Inflation is the general increase in price levels experienced in an economy. A little inflation is a norm but a lot of inflation has drastic economic effects. Prices rising too fast means incomes are decimated in the wake. High inflation also introduces a measurement problem, if the value of money changes quickly the values of assets get distorted as do income, expenditure and liabilities. International Accounting Standard 29: Financial Reporting in Hyper-inflationary Economies provides for financial reporting in inflation affected economies. The objectives of inflation accounting standards are to provide a uniform way of accounting in times of high inflation that everyone can understand.
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Methods of Inflation Accounting
There are two main methods of inflation accounting and we can briefly go through them to help us understand the objectives of inflation accounting,
Current Purchasing Power
The Current Purchasing Power (CPP) method adjusts historical prices to current prices using the Consumer Price Index. Financial statements prepared in this way give a current value of past transactions. This method uses the Consumer Price Index (CPI), which inflation statistics are based on to calculate a current value for transactions or items in the accounts. Under this method, monetary items and non-monetary items are separated. Monetary items are items such as cash, debtors, liabilities which have a value expressed in monetary terms and this does not change. Non monetary items such as inventory are adjusted using the CPI.
Current Cost Accounting
The Current Cost accounting approach values assets at their fair value in the market rather than the price incurred during the purchase of the fixed asset. Under this method, both monetary and non-monetary items are restated to current values. This involves keeping track of the fair market value of assets. This is not always practical especially in a hyperinflationary environment where prices can move daily or hourly. Using a similar method to CPP of applying a conversion factor based on the index is more appropriate though it may not always be accurate.
The two methods show some of the common objectives of inflation accounting. Inflation accounting objectives include removing price distortions, improving the quality of financial statement information, improving the reliability of the information, showing realistic values and improving management decision making. Let us list the objectives of inflation accounting
Removing Price Distortions
As noted earlier one of the effects of inflation is that over time prices become meaningless. Assets purchased long ago may have a historical cost that is meaningless in today’s money. The objective of inflation accounting, in this case, is to record values of assets, liabilities, income and expenditure at levels commensurate with the present value of money.
More meaningful inter-period comparison.
One of the key requirements of financial statement information is that it be comparable to other organisations and also to the same organisation through time. In high inflation or hyperinflationary environments, this is not possible because of the aforementioned distortions. The objective of inflation accounting methods here is to make information comparable through time.
To improve the meaning and measurement of income and expenses
Hyperinflation occurs when month-on-month inflation exceeds 50% per month. In such scenarios historical accounting for revenue and expenditure becomes very difficult. In simple terms revenue from the previous month will be worth 50% less in the current month. The objective of inflation accounting is to counter this by bringing values up to today’s levels. Hyperinflation also creates a bias towards more recent income which creates an opportunity for window dressing financial statements.
To improve decision making in the organization.
Financial statement information is of course primarily information for decision making. The various user groups including management, shareholders, creditors and employees use the information to make decisions about future involvement with the organisation. This is very difficult to do with information based on the historical cost that is no longer applicable. Even where attempted, it is based on flawed information. The inflation accounting objective is to improve the usefulness of the information for decision making.
Show the true result of the operation
By bringing historical cost figures to current cost levels inflation accounting shows the true results of operations. The objectives of inflation accounting are to level the field so that those looking at financial statements can see the true meaning of the results of operations over the period covered by the financial statements. Historical cost accounting has a bias towards recent figures while understating older figures. This would distort the income statement.
To show true financial position in current values
The balance sheet is not immune to the effects of inflationary environments as assets and liabilities are also stated in historical cost terms. The effect of this would render the value of older assets and liabilities meaningless. The objective of inflation accounting is to ensure statements show the true financial position of a business by presenting realistic values of assets and liabilities.
To indicate the real capital employed
Financial statement users do not stop at looking at the absolute figures shown in the financial statements. It is customary to conduct financial statement analysis through financial ratios to determine the performance, profitability and efficiency of a business. One of the most important of these is Return on Capital Employed which tells users how well management has utilised capital available to them. In a hyperinflationary environment capital employed at historical cost would be a small number giving the illusion of high performing management. The objective of inflation accounting is to present a realistic capital employed figure to measure performance against.
To make accounting record reliable for the various uses
One of the important characteristics of good accounting information is reliability. Information presented must be accurate and honest to the extent that users of financial statements can rely on the information for analysis and decision making. Historical information becomes unreliable in hyperinflationary environments. The objective of inflation accounting is to present information that is reliable in the financial statements.
To provide sufficient depreciation to generate funds for the replacement of fixed assets
In depreciation accounting, the provision for depreciation creates a fund for the replacement of assets when their useful life is up. Maintaining asset value at historical cost and thus calculating provision for depreciation at historical cost will leave the business shortchanged when it is time to replace the asset. Inflation accounting objectives are to make sure that provision for depreciation is commensurate with current price levels.
In conclusion, the objectives of inflation accounting are to help preparers of financial statements present accounting information that has hallmarks of good quality information. By adjusting historical cost to present value pricing information is made more accurate, helpful, reliable and complete.