words the holding company and its subsidiary (ies) are
treated as one entity for the preparation of these consolidated financial statements. Consolidated profit/loss
account and consolidated balance sheet are prepared for disclosing the total profit/loss of the group and total
assets and liabilities of the group. As per this accounting standard, the conslidated balance sheet if prepared
Accounting for Taxes on Income : This accounting standard prescribes the accounting treatment for taxes on
income. Traditionally, amount of tax payable is determined on the profit/loss computed as per income tax laws.
According to this accounting standard, tax on income is determined on the principle of accrual concept. According
to this concept, tax should be accounted in the period in which corresponding revenue and expenses are
accounted. In simple words tax shall be accounted on accrual basis; not on liability to pay basis.
Accounting for Investments in Associates in consolidated financial statements : The accounting standard
was formulated with the objective to set out the principles and procedures for recognizing the investment in
associates in the cosolidated financial statements of the investor, so that the effect of investment in associates on
Discontinuing Operations : The objective of this standard is to establish principles for reporting information about
discontinuing operations. This standard covers "discontinuing operations" rather than "discontinued operation". The
focus of the disclosure of the Information is about the operations which the enterprise plans to discontinue rather
than dsclosing on the operations which are already discontinued. However, the disclosure about discontinued
generally for a period of 3 months. As per clause 41 of listing agreement the companies are required to publish the
Intangible Assets : An Intangible Asset is an Identifiable non-monetary Asset without physical substance held for
use in the production or supplying of goods or services for rentals to others or for administrative purpose
Financial Reporting of Interest in joint ventures : Joint Venture is defined as a contractual arrangement
whereby two or more parties carry on an economic activity under 'joint control'. Control is the power to govern the
financial and operating policies of an economic activity so as to obtain benefit from it. 'Joint control' is the
Impairment of Assets : The dictionary meanong of 'impairment of asset' is weakening in value of asset. In other
words when the value of asset decreases, it may be called impairment of an asset. As per AS-28 asset is said to
be impaired when carrying amount of asset is more than its recoverable amount.
Provisions, Contingent Liabilities And Contingent Assets : Objective of this standard is to prescribe the
accounting for Provisions, Contingent Liabilitites, Contingent Assets, Provision for restructuring cost.
Provision: It is a liability, which can be measured only by using a substantial degree of estimation.
Liability: A liability is present obligation of the enterprise arising from past events the settlement of which is
expected to result in an outflow from the enterprise of resources embodying economic benefits.
Financial Instrument: Recognition and Measurement, issued by The Council of the Institute of Chartered
Accountants of India, comes into effect in respect of Accounting periods commencing on or after 1-4-2009 and will
be recommendatory in nature for An initial period of two years. This Accounting Standard will become mandatory in
respect of Accounting periods commencing on or after 1-4-2011 for all commercial, industrial and business Entities
except to a Small and Medium-sized Entity. The objective of this Standard is to establish principles for recognizing
and measuring Financial assets, financial liabilities and some contracts to buy or sell non-financial items.
Requirements for presenting information about financial instruments are in Accounting Standard.
Financial Instrument: presentation : The objective of this Standard is to establish principles for presenting
financial instruments as liabilities or equity and for offsetting financial assets and financial liabilities. It applies to the
classification of financial instruments, from the perspective of the issuer, into financial assets, financial liabilities
and equity instruments; the classification of related interest, dividends, losses and gains; and the circumstances in
which financial assets and financial liabilities should be offset. The principles in this Standard complement the
principles for recognising and measuring financial assets and financial liabilities in Accounting Standard Financial
Instruments:
Financial Instruments, Disclosures and Limited revision to accounting standards: The objective of this
Standard is to require entities to provide disclosures in their financial statements that enable users to evaluate:
• the significance of financial instruments for the entity’s financial position and performance; and
• the nature and extent of risks arising from financial instruments to which the entity is exposed during the
period and at the reporting date, and how the entity manages those risks.
Inflation Accounting
Inflation accounting is an accounting practice in which values are adjusted for inflation.
This is done to provide a more accurate picture of a financial situation. In some nations,
this type of accounting is required for companies which make public financial reports if
they are above a certain size and smaller companies may utilize inflation accounting as
well. This technique requires some careful accounting work because it is possible to
muddy the financial picture with inflation accounting.
Inflation
Since we started understanding things around us, we all used to listen from our
Grandparents about the things and articles especially Gold & Ghee being cheaper in
their times.
That time we used to think that why the things were cheaper in our Grandparents'
time and why had they started becoming costlier. So this question would keep us
puzzled.
But now as we have grown in our knowledge and understanding, we have come to
know about the phenomenon of Inflation which in layman's language is known as the
state of rising pricing or the falling value of money was the greatest reason behind
this.
Inflation is a global phenomenon in present day times. There is hardly any country in
the capitalist world today which is not afflicted by the spectre of inflation.
Different economists have defined inflation in different words like Prof. Crowther has
defined inflation "as a state in which the value of money is falling, i.e., prices are
rising." In the words of Prof. Paul Einzig, "Inflation is that state of disequilibrium in
which an expansion of purchasing power tends to cause or is the effect of an
increase of the price level." Both the definition have emphasized on the rising prices
of the goods.
