Inflation accounting

From Wikipedia, the free encyclopedia Jump to: navigation, search 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.[1] Inflation accounting is used in countries experiencing high inflation or hyperinflation.[2] 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.

Contents
[hide] 1 Historical cost basis in financial statements 1.1 Measuring unit principle 1.2

2 History of inflation accounting 3 3.1 Constant dollar accounting

4 International standard for hyperinflationary accounting 5 6

[edit] Historical cost basis in financial statements

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.[3]

[edit] Measuring unit principle

Under a historical cost-based system of accounting, inflation leads to two basic problems. First, many of the historical numbers appearing on financial statements are not economically relevant because prices have changed since they were

incurred. Second, since the numbers on financial statements represent dollars expended at different points of time and, in turn, embody different amounts of purchasing power, they are simply not additive. Hence, adding cash of $10,000 held on December 31, 2002, with $10,000 representing the cost of land acquired in 1955 (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.[4] 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..

[edit] Misleading reporting under historical cost accounting

In most countries, primary financial statements are prepared on the historical cost basis of accounting without regard either to changes in the general level of prices or to increases in specific prices of assets held, except to the extent that property, plant and equipment and investments may be revalued.[5] Ignoring general price level changes in financial reporting creates distortions in financial statements such as[6] 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)

[edit] History of inflation accounting

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.[7] 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.[8]

[edit] Inflation accounting models

Inflation accounting is not fair value accounting. Inflation accounting, also called price level accounting, is similar to converting financial statements into another currency using an exchange rate. Under some (not all) inflation accounting models, historical costs are converted to price-level adjusted costs using general or specific price indexes.[9] Income statement general price-level adjustment example[10] On the income statement, depreciation is adjusted for changes in general price levels based on a general price index. 2001 Revenue Depreciation Operating income Purchasing power loss Net income (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 33,000 30,000 3,000 3,000 2002 36,302 31,500 (a) 4,802 1,500 (c) 3,302 2003 39,931 33,000 (b) 6,931 3,000 (d) 3,931 Total 109,233 94,500 14,733 4,500 10,233

[edit] Constant dollar accounting

Constant dollar accounting is an accounting model that converts nonmonetary 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.[11]

[edit] International standard for hyperinflationary accounting

The International Accounting Standards Board defines hyperinflation in IAS 29 as:"the cumulative inflation rate over three years is approaching, or exceeds, 100%." [12] Companies are required to restate their historical cost financial reports in terms of the period end hyperinflation rate in order to make these financial reports more meaningful. [13] [14] [15] 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." [16]

[edit] See also

Philosophy of Accounting

[edit] Notes and references

^ Wall Street Words: An A to Z Guide to Investment Terms for Today's Investor, David L. Scott. ^ [1] Inflation Accounting: Sandilands Report - May I also ask 297 him to assure us that, when this new system of current cost accounting is introduced, these new realistic figure will be used for the purposes of company taxation, and not the historic cost figures, which are totally meaningless at a time of high inflation. ^ Epstein, Barry J.; Eva K. Jermakowicz (2007). Interpretation and Application of International Financial Reporting Standards. John Wiley & Sons. p. 965. ISBN 9780471798231. ^ Wolk, Harry I.; James L. Dodd and Michael G. Tearney (2004). Accounting Theory: Conceptual Issues in a Political and Economic Environment, 6th ed. SouthWestern. pp. 448. ISBN 0324186231.

^ International Accounting Standards Committee (1995). Interna In most countries, primary financial statements are prepared on the historical cost basis of accounting without regard either to changes in the general level of prices or to increases in specific prices of assets held, except to the extent that property, plant and equipment and investments may be revalued.[5] Ignoring general price level changes in financial reporting creates distortions in financial statements such as[6] 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) [edit] History of inflation accountingtional Accounting Standard 1995. London, International Accounting Standards Committee. pp. P. 502. ISBN 0-905625-26-9. ^ Epstein, pp. 966-997. ^ Whittington, Geoffrey (1983). Inflation accounting: an introduction to the debate. Cambridge, UK: Cambridge University Press. pp. 66. ISBN 0-521-27055-3. ^ Wolk pp 450-455 ^ Epstein, pp. 968-969. ^ Wolk p.5. ^ Epstein, p. 962. ^ International Accounting Standards Committee (1995). International Accounting Standard 1995. London, International Accounting Standards Committee. pp. Par 3 (e) P. 502. ISBN 0-905625-26-9. ^ International Accounting Standards Committee (1995). International Accounting Standard 1995. London, International Accounting Standards Committee. pp. Par 8 P. 503. ISBN 0-905625-26-9. ^ International Accounting Standards Board. IAS 29 Financial Reporting in Hyperinflationary Economies. IASB. pp. http://www.iasb.org/NR/rdonlyres/C2563EF2-89A8-4ED7-82A3E31EDF33E428/0/IAS29.pdf. ^ Deloitte. FINANCIAL REPORTING IN HYPERINFLATIONARY ECONOMIES. Deloitte, IAS Plus. pp. http://www.iasplus.com/standard/ias29.htm. ^ PricewaterhouseCoopers. International Financial Reporting Standards Financial Reporting in Hyperinflationary Economies Understanding IAS 29.

