impact of inflation on the financial statements

8/11/2019 Impact of Inflation on the Financial Statements

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Impact of Inflation on the

Financial Statements

Objective: Explain the

impact of inflation on thefinancial statements


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Historical Cost

Accounting A measure of value used in

accounting in which the price of an

asset on the balance sheet is based onits original cost when acquired by the

company.

The historical-cost method is used forassets under generally accepted

accounting principals (GAAP).


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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 thepossibility that the current market value

of that asset may be higher or lower

than it is on the books.


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Inflation and Financial

Statements Historical cost accounting practices

reflect results of prices and costs in

effect at the time the transactionsoccurred.

This approach does not account for thefact that the purchasing power

diminishes during periods of inflation.


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Therefore, another main

criticism of historical

accounting method is itsobvious flaws in times of

inflation.


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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.


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An asset purchased at a point in timemay be more expensive in the future.

The traditional accounting principlesrecord all assets at an original cost and

continue to use these historic figures

throughout the asset's life, but moneyhas a time-value attached to it.


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In addition, effects of inflation may not

be the same for all the companies

because they may operate in differentcountries with different levels of inflation

and historical cost accounts become

almost unhelpful when comparingcorporate performance.


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FYI - What is inflation?

Inflation is defined general rise

in prices for goods and services.

It is measured as an annualpercentage increase.

As inflation rises, every dollar

you own buys a smaller amountof goods or services.


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Solution to historical

cost accountingAlternatives to historical cost

accounting.

Current cost accounting

Fair value


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air Value

An alternative approach tomeasurement 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 andwilling parties in an arms length

transaction".


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Under the fair value measurementapproach, assets and liabilities are re-

measured periodically to reflect

changes in their value, with the resultingchange impacting net income.


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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.


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This is the method which includes the

process of preparing and interpreting

financial statement in such a way thatrelevant change in the price is

considered significantly.

In CCA method, the assets are valuedon a current cost basis. It does not

consider the retail price index.


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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 financialstatement is to be restated in terms of

the current value of such items.


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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

less3. Revaluation surplus are transferred to

current cost accounting reserve but not

distributed as dividend to shareholders.


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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.


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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 re-measured periodically to reflect changes in

their value- (Revaluation of assets)

Current cost accounting - the financialstatements are restated in terms of the

current value of items. (Replacement Value)


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See cases:

Lladnar Ltd revenue earning

capicity of assets

And comparison of incomestatements


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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 thepreparation of current value financial statementsbased on IAS 15, Information reflecting the effect ofchanging prices.

In reflecting the impact of inflation, Eskom hasadjusted the most significant of these effects byrevaluing the property, plant and equipment andcharging the related additional depreciation to theincome statement.

To the extent that further adjustment is necessary,especially as regards the effect of inflation on futurefuel supplies and maintenance and consumablesinventory and the relief provided by funding assetswith monetary liabilities, additional adjustments have

been made.


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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

$ $

Historic cost of net profit for the after

tax

1 759 2 062

Inflation adjustments ( 3 253) (3 483)

Addition depreciation (3 635) (4 233)

Cost of sales (263) (203)

Gearing adjustment 645 953

Inflation-adjusted net loss for theperiod (1 494) (1 421)

impact of inflation on the financial statements

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