INFLATION

ACCOUNTING
Presented To,
Lec. Bhavika Batra
Faculty of Management

Presented By,
Mitesh Mevada
Renison Christian
Kruti Mewada 1
 Inflation: Definitions
 Decrease in purchasing power of money due to an
increase in the general price level
 “A process of steadily rising prices resulting in
diminishing purchasing power of a given nominal sum
of money”
The Penguin Dictionary of Economics
 “Rise in prices brought about by the expansion of the
supply of bank money, credit, etc.”
Oxford Advanced Learner’s Dictionary of Current
English

2
 Inflation Accounting : Definition
 Inflation Accounting is a financial reporting
procedure which records the consequences of
inflation on the financial statements that a
company prepares and publishes at the end of the
financial year. It is based on the assumption that
the currency is stable. But in certain countries this
assumption is not valid specially for certain
countries which are experiencing hyperinflation
and the adjustments are done according to the
changes in the purchasing power of the masses.

3
 Inflation Accounting : History
 Inflation accounting was practiced in the US by
the American Institute of Certified Public
Accountants for over 50 years. During the period
of Great Depression many companies
reconstructed their financial reports recording
the inflation in them. During those 50 years
many companies were encouraged to record the
price-level adjusted statements in place of cost-
based financial statements. The FSAB or the
Financial Accounting Standards Board raised a
proposal of publishing the price-level adjustment
statements which was withdrawn by them later
due to certain problems.
4
 Inflation Accounting : Model
Inflation Accounting is also referred to as the
Price Level Accounting. In certain inflation
accounting models price level costs were
achieved by employing particular indexes. The
second model is the Constant Dollar Accounting.
This is yet another model of accounting. This
model helps to convert the non monetary assets
and equities into current dollars employing a
general price index. The monetary assets are
not taken into account during the conversion.

5
 Some Aspects on Inflation
Accounting
 Problems:
 Subjectivity
 Often complicated calculations
 Benefits:

 maintaining production capacity

 shows the internal logic of accounting

6
 Change in the price level is
described by indexes
 General indexes
 Price Index of Gross Domestic Product
 Cost-of-living Index
 Consumer Price Index
 Wholesale Price Index
 Production Price Index

 Special indexes
 Industry indexes
 Commodity group indexes
 Commodity indexes

7
Finnish Wholesale Price Index
1960-1994
1800
1600
1400
1200
1000
800
600
400
200
0
1960 1965 1970 1975 1980 1985 1990
Source: Statistical Yearbook of Finland 1995
8
 Yearly Change (%) in the
Finnish Wholesale Price Index
30
25
20
15
10
5
0
-51960 1965 1970 1975 1980 1985 1990

-10
Source: Statistical Yearbook of Finland 1995
9
 Inflation Accounting Methods
 CPP - Current Purchasing Power
 CCA - Current Cost Accounting
 The Finnish AHI-Method (Aktivoitujen
Hankintamenojen Indeksointisovellutus)

10
Current Purchasing Power (CPP)
 CPP technique of accounting requires the companies to keep their
records and present the financial statements on conventional historical
cost basis but it further requires presentation of supplementary
statements in items of current purchasing power of currency at the end
of the accounting period.

 In this method the various items of financial statements, i.e. balance

sheet and profit and loss account are adjusted with the help of
recognized general price index. Any approved price index prepared by
the RBI is used to convert the various items of B/S and P&L account.

 The main objective of this method is to take into consideration the

changes in the value of money as a result of changes in the general
price levels.

 It helps in presenting the financial statements in terms of a unit of

measurement of constant value when both cost and revenue have
been changing due to changes in the price levels.
11
 Current Purchasing Power (CPP)
 Retains historic cost accounting conventions
 In U.S. General Purchasing Power (GPP)
 Expresses accounts in terms of “purchasing units”
 The purchase power of money at the end of the
accounting period as the base
 Maintains the general purchasing power of the invested
capital
 The original purchasing costs are corrected by
correction coefficients applying some general index, for
example Retail Price Index

12
 Current Purchasing Power
(CPP)
 Monetary items - financial assets and liabilities - remain
unchanged
 Inventories: FIFO purchase cost is corrected by a
suitable correction coefficient to correspond the
purchase power of the end of accounting period
 Fixed assets:
 The purchase cost is corrected to correspond the purchase
power of the end of the accounting period
 The balance value of the fixed assets is the same
percentage of the corrected purchase cost as the book value
is of the original purchase cost
13
 Current Purchasing Power
(CPP)
 Equity is defined as Assets - Liabilities
 Shareholders’ point of view
 Unsuitable for financing decisions
 Work intensive method

14
Nominal Statement of Income

TO TO = Turnover
- VC VC = Variable Costs
= GP GP = Gross Profit
- FC FC = Fixed Costs
= OP OP = Operating Profit
- IC IC = Interest Costs
- D D = Depreciation
= NP NP = Net Profit
Below we also need:
[ NG = Net Gain from
Liabilities
TP = Total Profit ]
15
Nominal Balance Sheet
FA FA = Financial Assets
Inv Inv = Inventories
FixAss FixAss = Fixed Assets
Assets Assets = Total Assets