PricewaterhouseCoopers. pp. http://www.pwc.com/gx/eng/about/svcs/corporatereporting/IAS29Publication06.pd f

Inflation Accounting
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.
History of Inflation Accounting

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.
Historical Cost Accounting

Historical accounting replaced fair value accounting during the 1930s post Great Depression period. This was replaced since the values had been overstated by certain companies. The principles of historical cost accounting came into being post Wall Street Crash which took place in 1929 along with the assumption of stable currency.
Basic Principle of Inflation Accounting

One of the most important and basic principles of the accounting process is known as 'The Measuring Unit Principle'. The standard of measurement is the currency which is the most relevant one in the economy. The changes in the purchasing power is not deemed important to be considered. The assumption is that the value of the currency is fixed. However, the use of the principle actually led to misleading reports. The alterations in the price level were not always taken into account while preparing the reports. The price level is considered to be more or less fixed. This may lead to various types of distortions. The influence of price change is not clear, the profits are misquoted, the asset values do not reflect the economic value of the business, future earnings and future capital needs cannot be predicted properly. The misinterpretation of real economic performance has far reaching effects like tampering the whole of the socio-political system of a country.

Models of Inflation Accounting

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.

inflation accounting Alteration of a firm's financial statements to account for changes in the purchasing power of money. With inflation accounting, gains and losses from holding monetary items during periods of changing prices are recognized. Likewise, long-term assets and liabilities are adjusted for changing price levels. Inflation accounting is used to supplement regular financial statements in order to illustrate how changing price levels can affect a firm. Also called general price level accounting. Wall Street Words: An A to Z Guide to Investment Terms for Today's Investor by David L. Scott. Copyright 2003 by Houghton Mifflin Company. Published by Houghton Mifflin Company. All rights reserved.

Inflation Accounting A method of accounting that includes inflation. In inflation accounting, one records price changes that affect the purchasing power of current assets and the value of the company's long-term assets and liabilities. This can provide a more accurate picture of a company's value. It is used to supplement a company's ordinary financial statements. It is less commonly called general price level accounting.Over time, currencies experience inflation in value. A set amount in a given currency in 1990, for example, has a different value in 2000. Inflation occurs over the course of a given year, and can wax and wane depending on a number of economic factors. If financial reporting was provided in the actual values at the time, it might provide in accurate picture. For example, a company could say that it earned one million currency units in 2003 and two million currency units in 2013. On the surface, it might look like the company's income had doubled, but because of inflation, this might not actually be the case. With inflation accounting, the accountant takes the actual value and adjusts it for inflation. This practice may also be known as price level accounting, and it can be very revealing. For example, an accountant preparing statements in 2008 which showed that a company earned $100,000 United States Dollars (USD) in a particular division in 1990 could use inflation accounting to show that this would be $162,727 USD in 2008 dollars. If that

division is still earning $100,000 USD in 2008, it would suggest that it is not doing very well. Adjustments for inflation are done with the assistance of tools like the consumer price index and other indicators which are released by government agencies. Accountants are generally required to show their math when doing inflation accounting so that someone reviewing the accounts can see which index was used to calculate values with inflation. This reduces the risk of using varying indexes to make a financial report more favorable by massaging the numbers.

inflation accounting
Definition
Adjusting financial statements to show a firm's real financial position in inflationary times. It aims to indicate how rising prices and lower purchasing power of the currency affect a firm's cost of refinancing its productive assets, and of its ability to maintain an adequate level of profit on the capital employed. One method is to adjust every figure in the balance sheet on the basis of a price index (such as consumer price index) which reflects the current purchasing power of the currency. Another method suggests to revalue tangible assets at their replacement cost. In valuation of an inventory, inflation accounting treatment can effect the firm's taxable income, cash position, and reported earnings, depending on whether the firm uses FIFO or LIFO methods. FIFO method, shows a higher profit, therefore higher tax burden and a decrease in net cash flow. LIFO method lowers the profit and tax burden and increases the net cash flow.

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