The basic factors behind the inflation are either the rising demand or the shortening
of supply due to any reason.
The impact of inflation on business can be bifurcated into two parts like
As far as impact of inflation on costs and revenues is concerned, definitely both will
rise but whether they result into extraordinary profits will be determined by that how
much opening stock was available at old prices with the company and how much
later the demand for increasing wages is entertained by the company.
In case of monetary assets and liabilities, a company will lose in case of being
creditor and gain in case of being debtor in real terms.
If we talk about other assets like building, land and other securities, the company
will be having holding gains in monetary terms but may have neutral impact in real
terms due to the rise in prices on the one hand but fall in value of money on the
other.
The impact of inflation comes in the form of rising prices of output and assets. As the
financial accounts are kept on Historical cost basis, so they don't take into
consideration the impact of rise in the prices of assets and output. This may
sometimes result into the overstated profits, under priced assets and misleading
picture of Business etc.
So, the financial statements prepared under historical accounting are generally
proved to be statements of historical facts and do not reflect the current worth of
business. This deprives the users of accounts like management, shareholders, and
creditors etc. to have a right picture of business to make appropriate decisions.
Hence, this leads towards the need for Inflation Accounting. 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.
The significance of inflation accounting emerges from the inherent limitations of the
historical cost accounting system. Following are the limitations of historical
accounting:
1. Historical accounts do not consider the unrealised holding gains arising from the
rise in the monetary value of the assets due to inflation.
2. The objective of charging depreciation is to spread the cost of the asset over its
useful life and make reserve for its replacement in the future. But it does not take
into account the impact of inflation over the replacement cost which may result into
the inadequate charge of depreciation.
3. Under historical accounting, inventories acquired at old prices are matched against
revenues expressed at current prices. In the period of inflation, this may lead to the
overstatement of profits due mixing up of holding gains and operating gains.
In the last few years, inflation accounting has been adopted as a supplementary
financial statement in the United States and the United Kingdom. This comes after
more than 50 years of debate about methods of adjusting financial accounts for
inflation.
Accountants in the United Kingdom and the United States have discussed the effect
of inflation on financial statements since the early 1900s, beginning with index
number theory and purchasing power. Irving Fisher's 1911 book The Purchasing
Power of Money was used as a source by Henry W. Sweeney in his 1936 book
Stabilized Accounting, which was about Constant Purchasing Power Accounting. This
model by Sweeney was used by The American Institute of Certified Public
Accountants for their 1963 research study (ARS6) Reporting the Financial Effects of
Price-Level Changes, and later used by the Accounting Principles Board (USA), the
Financial Standards Board (USA), and the Accounting Standards Steering Committee
(UK). Sweeney advocated using a price index that covers everything in the gross
national product. In March 1979, the Financial Accounting Standards Board (FASB)
wrote Constant Dollar Accounting, which advocated using the Consumer Price Index
for All Urban Consumers (CPI-U) to adjust accounts because it is calculated every
month.
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.
Still to cater to the needs of an Inflation Accounting, the IASB came out with an
Accounting Standard known as IAS 29.
Under this method of adjusting accounts to price changes, all items in the financial
statements are restated in terms of a constant unit of money i.e. in terms of general
purchasing power. For measuring changes in the price level and incorporating the
changes in the financial statements we use General Price Index, which may be
considered to be a barometer meant for the purpose. The index is used to convert
the values of various items in the Balance Sheet and Profit and Loss Account. This
method takes into account the changes in the general purchasing power of money
and ignores the actual rise or fall in the price of the given item. CPP method involves
the refurnishing of historical figures at current purchasing power. For this purpose,
historical figures are converted into value of purchasing power at the end of the
period. Two index numbers are required: one showing the general price level at the
end of the period and the other reflecting the same at the date of the transaction.
Profit under this method is an increase in the value of the net asset over a period, all
valuations being made in terms of current purchasing power.
Changes in the general price level are measured by Index Numbers. Specific price
change occurs if price of a particular asset changes without any general price
change. Under this method, asset are valued at current cost which is the cost at
which asset can be replaced as on a date.
While the Current Purchasing Power (CPP) method is known as the General Price
Level approach, the Current Cost Accounting (CCA) method is known as Specific
Price Level approach or Replacement Cost Accounting.
Though Inflation Accounting is more practical approach for the true reflection of
financial status of the company, there are certain limitations which are not allowing
this to be a popular system of accounting. Following are the limitations:
1. Change in the price level is a continuous process.
2. This system makes the calculations a tedious task because of too many
conversions and calculations.
Conclusion
Every person on this earth has been affected by Inflation, some positively but most
of the people negatively because the Inflation leads to the erosion of general
purchasing power. The Inflation spares none and it equally influences the Businesses
like the people.
Historical cost accounting does not take into account the changes in the rise in the
value of assets and its impact on Balance Sheet and P&L Account due to inflation and
does not reflect the real worth of the business which is very required for effective
decision making.
Inflation Accounting has removed this drawback by providing methods for adjusting
the figure according to General or Specific Price levels.