Debt Debt = Liabilities

Eq Eq = Owners’ Equity

16
CPP - Statement of Income
CPI t ,12
TOCPP TO CPP
t  TO t *
CPI t ,6
- VCCPP
= GPCPP VCCPP
t  Inv CPP
t 1,12
- FCCPP K
CPI t ,12
= OPCPP   Purch t ,k *  Inv CPP
t ,12
k 1 CPI t ,k
- ICCPP
- DCPP CPI t,12
FC CPP
t  FCt *
= NPCPP CPI t,6
+/- NG CPI t,12
=TPCPP IC CPP
t  IC t *
CPI t,6
17
CPP - Statement of Income
N
Dt ,i
TOCPP D CPP
t  * FixAssCPP
t ,i
i 1 FixAss
- VCCPP t ,i

= GPCPP CPI t ,12

NG  Liab t 1,12 *  Liab t 1,12
- FCCPP CPI t 1,12
= OPCPP CPI t ,12
- ICCPP  ΔLiab t *  ΔLiab t
CPI t ,6
- DCPP
CPI t ,12
= NPCPP  FA t 1,12  FA t 1,12 *
+/- NG CPI t 1,12
=TPCPP CPI t ,12
 ΔFA t  ΔFA t *
CPI t ,6
18
 CPP - Balance Sheet

FA CPP
t  FA t
FACPP
InvCPP
K
CPI t ,12
Inv CPP
t   Purch k *
FixAssCPP k 1 CPI k
AssetsCPP N
CPI t ,12
FixAss CPP
t   FixAss i ,t *
i 1 CPI p
DebtCPP
EqCPP Debt CPP
t  Debt t
Eq CPP
t  Assets CPP
t  Debt t

19
Current Cost Accounting (CCA)
 The crux of the Current Cost Accounting Technique is the
preparation of financial statements (B/S and P&L account) on
the current values of individual items and not on the historical or
original cost.

 The Current Cost Accounting Technique (CCA) has been

preferred to the CPP technique of price level accounting as it is a
complete system of inflation accounting.

 The financial statements prepared under this technique provide

more realistic information and make a distinction between profits
earned from business operations and the gains arising from
changes in price levels.
 As depreciation under CCA is provided on current cost, the
method prevents overstatement of profits and keeps the capital
intact. The effect of holding monetary items in terms of gains and
losses having an impact on the finance ofthe business is also
highlighted.
20
Current Cost Accounting (CCA)
 Maintaining the production level of the
company
 Main focus on replacement of production
capacity
 Money is retained as the unit of measurement
 Different special indexes are applied to
different items
 Work intensive

21
 However, there are many difficulties in the
operation of CCA technique:

 It is very difficult to determine the ‘value to

the business’ of a real asset.
 There is an element of subjectivity in this
technique.
 It does not hold good during the periods of
depreciation

22
 Some important adjustments
required under CCA technique:
 Current Cost of Sales Adjustment (COSA): Under
the CCA technique, cost of sales are to be calculated on
the basis of cost of replacing the goods at the time they
are sold. The important principle is that current costs
must be matched with current revenues. As for sales are
concerned, it is current revenue and out of the costs, all
operating expenses are current costs. But in case of
inventories, certain adjustments will have to be made,
known as cost of sales adjustment.

23
 Some important adjustments
required under CCA technique:
 Depreciate Adjustment: under the CCA method,
assets are shown in the balance sheet on current
replacement costs after allowing for depreciation. This
will require an adjustment in depreciation also.

 Backlog Depreciation: whenever an asset is

revalued, the profit on revaluation is transferred to
Revaluation Reserve Account. But, the revaluation also
gives rise to a backlog depreciation. This backlog
depreciation should be charged to Revaluation Reserve
Account.
24
 Some important adjustments
required under CCA technique:

 Monetary Working Capital Adjustment (MWCA):

working capital is that part of capital which is required to
meet the day to day expenses and for holding current
assets for the normal operations of the business. It is
referred to as the excess of current assets over current
liabilities. The changes in the price levels disturb the
working capital position of a concern. CCA method
requires a financing adjustment reflecting the effects of
changing prices on net monetary items, leading to a loss
from holding net monetary assets or to a gain from
holding net monetary liabilities when prices are rising,
and vice versa, in order to maintain the monetary
working capital of the enterprise. This adjustment reflects
the amount of additional finance needed to maintain the 25
same working capital due to the changes in price levels.
 Some important adjustments
required under CCA technique:
 Gearing Adjustment: During the period of rising
prices, shareholders are benefited to the extent fixed
assets and net working capital, are financed while the
amount of borrowings to be repaid remains fixed except
interest charges. In the same manner, there is a loss to
the shareholders in the period of falling prices. To adjust
such profit or loss on account of borrowings, ‘gearing
adjustment’ is required to be made. ‘Gearing adjustment’
is also a financing adjustment like COSA and MWCA.
This adjustment reduces the total adjustment for cost of
sales, depreciation and monetary working capital in the
proportion of finance by borrowings to the total financing.
26
 The Finnish AHI-Method
 A combination of the CPP and CCA-methods
 Specially developed for firm analysis
 Calculations simple
 Little extra information needed
 Change in the general price level is described by
the wholesale price index
 Adjustments are made on a yearly basis
 the price level at the middle of the accounting period
as the base

