Impact Of Inflation On Historical Cost Financial Statements Accounting

Table of Content

The relentless rising prices experienced by many industrialized states during the 1970 ‘s caused widespread committedness to Historical Cost. Historical cost based accounting has provided a base on which accounting rules have been established over many old ages and has been the footing for published fiscal studies. Its strengths are good known because of its simpleness and straightness. Historical cost based accounting leads to certainty and tantrums in with the hard currency flow statement. It tells precisely what has been paid and what has been received and hence there is no uncertainty about balance sheet sums.

However its failings are extremely recognised in times of altering monetary values when historical based statements be given to be deep of the measuring of public presentation.

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Historical cost does non exhibit the just market value. This means if a company purchased an plus, it is non recorded at just market value, which would be what the company could sell the plus for in the unfastened market. Historical cost is non interested in the value of an plus but instead the cost allotments. Whilst historical cost tells the user the acquisition cost of an plus and depreciation in the undermentioned old ages, it disregards the likeliness that the current market value of that plus may be higher or lower than it suggests.

Under Historical Cost Based accounting it is presumed that the pecuniary unit is the appropriate unit of history. The persistent job in the accounting literature is the accounting for monetary value alterations and the many efforts for solutions that surround it.

The trouble in accounting is that money alterations because of its buying power, which consequences in rising prices. For illustration as monetary values rise, less can be obtained with any given figure of lbs. While money may non hold a cardinal value it has a clip value, even if the buying power of the lb does non alter, the lbs received at different times are non comparable.

Drummond & A ; Stickler ( 1983 )

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

by R Alagiah … / 080123AtheoreticalforIntAccntngConference.doc 09/02/2011 13:28

In the UK, most monetary values are lifting more quickly than we would wish in visible radiation of the recent economic downswing. Harmonizing to a BBC study the UK Consumer Prices Index ( CPI ) one-year rising prices rate rose to 4 % in January, up 0.3 % from December, because of the effects of the VAT rise. Higher oil monetary values besides meant rising prices remained above the 2 % mark. Retail Monetary values Index ( RPI ) rising prices which includes mortgage involvement payments rose 0.3 % to 5.1 % .

The CPI figure is the highest since November 2008, and will set force per unit area on the Bank of England to raise involvement rates to restrict speed uping rising prices.

Bank of England governor, Mervyn King has written to the authorities, explicating that rising prices is likely to lift towards 5 % in the approaching months. He said the rise in rising prices was due to the VAT rise, the past failing of the lb and recent rises in trade good monetary values.

hypertext transfer protocol: // ( BBC, 2011 )

UK rising prices

hypertext transfer protocol: // ( BBC, 2011 )

Fiscal Statements based on Historical Cost do non sufficiently depict fiscal place during a period of rising prices. Below is a sum-up 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 replacing costs. During a period of lifting monetary values the Historical Cost of assets obtained becomes dated. Reporting assets utilizing their original costs will be apt to minimize fiscal place because current values will be higher. The understatement will be greater, the higher the rate of rising prices. Assetss, for illustration, equipment held at the terminal of an accounting period will usually be procured at different day of the months. This makes the company vulnerable to coup d’etat commands, stockholders will necessitate to bear in head this will take to lower ratings for their portions.

Depreciation – As the assets are undervalued, accordingly the depreciation on such assets are besides undervalued. This leads to deformations in the brand or purchase determinations of the assets. This once more will exaggerate the net income of an endeavor.

Tax Payment – Because historical accounting overstates net incomes, these are taxed and unless assorted extra revenue enhancement allowances are given, the revenue enhancement paid is inordinate, and more than true net incomes adjusted for rising prices. This leads to companies holding a deficit of hard currency and unequal finance being available for future assets.

Net incomes and return on investings are overstated as grosss are recorded at increased monetary value degrees whilst costs are non, this will do shortages in Historical Cost Balance Sheets and Profit Calculations.

Monetary assets – When goods are held they rise in pecuniary footings during a period of rising prices. However keeping pecuniary assets for illustration hard currency and bank, will bring forth jobs.

hypertext transfer protocol: // ( Sept 2008 )

Wood and Sangster ( 2008 )

Alexander and Nobes ( 2007 )

Unless accommodations are made, users of histories may be earnestly misled about the value and profitableness of a concern and about what may be suited degrees of dividends, rewards or monetary values. If accommodations are non made to rectify for altering monetary values, some disbursals based on past costs will be matched against grosss based on current gross revenues monetary values.

