Inflation : We all used to listen from our parents/Grandparents about the things and articles especially

Gold & other commodities being cheaper in their times. We definitely used to think that why the things
were cheaper in our Grandparents' time and why had they started becoming costlier. But now as we
have grown in our knowledge and understanding, we have come to know about the phenomenon of
Inflation which in common language is known as the ‘state of rising pricing or the falling value of money’
was the greatest reason behind this.

Inflation is a global phenomenon in present day times. There is hardly any country in the capitalist world
today which is not afflicted by the inflation. Different economists have defined inflation in different
words like Prof. Crowther has defined inflation "as a state in which the value of money is falling, i.e.,
prices are rising." In the words of Prof. Paul Einzig, "Inflation is that state of disequilibrium in which an
expansion of purchasing power tends to cause or is the effect of an increase of the price level." Both the
definition have emphasized on the rising prices of the goods. The basic factors behind the inflation are
either the rising demand or the shortening of supply due to any reason.

Effect of Inflation on Business : The impact of inflation on business can be bifurcated into two parts:

1. Impact on costs and revenue

2. Impact on assets and liabilities

As far as impact of inflation on costs and revenues is concerned, definitely both will rise but whether
they result into extraordinary profits/losses will be determined by that how much opening
stock/machinery was available at old prices with the company and how much later the demand for
increasing wages is entertained by the company. In case of monetary assets and liabilities, a company
will lose in case of being creditor and gain in case of being debtor in real terms.

If we talk about other assets like building, land and other securities, the company will be having holding
gains in monetary terms but may have neutral impact in real terms due to the rise in prices on the one
hand but fall in value of money on the other.

Inflation Accounting and its significance : The impact of inflation comes in the form of rising prices of
output and assets. As the financial accounts are kept on Historical cost basis, so they don't take into
consideration the impact of rise in the prices of assets and output. This may sometimes result into the
overstated profits, underpriced assets and misleading picture of Business etc.

So, the financial statements prepared under historical accounting are generally proved to be statements
of historical facts and do not reflect the current worth of business. This deprives the users of accounts
like management, shareholders, and creditors etc. to have a right picture of business to make
appropriate decisions. Hence, this leads towards the need for Inflation Accounting. 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. The significance of inflation accounting emerges from the
inherent limitations of the historical cost accounting system.

Limitations of historical accounting:

1. Historical accounts do not consider the unrealised holding gains arising from the rise in the monetary
value of the assets due to inflation.

2. The objective of charging depreciation is to spread the cost of the asset over its useful life and make
reserve for its replacement in the future. But it does not take into account the impact of inflation over
the replacement cost which may result into the inadequate charge of depreciation.

3. Under historical accounting, inventories acquired at old prices are matched against revenues
expressed at current prices. In the period of inflation, this may lead to the overstatement of profits due
mixing up of holding gains and operating gains.

4. Future earnings are not easily projected from historical earnings.

Techniques of Inflation Accounting : To measure the impact of inflation on financial statements,

Current Purchasing Power (CPP) Method

Under this method of adjusting accounts to price changes, all items in the financial statements are
restated in terms of a constant unit of money i.e. in terms of general purchasing power. For measuring
changes in the price level and incorporating the changes in the financial statements we use General
Price Index, which may be considered to be a barometer meant for the purpose. The index is used to
convert the values of various items in the Balance Sheet and Profit and Loss Account. This method takes
into account the changes in the general purchasing power of money and ignores the actual rise or fall in
the price of the given item. CPP method involves the refurnishing of historical figures at current
purchasing power. For this purpose, historical figures are converted into value of purchasing power at
the end of the period. Two index numbers are required: one showing the general price level at the end
of the period and the other reflecting the same at the date of the transaction. Profit under this method
is an increase in the value of the net asset over a period, all valuations being made in terms of current
purchasing power.
Current Cost Accounting (CCA) Method

The Current Cost Accounting is an alternative to the Current Purchasing Power Method. The CCA
method matches current revenues with the current cost of the resources which are consumed in
earning them.

Changes in the general price level are measured by Index Numbers. Specific price change occurs if price
of a particular asset changes without any general price change. Under this method, asset are valued at
current cost which is the cost at which asset can be replaced as on a date. While the Current Purchasing
Power (CPP) method is known as the General Price Level approach, the Current Cost Accounting (CCA)
method is known as Specific Price Level approach or Replacement Cost Accounting.

Limitations of Inflation Accounting

Though Inflation Accounting is more practical approach for the true reflection of financial status of the
company, there are certain limitations which are not allowing this to be a popular system of accounting.
Following are the limitations:

1. Change in the price level is a continuous process.

2. This system makes the calculations a tedious task because of too many conversions and calculations.

3. This system has not been given preference by tax authorities.