27
 AHI-Statement of Income
 Adjustments on
 Variable Costs
 Depreciation

Other posts remain unchanged

Adjustment on variable costs is computed by multiplying
the opening inventory value by the relative change in
the index
Adjustment on depreciation is the difference between
AHI-depreciation and the depreciation in the income
statement

28
AHI - Statement of Income

TO tAHI  TO t
TO AHI

- VCAHI VCtAHI  VCt 

WPI t
* Inv t -1  Inv t -1
= GPAHI WPI t -1
- FCAHI
FC tAHI  FC t
= OPAHI
ICtAHI  ICt
- ICAHI N
- DAHI D tAHI   D iAHI
i 1
,t

= NPAHI  WPI t 
D iAHI  * FixAss i , p  EconLife i
,t  WPI p 
 
p  purchase date,
i  asset i
29
 Adjustments to the Balance
Sheet - Assets
 Financial Assets and Inventories (FIFO) remain unchanged
 Fixed Assets - first AHI-year
 The original purchase cost is revaluated to the price level of the current year
 Depreciation/year is computed according to the economic lifetime of the
asset
 The depreciations up to the current year are subtracted from the revaluated
purchase cost
 Fixed Assets - after the first year
 The AHI-balance value of the previous year is revaluated to the current year
 New depreciation is computed based on the remaining economic
lifetime

30
 Adjustments to the Balance
Sheet - Equity and Liabilities
 Equity
 The accounting result is replaced by the AHI-
result
 Liabilities
 Liabilities remain unchanged
 Inflation Reserves
 Correspond to the adjustments made in the
Statement of Income and the Balance Sheet

31
 AHI - Balance Sheet

FA tAHI  FA t
FAAHI
Inv tAHI  Inv t
InvAHI
FixAssAHI N
FixAss tAHI  i1FixAss i , p *
WPI t
  t  p  1 * DiAHI
,t

AssetsAHI WPI p

Debt tAHI  Debt t

Debt AHI

EqAHI Eq tAHI  Eq tAHI

-1
 NPtAHI
InflResAHI

32
 AHI - Balance Sheet

FAAHI IflRes tAHI  InvRes tAHI  FixAssRes tAHI

InvAHI InvRestAHI  InvRestAHI   VCtAHI  VCt 
-1
FixAssAHI t
FixAssRes tAHI   D AHI  
 D j  FixAss tAHI  FixAss t 
AssetsAHI j 1
j

DebtAHI
EqAHI
InflResAHI

33
 Numerical Example
Correcting annual reports for a company over
years 1975-1976 using the AHI-method. A
period of high inflation rate.
Wholesale Price Index
1972 338
1973 398 700
600

1974 495 500

400

1975 562 300

200

1976 626 100

0
1972 1973 1974 1975 1976

34
Wholesale Price Index and its
Relative Change 1960-1994
1800
1600
1400
1200
1000
800
600
400
200
0
1960 1965 1970 1975 1980 1985 1990
30
25
20
15
10
5
0
-51960 1965 1970 1975 1980 1985 1990

-10

35
 Advantages of price level
Accounting
1. It enables company to present more realistic view of its profitability
because current revenues are matched with current costs.
2. Depreciation charged on current values of assets in inflation
accounting further enables a firm to show accounting profits more
nearer to economic profits and replacement of these assets when
required.
3. It enables a company to maintain its real capital by avoiding
payment of dividends and taxes out of its capital due to inflated
profits in historical accounting.
4. 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.
5. 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.
36
 Disadvantages of price level
Accounting
1. Adjusting accounts to price level changes is a never-ending
process. It involves constant changes
and alterations in the financial statements.
2. Price level accounting involves many calculations and makes
financial statements so complicated and confusing that it becomes
very difficult for man of ordinary prudence to understand, analyze
and interpret them.
3. 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 of
accounts due to the element of subjectivity in it. People may adjust
the accounts according to the values most suited to them, thereby,
making the financial statements more inaccurate.
4. Depreciation charged on current values of fixed assets is not
acceptable under the Income Tax Act, 1961 and hence adjusting it
to price changes does not serve any practical purpose.
37
 Some Internet Addresses
 http://www.xrefer.com/entry/445526
 http://www.drury-online.com/

38
THANK YOU

39