Adjustments need to be made for the benefit of the users of fiscal statements. For illustration stockholders will necessitate to cognize how effectively managers are executing and utilize fiscal statements as a base for determinations. Other users include employees, bankers, grosss and imposts, direction, public etc.

Wood and Sangster ( 2008 )

Methods that are used for accommodations in fiscal statements include: –

Current Cost Accounting

When fixing the fiscal statements, specific monetary value alterations that affect the concern must be taken into history. CCA is a really of import and dominant method of accounting for specific monetary value alterations, it is chiefly based on the current cost of replacing an point. Therefore the current costs of points are recorded instead than the historic costs.

Under CCA, the net income available for distribution is calculated by fiting the gross with the cost of replacing the points that were sold. Price alterations in a batch of instances that affect a company will non resemble to general monetary values alterations go oning within the economic system. Nevertheless for the interest of convenience it is assumed that specific monetary value of goods alterations in line with the general rate of rising prices.

CCA seeks to keep the graduated table of concern operations so that the concern can go on to run at the same degree and is recognised for its relevancy.

A simple CCA illustration is a Street Trader who goes to a sweeping market and buys 100 melons for ?2.00 each. He sells them for ?2.50 each so he works out his net income for the twenty-four hours by the traditional Historic Cost method as: –

Gross saless 250

Less cost of goods sold ( at HC ) 200

Net income 50

He feels he has had a productive twenty-four hours and goes to the shopping Centre and spends his ?50 net income. The following twenty-four hours he arrives at the sweeping market and finds that while he was selling his melons the old twenty-four hours, the sweeping monetary value had inflated to ?2.25. He realises he merely has ?100 to pass, so he can non replace his stock of 100 melons, he can merely afford 80. On the other manus, if he had done CCA, he would hold calculated his net income after bear downing the current replacing cost of his melons.

Gross saless 250

Less CC of goods sold 225

Net income 25

He would merely hold spent ?25 in the shopping Centre and would hold preserved adequate hard currency to retain his capital stock of 100 melons.

( Geoffrey Whittington, 2007, PP 197-198 )

An issue that may originate with CCA is the dependability of information, peculiarly where the assets are alone and where there is no market for them. Occasionally the menace is raised of corrupt managers pull stringsing CCA figures to portray a image of good finance that they would wish users to see.

An illustration of this is energy company Enron, one million millions of lbs were deliberated miscalculated and executives non merely misled Enron ‘s board of managers and audit commission on bad accounting patterns, but besides pressured scrutinizing company Andersen to disregard the issues. This conveys to stockholders the hazard of puting in companies as portion values decreased more than 10 % because of this dirt and stockholders lost one million millions of lbs. Enron finally went belly-up as cipher wanted to buy the company. This hazard nevertheless may be prevented by engaging independent valuers to supply the CCA information.

hypertext transfer protocol: // ( BBC, 2002 )

Atrill and McLaney ( 2010 )

Introduction to Financial Accounting

Nobes, 3rd Edition, 151-152

Alexander and Britton ( 2004 )

Current Buying Power

This is the accommodation of historical cost accounting figures by a monetary value index figure to give figures, it conveys what Wood and Sangster describe as existent capital care. Many people including have been disappointed with it.

CPP trades with general monetary value rises merely. It aims to prolong the inflation-adjusted value of the proprietor ‘s capital. It is non bring forthing a current rating of the point concerned, but in general footings is re-expressing in footings of current lbs, the figures as originally calculated under the original measurement footing. A general monetary value index, such as RPI or CPI is used to mensurate alterations in the buying power of the lb.

For illustration, a figure for assets such as edifices in a balance sheet means the figure of current lbs that would hold to be spent today to purchase the edifices if all economic fortunes were precisely unchanged from when the original acquisition was made. However all economic fortunes will most likely non be unchanged from when the original purchase was made.

With CPP all necessary figures are stated in footings of a common buying power unit and this facilitates proper comparing. It is good in that it distinguishes between additions or losingss on pecuniary liabilities and assets, and existent additions and losingss through trading activities besides. CPP is easy auditable as it requires merely a merely nonsubjective accommodation to Historical Cost histories.

However the CPP attack forsakes money as the unit of measuring. Alternatively points are expressed in footings of lbs of Current Purchasing Power. A batch of users nevertheless may happen this measurement unit hard to construe and so may fight to understand the significance of CPP fiscal statements. The relevancy of the CPP attack is besides disputed.

Atrill and McLaney ( 2010 )

Introduction to Financial Accounting

Nobes, 3rd Edition, 151-152

Alexander and Britton ( 2004 )

The pick of the above two accommodations determines how assets are to be restated and in each instance net income is what remains after the appropriate step of capital has been maintained. It is possible to fall in both in fiscal studies so that both rising prices and specific monetary value alterations are taken into history.

