Inflation Accounting: Meaning, Effect, Need, CPP and CCA Techniques, Limitation՚s Commerce YouTube Lecture Handouts

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Inflation Accounting: Meaning, Effect, Need, CPP and CCA Techniques, Limitations | Commerce

Title: Inflation Accounting

Meaning of Inflation Accounting

Inflation accounting is a system of accounting, which shows the effect of changing costs and prices on affairs of a business unit during an accounting year. While the cost in the traditional accounting refers to the historical cost, in inflation accounting, it represents the cost that prevails at the time of reporting.

Effects of Price Level Changes on Accounts

  • Financial statements are usually based on actual or historical cost concept. But measurement unit of various transactions, i.e.. , money, relates to different points of time.
  • Profit as arrived from the profit and loss account on the basis of historical cost has a tendency to be overstated in times of rise in prices.
  • The effect of inflation on fixed assets is worse because it results in non-availability of sufficient funds for replacement of fixed assets.
  • Thus, accounting based on historical cost concept inflates book profits, increases tax liability and erodes equity capital.

Needs of Inflation Accounting

  • Inaccurate presentation of financial statements during the changes in the price levels.
  • Unrealistic, imaginary and inflated book profits in times of rise in prices due to overvaluation of stock in trade and writing off depreciation on fixed assets at a lower rate.
  • Payment of dividends and taxes, much more than warranted by the real profits, out of the equity capital resulting in the erosion of capital.
  • Difficulties in replacement of fixed assets during inflation.
  • Inadequacy of working capital arising out of increasing price levels.
  • Losses arising as a result of holding monetary current assets such as cash and receivables and gains accruing from holding current liabilities as sundry creditors.

Limitations of Historical Accounting

The significance of inflation accounting emerges from the inherent limitations of the historical cost accounting system.

Following are the limitations of historical accounting

  • Fixed assets are stated at historical costs in the balance sheet, they do not show the true current worth and are often unrealistically low.
  • Historical accounts do not consider the unrealised holding gains arising from the rise in the monetary value of the assets due to inflation.
  • 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.
  • Future earnings are not easily projected from historical earnings.

Techniques of Inflation Accounting

There is no agreement on the method to be adopted for adjusting the financial statement for price level changes. Price level charges can be broadly classified into general price level changes and specific price level changes.

They are

  • Current Purchasing Power (CPP) method, based on changes in general price level changes.
  • Current Cost Accounting (CCA) method, based on changes in prices of specific assets.

Current Purchasing Power (CPP) Method

  • In this method, all the items in the financial statements are restated in terms of a constant unit of money i.e.. , in terms of general purchasing power. In order to measure changes in the price level and incorporate changes in the financial statement we use general price index, which is considered to be a barometer for this purpose.
  • The index is used to convert the values of various items in the Financial Statements. This method takes into account the charges in the general purchasing power of money and ignores the actual rise or fall in the price of the given item.

Techniques of Preparing Financial Statement under CPP Method

Conversion Technique

In this method, various items of balance sheet and profit and loss account are adjusted with the help of recognised general price index.

  • For example: A building was purchased in 1995 at a price of ₹ 90,000. The general price index at that time was 150. Convert the figure in current rupees on 31.12. 2002 when the index stood at 300
  • Solution: converted Value = ₹ 1,80, 000
Mid Period Conversion
Monetary and Non-Monetary Accounts

Current Cost Accounting (CCA) Method

  • This method is an alternative to the current purchasing power method. The current cost accounting method matches current revenues with the current cost of the resources, which are consumed in earning them. 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 is valued at current cost, which is the cost at which asset can be replaced on a date.

Other Techniques of Inflation Accounting

  • Only Putting a Note in Accounts
  • Replacement Reserve Method
  • Partial Change Method

Limitations of Inflation Accounting

  • Change in the price level is a continuous process.
  • Too many conversions and calculations.
  • This system has not been preferred by tax authorities.