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  Inflation Accounting and Reporting

Introduction to Inflation Accounting and Reporting

As we described earlier that there is an assumption in accounting that money, that is the unit of measurement, will stay stable over time. However, this is an unrealistic assumption as the value of money changes. Generally, it is inflation that is the culprit.

This happens while the general purchasing power of money is decreased due to a rise in prices. Sometimes it is due to deflation that occurs while the general purchasing power of money is increased due to a fall in prices.

The measurement of position and financial performance is complicated through changes in the value of money and this, consecutively can undermine the helpfulness of financial statements.

We shall observe that inflation results in an overstatement of profit and an insufficient portrayal of financial position. We shall also refer two broad approaches which attempt to right for the distorting influences of inflation in the financial statements.

Inflation and profit measurement

Throughout a period of inflation, profit tends to be overstated. This is since time elapses among buying a specific resource and its consequent use.

The difficulty of time elapsing among the acquisition of a resource and its final use is even more acute in the matter of non-current assets. A non-current asset, like a building, might be held for several years and the income statement for each of these years will be charged along with its depreciation. In which this charge is relies on the acquisition (historic) cost of the asset, it will turn into progressively more out of date and so will not imitate the resources consumed throughout the period. If not revenues are matched with depreciation charges expressed in current terms, profits will be overstated.

Inflation and financial position

Throughout a period of rising prices, financial statements relies on historic cost do not sufficiently portray financial position.

There are three potentially critical problems:

  • an erosion of the equity base might not be clearly recognised;
  • the assets of the business will tend to be understated; and
  • any gains and losses from holding monetary items will not be recognised.

 Maintaining the equity base

If the owners are to keep the purchasing power of their investment and the business is to preserve its scale of operations, the equity base of the business has to be kept intact. Though, there is a danger that inflation will erode this base and that the statement of financial position will be not successful to point out that this erosion has occurred.

Reporting assets

Throughout a period of rising prices, the acquisition (historic) cost of assets attained becomes outdated. Current values will be greater and so reporting assets by using their original costs will tend to understate financial position: the greater the rate of inflation, the higher this understatement.

It is significance remembering that assets held at the end of an accounting period will generally be obtained at different dates.

Monetary items

Some items emerging on a statement of financial position have a set number of pounds assigned to them. The specific amount may be fixed through contract or through statute and will not change as a result of inflation. These are termed as monetary items. It is significant to recognize monetary items as holding monetary assets throughout a period of inflation will result in a loss of purchasing power.

Reporting the effects of inflation

The distorting effects of inflation on the conventional financial statements can be harsh. Even comparatively low inflation rates can have an important cumulative effect over time. To combat the trouble, several methods of accounting for inflation have been planned and there has been much debate as to which should be adopted. At the core of the debate lies the problem of equity maintenance and, particularly, how equity maintenance should be described. Through resolving this problem, other problems, like the way in which profit is calculated and how assets should be reported, can then be resolved.

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