Impact Of Inflation On Historical Cost Financial Statements Accounting Essay

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The persistent inflation experienced by many industrialised nations during the 1970's caused widespread commitment to Historical Cost. Historical cost based accounting has provided a base on which accounting principles have been established over many years and has been the basis for published financial reports. Its strengths are well known because of its simplicity and directness. Historical cost based accounting leads to certainty and fits in with the cash flow statement. It tells exactly what has been paid and what has been received and therefore there is no doubt about balance sheet amounts.

Nevertheless its weaknesses are highly recognised in times of changing prices when historical based statements tend to be cryptic of the measurement of performance.

Historical cost does not exhibit the fair market value. This means if a company purchased an asset, it is not recorded at fair market value, which would be what the company could sell the asset for in the open market. Historical cost is not interested in the value of an asset but rather the cost allocations. Whilst historical cost tells the user the acquisition cost of an asset and depreciation in the following years, it disregards the likelihood that the current market value of that asset may be higher or lower than it suggests.

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Under Historical Cost Based accounting it is presumed that the monetary unit is the appropriate unit of account. The persistent problem in the accounting literature is the accounting for price changes and the many attempts for solutions that surround it.

The difficulty in accounting is that money changes because of its purchasing power, which results in inflation. For example as prices rise, less can be obtained with any given number of pounds. While money may not have a fundamental value it has a time value, even if the purchasing power of the pound does not change, the pounds received at different times are not comparable.

Drummond & Stickler (1983)

Writing the Future: A Theoretical Justification for a Single Global Currency in International Accounting

by R Alagiah

www.singleglobalcurrency.org/.../ 080123AtheoreticalforIntAccntngConference.doc 09/02/2011 13:28

In the UK, most prices are rising more rapidly than we would wish in light of the recent economic downturn. According to a BBC report the UK Consumer Prices Index (CPI) annual inflation rate rose to 4% in January, up 0.3% from December, because of the effects of the VAT rise. Higher oil prices also meant inflation remained above the 2% target. Retail Prices Index (RPI) inflation which includes mortgage interest payments rose 0.3% to 5.1%.

The CPI figure is the highest since November 2008, and will put pressure on the Bank of England to lift interest rates to limit accelerating inflation.

Bank of England governor, Mervyn King has written to the government, explaining that inflation is likely to rise towards 5% in the coming months. He said the rise in inflation was due to the VAT rise, the past weakness of the pound and recent rises in commodity prices.

http://www.bbc.co.uk/news/business-12462901 (BBC, 2011)

UK inflation

http://www.bbc.co.uk/news/business-12462901 (BBC, 2011)

Financial Statements based on Historical Cost do not sufficiently depict financial position during a period of inflation. Below is a summary of the:-

Impact of Inflation on Historical Cost Based Financial Statements

Fixed assets - Because fixed assets are valued at historic cost, the assets are stated at a much lower figure than their current replacement costs. During a period of rising prices the Historical Cost of assets obtained becomes dated. Reporting assets using their original costs will be liable to understate financial position because current values will be higher. The understatement will be greater, the higher the rate of inflation. Assets, for example, equipment held at the end of an accounting period will normally be procured at different dates. This makes the company vulnerable to takeover bids, shareholders will need to bear in mind this will lead to lower valuations for their shares.

Depreciation - As the assets are undervalued, consequently the depreciation on such assets are also undervalued. This leads to distortions in the make or buy decisions of the assets. This again will overstate the profit of an enterprise.

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Tax Payment - Because historical accounting overstates profits, these are taxed and unless various additional tax allowances are given, the taxation paid is excessive, and more than true profits adjusted for inflation. This leads to companies having a shortage of cash and inadequate finance being available for future assets.

Profits and return on investments are overstated as revenues are recorded at increased price levels whilst costs are not, this will cause deficits in Historical Cost Balance Sheets and Profit Calculations.

Monetary assets - When goods are held they rise in monetary terms during a period of inflation. However holding monetary assets for example cash and bank, will produce problems.

http://investmoneyinindia.com/504/impact-of-inflation-on-financial-statements-and-ias-29 (Sept 2008)

Wood and Sangster (2008)

Alexander and Nobes (2007)

Unless adjustments are made, users of accounts may be seriously misled about the value and profitability of a business and about what may be suitable levels of dividends, wages or prices. If adjustments are not made to correct for changing prices, some expenses based on past costs will be matched against revenues based on current sales prices.

