In this article we will discuss about:- 1. Need for Inflation Accounting 2. Merits of Inflation Accounting 3. Demerits.
Need for Inflation Accounting:
Accounting is based on the traditional concept of cost and revenue. Money is the yardstick for measuring profits and losses and financial health of the business — operating results and financial position. The basic objective of accounting is the preparation of financial statements in a way that they give a true and fair view of the business. That is, the income statement should disclose the true profit or loss made by the business during a particular period while the balance sheet must show a true and fair view of the financial position of the business on a particular date. Financial statements are prepared in monetary units i.e., rupee. The medium of expression is the money value.
The value of money is itself fluctuating; any measurement with an unsteady scale cannot be finite and comparable. The recording of business transactions under the assumption that monetary unit is stable is known as historical accounting. However, it has been our experience that over a period of time, the prices have not remained stable.
There have been inflationary as well as deflationary tendencies. Rise in general price level, termed inflation erodes the intrinsic value of money, conversely, fall in general prices called deflation, raises its purchasing power. Inflation is a concept which every human being is not only aware of, but also painfully experiencing. The direct effect of inflation is the erosion in the purchasing power of money. The root cause of the problem is the change in the value of money.
Monetary unit is never stable and all types of countries have been experiencing high rates of inflation. The prices change as a result of various economic and social forces and such changes bring about a change in the purchasing power of money.
Unless the necessary adjustments are made, price level changes produce distortions in the financial statements and suffer serious limitations. Financial statements, prepared according to conventional or historical accounting system, do not reflect current economic realities.
The assumption of stable money value subject to which the financial statements are prepared is fallacious in the context of rising prices. Inflation by which we mean a rise in general price level and a fall in the value of money. Because historical rupee is not comparable to the present day rupee. Unlike physical units, such as kilogram, meter etc. are stable units in measuring weight and distance, monetary units i.e., rupee is an unstable unit of exchange value.
Thus it is clear that the profit is over-stated and the fixed assets are under-stated, when the effect of inflation is ignored. In this example, when the asset has to be replaced, larger funds are required on account of inflationary conditions. The asset purchased for Rs. 8, 00,000 and its life was expected to be 10 years, a sum of Rs 80,000 (10%) would be charged as depreciation every year. If after 10 years, the asset can be purchased for Rs. 13, 00,000, the firm may have to face serious problems because of insufficiency of funds. Hence, the need for inflation accounting.
Merits of Inflation Accounting:
The following are the advantages:
1. Since assets are shown at current values, Balance Sheet exhibits a fair view of the financial position of a firm.
2. Depreciation is calculated on the value of assets to the business and not on their historical cost—a correct method. It facilitates easy replacement.
3. Profit and Loss Account will not overstate business income.
4. Inflation accounting shows current profit based on current prices.
5. Profit or loss is determined by matching the cost and the revenue at current values which are comparable—a realistic assessment of performance.
6. Financial ratios based on figures, adjusted to current value, are more meaningful.
7. Inflation accounting gives correct information, based on current price to the workers and shareholders. In the absence of this, workers may claim for higher wages and shareholders too claim for higher dividends.
Demerits of Inflation Accounting:
1. The system is not acceptable to Income tax authorities.
2. Too much calculations make complications.
3. Changes in prices are a never ending process.
4. The amount of depreciation will be lower in times of deflation.
5. The profit calculated on the system of price level accounting may not be a realistic profit.