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Bsc Chemistry ____________________________________________________________________________________________________ Subject COMMERCE Paper No and Title 4 Accounting Theory and Practice Module No and Title 30 Inflation Accounting Module Tag COM_P4_M30 COMMERCE 4 Accounting Theory and Practice 30 Inflation Accounting ____________________________________________________________________________________________________ TABLE OF CONTENTS 1. Learning Outcomes 2. Introduction of Inflation Accounting 3.Historical Cost Accounting 3.1 Arguments in favour of Historical cost Accounting (HCA) 3.2 Limitations of Historical Cost Accounting 4. Methods of Accounting For Changing Prices 4.1 Current Purchasing Power Accounting (CPPA) 4.2 Current Cost Accounting (CCA) 5. Summary COMMERCE 4 Accounting Theory and Practice 30 Inflation Accounting ____________________________________________________________________________________________________ COMMERCE 4 Accounting Theory and Practice 30 Inflation Accounting ____________________________________________________________________________________________________ 1. Learning Outcomes After studying this module, you shall be able to: Some particular limitations of historical cost accounting in terms of its ability to cope with various issues associated with changing prices A number of alternative methods of accounting that have been developed to address problems associated with changing prices Some of the strengths and weaknesses of the various alternative accounting methods COMMERCE 4 Accounting Theory and Practice 30 Inflation Accounting ____________________________________________________________________________________________________ 2. Inflation Accounting 2.1 Introduction The basic objective of Accounting is the preparation of financial statements is a way that gives a true and fair view of the operating results and the financial position of the business to its various users namely, investors, government, creditors, management, trade unions, research institutions etc. These financial statements are prepared based on certain accounting concepts and conventions. The money measurement concept is a basic attribute of accounting. The money measurement concept states that only those business transactions can be recovered in the books of accounts that are capable of being expressed in terms of money. It also assumes that the monetary unit used for recording the transaction is stable in nature. However, this is not true in practice as many countries, developed as well as developing, have been experiencing inflation of high magnitude in recent times. Inflation refers to state of continuous rise in prices. It brings downward changes in the purchasing power of the monetary unit. Thus, the financial statements prepared without taking into account the change in purchasing power of the monetary unit lose their significance. There is a demand that business enterprise should prepare inflation adjusted financial statements. The different ways through which financial accounts can be adjusted for changing prices is studied under the subject “Inflation Accounting”. Given that price changes can also be downward, it is more appropriately called “Accounting for price level changes. Inflation accounting is a term describing a range of accounting systems designed to correct problems arising from historical cost accounting in the presence of inflation. Inflation accounting is used in countries experiencing high inflation or hyperinflation. For example, in countries experiencing hyperinflation the International Accounting Standards Board requires corporate financial statements to be adjusted for changes in purchasing power using a price index. 2.2 History of inflation accounting Accountants in the United Kingdom and the United States have discussed the effect of inflation on financial statements since the early 1900s, beginning with index number theory and purchasing power. Irving Fisher's 1911 book The Purchasing Power of Money was used as a source by Henry W. Sweeney in his 1936 book Stabilized Accounting, which was about Constant Purchasing Power Accounting. This model by Sweeney was used by The American Institute of Certified Public Accountants for their 1963 research study (ARS6) Reporting the Financial Effects of Price-Level Changes, and later used by the Accounting Principles Board (USA), the Financial Standards Board (USA), and the Accounting Standards Steering Committee (UK). Sweeney advocated using a price index that covers everything in the gross national product. In March 1979, the Financial Accounting Standards Board (FASB) wrote Constant Dollar Accounting, which advocated using the Consumer Price Index for All Urban Consumers (CPI-U) to adjust accounts because it is calculated every month. COMMERCE 4 Accounting Theory and Practice 30 Inflation Accounting ____________________________________________________________________________________________________ During the Great Depression, some corporations restated their financial statements to reflect inflation. At times during the past 50 years standard-setting organizations have encouraged companies to supplement cost-based financial statements with price-level adjusted statements. During a period of high inflation in the 1970s, the FASB was reviewing a draft proposal for price-level adjusted statements when the Securities and Exchange Commission (SEC) issued ASR 190, which required approximately 1,000 of the largest US corporations to provide supplemental information based on replacement cost. The FASB withdrew the draft proposal. 3. Historical Cost Accounting (HCA) Fair value accounting (also called replacement cost accounting or current cost accounting) was widely used in the 19th and early 20th centuries, but historical cost accounting became more widespread after values overstated during the 1920s were reversed during the Great Depression of the 1930s. Most principles of historical cost accounting were developed after the Wall Street Crash of 1929, including the presumption of a stable currency. Historical Cost Accounting (HCA), also known as conventional accounting, record transactions appearing in both the balance sheet and the profit and loss account in monetary amount which reflects their historical cost. The historical cost principal requires that accounting records be maintained at original transaction prices and that these value be retained throughout the accounting process to serve as the basis for values in the financial statements. HCA is based on the realization principle which requires the recognition of revenue when it has been realized. 3.1 Arguments in favour of Historical Cost Accounting (HCA) Arguments which are advanced in favour of HCA are listed as follows: 1. Accounting data under HCA are generally considered free from bias, independently verifiable, and hence more reliable by the investing public, and other external users. 2. Historical accounting reduces to a minimum the extent to which the accounts may be affected by the personal judgments of those who prepare them. 3. It has been generally found that users, internal and external, have preference for HCA and financial statements prepared under it. 4. Historical accounting is also defended on the ground that it is only the legally recognized accounting system accepted as a basis for taxation, dividend declaration, defining legal capital, etc. 5. Historical cost valuation is, among all valuation methods currently proposed, the method that is least costly to society considering the social costs of recording, reporting, auditing and settling disputes. 3.2 Limitations of Historical cost Accounting The drawbacks of HCA are listed as follows: COMMERCE 4 Accounting Theory and Practice 30 Inflation Accounting ____________________________________________________________________________________________________ 1. In times of inflation, the value of money declines and, therefore, the monetary unit (e.g. , rupee in India) which is used as a standard of measurement does not have a constant value and shrinks in value as the prices rise. The HCA ignores this decline in the value of rupee and keeps adding transactions acquired at different dates with rupee of varying purchasing power. The HCA is based on the assumption of stable monetary unit which assumes that (i) there is no inflation, or (ii) the rate of inflation can be ignored. This assumption does not prove true during inflation because of the change in general purchasing power of the monetary unit. 2. Secondly, HCA does not match current revenues with the current costs of operations. Revenues are measured in inflated (current) rupees whereas production costs are a mix of current and historical costs. Some costs are measured in very old rupees (e.g. depreciation), other trend to be in more recent rupees (e.g. inventories), while still others reflect current rupees (e.g. wages, salary, selling expenses and similar current operating expenses). In general, whenever there is a time lag between acquisition and utilisation, historical cost may well differ significantly from current cost. 3. The ‘inflated’ profits resulting under HCA are not the real profits but exaggerated and illusory. This causes the depreciation allowance to become inadequate to replace fixed assets and finance growth and expansion. 4. Inflation causes many other problems and dislocations, such as the following, which are not considered in HCA. The result is that Historical cost figures become of less and less significant and the value of accounts for decision-making is severely restricted.
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