Impact Of Inflation On The Financial Statements

Impact of Inflation on the Financial Statements Objective: Explain the impact of inflation on the financial statements

Historical Cost Accounting • A measure of value used in accounting in which the price of an asset on the balance sheet is based on its original cost when acquired by the company. • The historical-cost method is used for assets under generally accepted accounting principals (GAAP).

Drawbacks of historical cost accounting • Historical costs is only interested in cost allocations and not in the market value of an asset. • While it tells the user the acquisition cost of an asset and its depreciation in the following years, it ignores the possibility that the current market value of that asset may be higher or lower than it is on the books.

Inflation and Financial Statements • Historical cost accounting practices reflect results of prices and costs in effect at the time the transactions occurred. • This approach does not account for the fact that the purchasing power diminishes during periods of inflation.

• Therefore, another main criticism of historical accounting method is its obvious flaws in times of inflation.

• The validity of historic accounting rests on the assumption that the currency in which transactions are recorded remains stable, i.e. its purchasing power remains the same over a period of time.

• An asset purchased at a point in time may be more expensive in the future. • The traditional accounting principles record all assets at an original cost and continue to use these historic figures throughout the asset's life, but money has a time-value attached to it.

• In addition, effects of inflation may not be the same for all the companies because they may operate in different countries with different levels of inflation and historical cost accounts become almost unhelpful when comparing corporate performance.

FYI - What is inflation? • Inflation is defined general rise in prices for goods and services. • It is measured as an annual percentage increase. • As inflation rises, every dollar you own buys a smaller amount of goods or services.

Solution to historical cost accounting Alternatives to historical cost accounting. • Current cost accounting • Fair value

Fair Value • An alternative approach to measurement that seeks to capture changes in asset and liability values over time. • The International Accounting Standards Board (IASB) defines fair value as "... an amount at which an asset could be exchanged between knowledgeable and willing parties in an arms length transaction". •

• Under the fair value measurement approach, assets and liabilities are remeasured periodically to reflect changes in their value, with the resulting change impacting net income.

• The result is a balance sheet that better reflects the current value of assets and liabilities. • The cost is greater volatility in periodic reported performance caused by changes in fair value.

Current Cost Accounting • Current costing accounting (CCA) approach recognizes the changes in the price of individual items due to the change in general price level (inflation).

• This is the method which includes the process of preparing and interpreting financial statement in such a way that relevant change in the price is considered significantly. In CCA method, the assets are valued on a current cost basis. It does not consider the retail price index.

• This method considers the replacement value of the assets for its accounting records. • The value of assets at which it is to be replaced in future is called the replacement value. • Sometimes it is known as replacement cost accounting approach. • Under this method, each financial statement is to be restated in terms of the current value of such items.

Features Of Current Cost Accounting(CCA) 1. The fixed assets are recorded at replacement cost value in the balance sheet. 2. Inventories are shown at market value rather than cost price whichever less 3. Revaluation surplus are transferred to current cost accounting reserve but not distributed as dividend to shareholders.

4. Depreciation of fixed assets is to be calculated at replacement value. 5. Two types of profit i.e. profit from operation and profit from revaluation are calculated. 6. Liabilities are recorded in their original value because there is no change in monetary unit.

Summary • Historical cost - the financial statements reflects the original costs in effect at the time of the transactions occurred • Fair value - assets and liabilities are remeasured periodically to reflect changes in their value- (Revaluation of assets) • Current cost accounting - the financial statements are restated in terms of the current value of items. (Replacement Value)

See cases: • Lladnar Ltd – revenue earning capicity of assets • And comparison of income statements

Case - Eskom • In an attempt to eliminate the effects of changing prices on assets and income, and to ensure that • funds needed to maintain the operating capacity are preserved, historical costs have been restated by the preparation of current value financial statements based on IAS 15, Information reflecting the effect of changing prices. • In reflecting the impact of inflation, Eskom has adjusted the most significant of these effects by revaluing the property, plant and equipment and charging the related additional depreciation to the income statement. • To the extent that further adjustment is necessary, especially as regards the effect of inflation on future fuel supplies and maintenance and consumables inventory and the relief provided by funding assets with monetary liabilities, additional adjustments have been made.

The following summary shows the fully adjusted performance and financial position of Eskom prepared in terms of the principles contained in IAS 15. Summarised income statement Eskom `

2000

1999

$

$

1 759

2 062

( 3 253)

(3 483)

Addition depreciation Cost of sales Gearing adjustment

(3 635) (263) 645

(4 233) (203) 953

Inflation-adjusted net loss for the period

(1 494)

(1 421)

Historic cost of net profit for the after tax Inflation adjustments