Alexander and Nobes ( 2007 )

The two chief systems advocated for doing these accommodations are: –

The Approach of the ASB

The ASB has followed a gradual alteration attack and to necessitate consistence in the intervention of specific assets and liabilities where it is current pattern to travel off from historical costs. The ASB position 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 bing system of modified historic costs:

To take the right to change cost in fiscal statements

To present a clear current value system straightaway

To do ad hoc betterments to the current historic system

The Approach of the IASB

The IASB besides have struggled in happening a solution to cover with rising prices. There is an point for rising prices adjusted fiscal statements no affair what the rate of rising prices is but the accounting criterions need to transport the people who use and prepare the histories with them. This fundamentally means that there has to be a consensus that Historical cost based fiscal statements are neglecting to give a true and just position therefore this is influenced by the current rate of rising prices

When the rates in the economic system were in high figures, there was force per unit area for a mandatory criterion so that fiscal statements were comparable. This led to the issue of IAS 15 Information Reflecting the Effects of Changing Monetary values which required companies to repeat the HCA histories utilizing either a general monetary value index or replacing costs with accommodations for depreciation, cost of gross revenues and pecuniary points. This will discussed in the following subdivision.

( Elliot and Elliot 2009, PP 81-84 )

Current View of the International Accounting Standards Board

The end of the International Accounting Standards Board is ‘to provide the universe ‘s integrating capital markets with a common linguistic communication for fiscal coverage ‘

( Needles and Powers, 2009, Pg 4 )

In adhering to this, the accounting criterion IAS15 was an effort to compensate the effects of altering monetary values on fiscal statements. It was publicised to stipulate the revelations needed to pass on the consequence of monetary value alterations on describing entities, consequences of operations and fiscal places. It granted preparers the option of using general monetary value degree accommodations or utilizing current costs. Most of the Financial Reporting Standards adopted have either been withdrawn, made optional or non used during clip. IAS15 was made optional 1989 and as portion of IASB ‘s Improvements Project the criterion was withdrawn in 2005. The criterion has been withdrawn nevertheless does stay recorded as one extremely evolved set of counsel that entities can still utilize, to show auxiliary fiscal statements on a footing which removes the effects of cost alterations.

IAS29 addresses fiscal coverage in Hyperinflationary economic systems. While in general, this applies the same rules as are employed when utilizing general monetary value degree accounting, the aim is to make elaborate criterions for entities describing in the currency of a hyperinflationary ( really high rising prices ) economic system, so fiscal 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

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IAS 29 purposes to get the better of the boundaries of historical cost fiscal coverage in hyperinflationary environments.

The rule in IAS 29 is that the fiscal statements of an entity that reports in the currency of a hyperinflationary economic system should be stated in footings of the mensurating unit current at the balance sheet day of the month. Comparative figures for old periods should be restated into the same current measurement unit.

Restatements are made by using a general monetary value index. Items such as pecuniary points that are already stated at the mensurating unit at the balance sheet day of the month are non restated. Other points are restated based on the alteration in the general monetary value index between the day of the month those points were acquired or incurred and the balance sheet day of the month.

A addition or loss on the net pecuniary place is included in net income. It should be disclosed individually.

The Standard does non set up a entire rate at which hyperinflation is to originate but allows governing as to when restatement of fiscal statements becomes necessary.

hypertext transfer protocol: // ( Jan 2010 )

Melville, Alan ( 2009 )

Below are a few selected features of being of hyperinflation:

Wealth is kept in non-monetary assets or in a reasonably stable foreign currency and sums of local currency held is invested to prolong buying power.

Monetary sums are regarded non in footings of local currency but in footings of a stable foreign currency.

Interest rates, rewards and monetary values are connected to a monetary value index and

Accumulative rising prices rate over three old ages approaches or goes beyond 100 % .

hypertext transfer protocol: // See Appendix 1

Melville, Alan ( 2009 )

Fiscal Reporting in Hyperinflationary Economies – Understanding IAS 29, PricewaterhouseCoopers, May 2006

However the restatement of historical cost fiscal statements in footings of IAS 29 does non bespeak the abolition of the historical cost theoretical account, it merely tries to rectify the jobs. PricewaterhouseCoopers: said “ Inflation-adjusted fiscal statements are an extension to, non a going from, historical cost accounting. ”

Fiscal Reporting in Hyperinflationary Economies – Understanding IAS 29, PricewaterhouseCoopers, May 2006. See Appendix 2


With no concrete solution for rising prices

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