Application of Inflation

Accounting

Presented by :-

 Santosh Warang - MFM 17

 Rajesh Warise - MFM 18
Inflation Accounting : Definitions

Decrease in purchasing power of money due to an increase

in the general price level
“A process of steadily rising prices resulting in
diminishing purchasing power of a given nominal sum of
money”
The Penguin Dictionary of Economics
“Rise in prices brought about by the expansion of the
supply of bank money, credit, etc.”
Oxford Advanced Learner’s Dictionary of Current English
Some Aspects on Inflation Accounting

 Problems:
Subjectivity
Often complicated calculations
 Benefits:
maintaining production capacity
shows the internal logic of accounting
Change in the price level is described by
indexes
General indexes
◦ Price Index of Gross Domestic Product
◦ Cost-of-living Index
◦ Consumer Price Index
◦ Wholesale Price Index
◦ Production Price Index
Special indexes
◦ Industry indexes
◦ Commodity group indexes
◦ Commodity indexes
Finnish Wholesale Price Index
1960-1994
1800
1600
1400
1200
1000
800
600
400
200
0
1960 1965 1970 1975 1980 1985 1990
Source: Statistical Yearbook of India 1995
Yearly Change (%) in
in the Finnish
Finnish
Wholesale Price Index
30
25
20
15
10
5
0
-51960 1965 1970 1975 1980 1985 1990

-10
Source: Statistical Yearbook of India 1995
Inflation Accounting Methods
CPP - Current Purchasing Power
CCA - Current Cost Accounting
The Finnish AHI-Method (Aktivoitujen
Hankintamenojen Indeksointisovellutus)
Current Purchasing Power (CPP)
 Retains historic cost accounting conventions
 In U.S. General Purchasing Power (GPP)
 Expresses accounts in terms of “purchasing units”
 The purchase power of money at the end of the accounting
period as the base
 Maintains the general purchasing power of the invested
capital
 The original purchasing costs are corrected by correction
coefficients applying some general index, for example
Retail Price Index
Current Purchasing Power (CPP)
Monetary items - financial assets and liabilities -
remain unchanged
Inventories: FIFO purchase cost is corrected by a
suitable correction coefficient to correspond the
purchase power of the end of accounting period
Fixed assets:
◦ The purchase cost is corrected to correspond the purchase
power of the end of the accounting period
◦ The balance value of the fixed assets is the same percentage
of the corrected purchase cost as the book value is of the
original purchase cost
Current Purchasing Power (CPP)
Equity is defined as Assets - Liabilities
Shareholders’ point of view
Unsuitable for financing decisions
Work intensive method
Current Cost Accounting (CCA)
Maintaining the production level of the
company
Main focus on replacement of production
capacity
Money is retained as the unit of
measurement
Different special indexes are applied to
different items
Work intensive
Nominal Statement of Income

TO TO = Turnover
- VC VC = Variable Costs
= GP GP = Gross Profit
- FC FC = Fixed Costs
= OP OP = Operating Profit
- IC IC = Interest Costs
- D D = Depreciation
= NP NP = Net Profit
Below we also need:
[ NG = Net Gain from
Liabilities
TP = Total Profit ]
 Inflation accounting models
Inflation accounting is not fair value accounting. Inflation
accounting, also called price level accounting, is similar
to converting financial statements into another currency
using an exchange rate. Under some (not all) inflation
accounting models, historical costs are converted to price-
level adjusted costs using general or specific price indexes.
Income statement general price-level adjustment
example

 
 On the income statement, depreciation is adjusted for
changes in general price levels based on a general price
index.

2001 2002 2003 Total

Revenue 33,000 36,302 39,931 109,233

Depreciation 30,000 31,500 (a) 33,000 (b) 94,500

Operating
income 3,000 4,802 6,931 14,733
Purchasing
power loss - 1,500 (c) 3,000 (d) 4,500

Net income 3,000 3,302 3,931 10,233

(a) 30,000 x 105/100 = 31,500

(b) 30,000 x 110/100 = 33,000
(c) (30,000 x 105/100) - 30,000 = 1,500
(d) (63,000 x 110/105) - 63,000 = 3,000
The role of inflation accounting in
finance
In economics, monetary correction is an adjustment made
periodically in certain base values of the economy in a
period of inflation. It is aimed at  compensating for the loss
of value of money. And in terms of tax accounting,
restatement can be referred to as active monetary
variation, or passive monetary variation.

Inflation has two components, and these are monetary

inflation and historical cost inflation. In an economy or firm
which uses the fair value accounting model only one
component of inflation applies, that is, monetary inflation.
Historical cost inflation is impossible in an economy,
company or group of companies making use of real value
accounting model.
Nominal Balance Sheet
FA FA = Financial Assets
Inv Inv = Inventories
FixAss FixAss = Fixed Assets
Assets Assets = Total Assets

Debt Debt = Liabilities

Eq Eq = Owners’ Equity
Adjustments to the Balance Sheet -
Assets
 FinancialAssets and Inventories (FIFO) remain unchanged
 Fixed Assets - first AHI-year
◦ The original purchase cost is revaluated to the price level of the current year
◦ Depreciation/year is computed according to the economic lifetime of the
asset
◦ The depreciations up to the current year are subtracted from the revaluated
purchase cost
 Fixed Assets - after the first year
◦ The AHI-balance value of the previous year is revaluated to the current year
◦ New depreciation is computed based on the remaining
economic lifetime
Adjustments to the Balance Sheet -
Equity and Liabilities
Equity
◦ The accounting result is replaced by the AHI-
result
Liabilities
◦ Liabilities remain unchanged
Inflation Reserves
◦ Correspond to the adjustments made in the
Statement of Income and the Balance Sheet
Numerical Example
Correcting annual reports for a company over
years 1975-1976 using the AHI-method. A
period of high inflation rate.
Wholesale Price Index
1972 338
1973 398 700
600
1974 495 500

1975 562 400

300

1976 626 200

100
0
1972 1973 1974 1975 1976
Wholesale Price Index and its Relative
Change 1960-1994
1800
1600
1400
1200
1000
800
600
400
200
0
1960 1965 1970 1975 1980 1985 1990

30
25
20
15
10
5
0
-51960 1965 1970 1975 1980 1985 1990

-10