Inflation Accounting

Presented By :-
What is Inflation ?
Inflation normally refers to the increasing
trend in general price level. In other words,
it is a state in which the purchasing power of
money goes down.
Simply stated what one can buy
for RS 100 cannot buy the same
thing for RS 100 after some time

One of the recent examples of

inflation is also Sugar
Concept of Inflation Accounting

It 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.
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 can
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.
Why Inflation Accounting ???
Suppose the income statement of
a company for 2006 -07 states
sales figure of Rs 50 lakh and Rs
75 lakh for 2007 -08 Prima facie
the sales show the performance
better 50%, the the fact remains
that this entire increase is not due
the performance of the company
but partly because of increase in
prices….
Methods of Inflation Accounting

Some of the generally accepted methods of

Inflation accounting are as follows –

(a) Current Purchasing Power Method

(CPP Method)

(b) Current Cost Accounting Method

(CCA Method)
Current Purchasing Power (CPP) Method
In CPP method common purchasing power of
all the items and transactions in the balance
sheet are worked out.
For the purpose, an appropriate price index,
wholesale or consumer price index is used.
The method tries to find out the current
purchasing power of transactions as well as
gains or losses arising out of holding the
monetary items.
CPP (Continued)….
In case of cash (ASSET )value will reduce
because of inflation.
In case/payables (LIABILITIES), inflation will
result in gain as fixed/agreed money payable
by the company will have less purchasing
power.
Such monetary gain or loss should be
computed separately and shown as a separate
item in the restated income statement in order
to find out the overall profit or loss under CPP
method.
Formula

Value of asset as per CPP =

Historical Cost of Asset x Conversion Factor

Conversion Factor =
Price Index at the date of conversion
Price at the date of transaction
Illustration:

A company purchased a plant on 1/1/2005

for a sum of Rs. 45,000. The consumer price
index on that date was 125 and it was 250
at the end of the year. Restate the value of
the plant as per CPP method as on 31st
December 2005.
Solution:
Conversion Factor =

Price Index as on 31/12/2005 = 250 = 2

Price Index as on 1/1/2005 = 125

Value of the plant on 31/12/05 =

Historical Cost x Conversion Factor
Rs 45,000 x 2 = Rs 90,000
Current Cost Accounting (CCA)Method
The items of the financial statements are
restated in terms of current value of that
item and in terms of general purchasing
power of the money.

Assets and liabilities are stated at their

current value to the business. Similarly, the
profits are computed on the basis of current
values of the various items to the business.
This requires carrying out the following
adjustments –
Adjustments under CCA

•Revaluation adjustment

•Depreciation adjustment

•Cost of Sales adjustment

•Monetary Working Capital adjustment

llustration
From the following data calculate net monetary
gain / loss as per CPP method –
Item 1-1-2008 31-12-2008
Cash Rs. 5,000 Rs 10000
Debtors Rs. 20,000 Rs 25000
Creditors Rs. 15,000 Rs 20000
Public Deposits Rs. 20,000 Rs 20000

Consumer Price index numbers are –

On 1//12008 -- 100
On 31/12/2008 -- 150
Average for the year -- 120
Impact on Assets
Assets as on 31/12/2008 = 35000 out of which
25000 are opening and rest 10000 are additions
during the year.

Value of assets as per CPP =

25000 x 150 / 100 =37500
+ 10000 x 150 / 120 =12500
50000

Less: Value of assets as per closing B/S 35000

Resultant monetary Loss 15000

Impact on Liabilities
Liabilities as on 31/12/2008 = 40000 out of
which 35000 are opening and rest 5000 are
additions during the year.

Value of liabilities as per CPP =

35000 x 150 / 100 = 52500
+5000 x 150 / 120 = 6250
58750

Less:Value of liabilities as per closing B/S 40000

Resultant monetary gain 18750

Net monetary Gain =

Monetary gain from liabilities 18750

Less: Monetary loss from assets 15000

Net Monetary gain = 3750

Monetary Vs Non Monetary Items:
• Monetary Items (both assets and liabilities) are
those items whose amounts are fixed by contracts
or otherwise they remain constant in terms of
monetary units. Example – debtors, creditors,
debentures, Preference share capital etc.

• During the period of inflation the holder of

monetary assets lose general purchasing power
since their claims against the firm remain fixed
irrespective of any changes in the general price
levels. Conversely, the holder of monetary
liabilities gains since he is to pay the same
amount due in rupees of lower purchasing power.
Monetary Vs Non Monetary Items:
• Non monetary items are those items that
cannot be stated in fixed monetary
amounts. They include tangible assets
such as building, plant & machinery,
stock etc.
• Under CPP method all such items are to
be restated to represent the current
purchasing power. For example a
machinery costing Rs 25,000 in 1996
may sell for Rs 35,000 today though it
has been used. This may be due to
change in the general price level.
Computation of Monetary gain or loss:
The changes in purchasing power affects both
monetary and non monetary items of the
financial statements. In case of monetary
assets and monetary liabilities, the firm
receives or pays the amounts fixed as per the
terms of the contract, but it gains or losses in
terms of real purchasing power.
Such monetary gain or loss should be
computed separately and shown as a separate
item in the restated income statement in order
to find out the overall profit or loss under CPP
method.
Impractical System
A serious flaw is that it cannot be accepted as a
statutory system of accounting because of gap
between theory of inflation and its practical
applicability.
Eg : A company earns a profit of Rs. 25 lakh
which, say is at a 5% rate of return on its
investments. If the rate of inflation is significantly
more after adjusting price level changes, the
figure of Rs.25 lakh may turn into a loss figure.
But the fact remains that the company is
physically holding Rs. 25 lakh (the value may be
less than Rs. 25 lakh)
Advantages of Inflation Accounting
•Assets are shown at real values uniformity.

•Financial statements of a company show

correct and current information about the
finance performance of the company.

•Inflation accounting enables a company to get

a fair for its shares by showing the current
values of its fixed assets.

•The value of the assets will be more accurate

and closer to its intrinsic value.
Disadvantage of Inflation Accounting
•Depreciation charging on the replacement
cost goes against the concept.

•Both the method CPP and CCA has serious

drawbacks and there is no general
consensus about the method to be used.

•Charging method on replacement cost not

acceptable to the income tax authorities.