Adjustments need to be made for the benefit of the users of financial statements. For example shareholders will need to know how effectively directors are performing and use financial statements as a base for decisions. Other users include employees, bankers, revenues and customs, management, public etc.

Wood and Sangster (2008)

Methods that are used for adjustments in financial statements include:-

Current Cost Accounting

When preparing the financial statements, specific price changes that affect the business must be taken into account. CCA is a very important and dominant method of accounting for specific price changes, it is mainly based on the current cost of replacing an item. Therefore the current costs of items are recorded rather than the historic costs.

Under CCA, the profit available for distribution is calculated by matching the revenue with the cost of replacing the items that were sold. Price changes in a lot of cases that affect a company will not resemble to general prices changes happening within the economy. Nevertheless for the sake of convenience it is assumed that specific price of goods changes in line with the general rate of inflation.

CCA seeks to maintain the scale of business operations so that the business can continue to operate at the same level and is recognised for its relevance.

A simple CCA example is a Street Trader who goes to a wholesale market and buys 100 melons for £2.00 each. He sells them for £2.50 each so he works out his profit for the day by the traditional Historic Cost method as:-

Sales 250

Less cost of goods sold (at HC) 200

Profit 50

He feels he has had a productive day and goes to the shopping centre and spends his £50 profit. The next day he arrives at the wholesale market and finds that while he was selling his melons the previous day, the wholesale price had inflated to £2.25. He realises he only has £100 to spend, so he cannot replace his stock of 100 melons, he can only afford 80. On the other hand, if he had done CCA, he would have calculated his profit after charging the current replacement cost of his melons.

Sales 250

Less CC of goods sold 225

Profit 25

He would only have spent £25 in the shopping centre and would have preserved enough cash to retain his capital stock of 100 melons.

(Geoffrey Whittington, 2007, PP 197-198)

An issue that may arise with CCA is the reliability of information, particularly where the assets are unique and where there is no market for them. Occasionally the threat is raised of corrupt directors manipulating CCA figures to portray a picture of good finance that they would like users to see.

An example of this is energy company Enron, billions of pounds were deliberated miscalculated and executives not only misled Enron's board of directors and audit committee on high-risk accounting practices, but also pressured auditing company Andersen to ignore the issues. This conveys to shareholders the risk of investing in companies as share values decreased more than 10% because of this scandal and shareholders lost billions of pounds. Enron eventually went bankrupt as nobody wanted to purchase the company. This risk however may be prevented by hiring independent valuers to provide the CCA information.

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http://news.bbc.co.uk/1/hi/business/2535951.stm (BBC, 2002)

Atrill and McLaney (2010)

Introduction to Financial Accounting

Nobes, 3rd Edition, 151-152

Alexander and Britton (2004)

Current Purchasing Power

This is the adjustment of historical cost accounting figures by a price index figure to give figures, it conveys what Wood and Sangster describe as real capital maintenance. Many people including have been disappointed with it.

CPP deals with general price rises only. It aims to sustain the inflation-adjusted value of the owner's capital. It is not producing a current valuation of the item concerned, but in general terms is re-expressing in terms of current pounds, the figures as originally calculated under the original measurement basis. A general price index, such as RPI or CPI is used to measure changes in the purchasing power of the pound.

For example, a figure for assets such as buildings in a balance sheet means the number of current pounds that would have to be spent today to buy the buildings if all economic circumstances were exactly unchanged from when the original acquisition was made. However all economic circumstances will most likely not be unchanged from when the original purchase was made.

With CPP all necessary figures are stated in terms of a common purchasing power unit and this facilitates proper comparison. It is good in that it distinguishes between gains or losses on monetary liabilities and assets, and real gains and losses through trading activities also. CPP is easily auditable as it requires only a simply objective adjustment to Historical Cost accounts.

Nevertheless the CPP approach forsakes money as the unit of measurement. Instead items are expressed in terms of pounds of Current Purchasing Power. A lot of users however may find this measurement unit difficult to interpret and so may struggle to understand the significance of CPP financial statements. The relevance of the CPP approach is also disputed.

Atrill and McLaney (2010)

Introduction to Financial Accounting

Nobes, 3rd Edition, 151-152

Alexander and Britton (2004)

The choice of the above two adjustments determines how assets are to be restated and in each case profit is what remains after the appropriate measure of capital has been maintained. It is possible to join both in financial reports so that both inflation and specific price changes are taken into account.

