Merits and Demerits of Inflation Accounting An In-Depth Look

The depreciation adjustment allows for the impact of price changes when determining the charge against revenue for the part of fixed assets consumed in the period. It is the difference between the value to the business of part of fixed assets consumed during the accounting period and the amount of depreciation charged on historical cost basis. The resulting total depreciation charge thus represents the value to the business of the part of fixed assets consumed in earning the revenue of the period.

1. In case of transactions occurring throughout a period, it will be advisable to convert them according to the average index of the period.
2. But due to inflation the cost of the machine might well have gone up to Rs 2, 00,000 or even more in 2011 when the machine is to be replaced and we may find it difficult to replace the asset.
3. To this extent extra funds do not have to be found by the business and this reduces the need for a COSA and in some cases for a MWCA on debtors.
4. In contrast, U.S. firms with activities in Argentina are being forced to use the dollar as their functional currency, costing them in foreign exchange losses.

What is the current purchasing power method?

When a company operates in a country where there is a significant amount of price inflation or deflation, historical information on financial statements is no longer relevant. To counter this issue, in certain cases, companies are permitted to use inflation-adjusted figures, restating numbers to reflect current economic values. All the balance sheet items such as liabilities, Equity Shares, and other expenses are not affected by changes in price levels because all of them are stated at historical prices. On the other hand, items such as Fixed Assets, accumulated Depreciation, provision for contingencies, etc. Are affected by price level changes because these are stated at market prices and they change according to the change in the value of money. These statements, in the end, are converted based on the current purchasing power of the currency.

IFRS permitted international businesses with subsidiaries in Argentina to continue using the peso for their accounts, provided they restate them to adjust for inflation. In contrast, U.S. firms with activities in Argentina are being forced to use the dollar as their functional currency, costing them in foreign exchange losses. Debentures and long-term liabilities are always affected by a change in price level, and necessary adjustments should be made. Therefore, price level does not affect them but the value of the closing stock can be affected, where its value is adjusted according to the price level. In this case, the LIFO method or FIFO method, or even replacement cost method, can be used.

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But apart from this, the method needs the presentation of supplementary financial statements of items at the end of the accounting period in the current purchasing power of the money/currency. The important principle to be remembered is that current costs must be matched with current revenues. As far as sales are concerned, it needs no adjustment as it is a current revenue. One of the features of current cost accounting is to show inventories in the Balance Sheet on the basis of their value to the business, and not at cost or market price, whichever is lower. If there are stocks, certain adjustments are to be made to cost of sales. If there are no stocks, then cost of sales will comprise only current purchases and cost of sales adjustment is not necessary.

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The cost of Sales Adjustment amounting to Rs. 8,000 (Rs. 32,000 – Rs. 24,000) will be charged to Profit and Loss Account and credited to Current Cost Accounting Reserve. (ii) Net Realisable value is the estimated selling price in the ordinary course of business less reasonably predictable costs of completion and disposal. (c) Profit is equivalent to net change in reserves (where equity capital has also been converted) or net change in equity (where equity capital has not been restated). In case of transactions occurring throughout a period, it will be advisable to convert them according to the average index of the period. Such transactions generally include revenue items such as sales and purchases of goods, payment of expenses etc.

It must be noted that, in the process of conversion, it is only the non monetary items which are adjusted to the current purchasing power of money. Further, if assets and liabilities are converted as stated above, it accounting for price level changes may be found that a loss or gain arises from the difference of the converted total value of assets and that of liabilities. Contrary to monetary items, non-monetary items denote such assets and liabilities that do not represent specific monetary claims and include land, buildings, machinery, investments, stocks, etc. For example, a land costing Rs. 50,000 in 1998 may sell for Rs. 1, 00,000 in 2000. Therefore, under CPP method, all such items are to be restated to represent current general purchasing power. In this method of price level accounting, all the liabilities and assets are represented in the balance sheet at the current values.

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Thus, when these assets have been realized, either by sale or use in the business, repayment of borrowing could be made so long as the proceeds are not less than the historical cost of those assets. Most businesses have other working capital besides stock involved in their day-to-day operating activities. For example, when sales are made on credit the business has funds tied up in debtors.