Alexander and Nobes (2007)

The two main systems advocated for making these adjustments are:-

The Approach of the ASB

The ASB has followed a gradual change approach and to require consistency in the treatment of specific assets and liabilities where it is current practice to move away from historical costs. The ASB view was set out in a Discussion Paper, The Role of Valuation in Financial Reporting, issued in 1993. The three options below are what the ASB considered for the existing system of modified historic costs:

To remove the right to alter cost in financial statements

To introduce a clear current value system straightaway

To make ad hoc improvements to the current historic system

The Approach of the IASB

The IASB also have struggled in finding a solution to deal with inflation. There is an item for inflation adjusted financial statements no matter what the rate of inflation is but the accounting standards need to carry the people who use and prepare the accounts with them. This basically means that there has to be a consensus that Historical cost based financial statements are failing to give a true and fair view thus this is influenced by the current rate of inflation

When the rates in the economy were in high figures, there was pressure for a compulsory standard so that financial statements were comparable. This led to the issue of IAS 15 Information Reflecting the Effects of Changing Prices which required companies to restate the HCA accounts using either a general price index or replacement costs with adjustments for depreciation, cost of sales and monetary items. This will discussed in the next section.

(Elliot and Elliot 2009, PP 81-84)

Current View of the International Accounting Standards Board

The goal of the International Accounting Standards Board is 'to provide the world's integrating capital markets with a common language for financial reporting'

(Needles and Powers, 2009, Pg 4)

In adhering to this, the accounting standard IAS15 was an attempt to counterbalance the effects of changing prices on financial statements. It was publicised to specify the disclosures needed to communicate the effect of price changes on reporting entities, results of operations and financial positions. It granted preparers the option of applying general price level adjustments or using current costs. Most of the Financial Reporting Standards adopted have either been withdrawn, made optional or not used during time. IAS15 was made optional 1989 and as part of IASB's Improvements Project the standard was withdrawn in 2005. The standard has been withdrawn however does remain recorded as one highly evolved set of guidance that entities can still use, to present supplementary financial statements on a basis which removes the effects of cost changes.

IAS29 addresses financial reporting in Hyperinflationary economies. While in general, this applies the same principles as are employed when using general price level accounting, the objective is to create detailed standards for entities reporting in the currency of a hyperinflationary (very high inflation) economy, so financial information provided is meaningful.

Wiley, International Financial Reporting Standards 2008, Interpretation and Application of IFRS's

Barry. J. Epstein, Eva. K. Jermakowkz, Pg 970, 972

http://medbib.com/Hyperinflation

IAS 29 aims to overcome the boundaries of historical cost financial reporting in hyperinflationary environments.

The principle in IAS 29 is that the financial statements of an entity that reports in the currency of a hyperinflationary economy should be stated in terms of the measuring unit current at the balance sheet date. Comparative figures for previous periods should be restated into the same current measuring unit.

Restatements are made by applying a general price index. Items such as monetary items that are already stated at the measuring unit at the balance sheet date are not restated. Other items are restated based on the change in the general price index between the date those items were acquired or incurred and the balance sheet date.

A gain or loss on the net monetary position is included in net income. It should be disclosed separately.

The Standard does not establish a total rate at which hyperinflation is to arise but allows ruling as to when restatement of financial statements becomes necessary.

http://realvalueaccounting.blogspot.com/2010_01_01_archive.html (Jan 2010)

Melville, Alan (2009)

Below are a few selected characteristics of existence of hyperinflation:

Wealth is kept in non-monetary assets or in a moderately stable foreign currency and amounts of local currency held is invested to sustain purchasing power.

Monetary amounts are regarded not in terms of local currency but in terms of a stable foreign currency.

Interest rates, wages and prices are connected to a price index and

Cumulative inflation rate over three years approaches or goes beyond 100%.

http://www.iasplus.com/standard/ias29.htm See Appendix 1

Melville, Alan (2009)

Financial Reporting in Hyperinflationary Economies - Understanding IAS 29, PricewaterhouseCoopers, May 2006

Nevertheless the restatement of historical cost financial statements in terms of IAS 29 does not indicate the abolishment of the historical cost model, it simply tries to correct the problems. PricewaterhouseCoopers: said "Inflation-adjusted financial statements are an extension to, not a departure from, historical cost accounting."

Financial Reporting in Hyperinflationary Economies - Understanding IAS 29, PricewaterhouseCoopers, May 2006. See Appendix 2

Conclusion

With no concrete solution for inflation