BUS202: Principles of Finance

General price level changes creates distortions in financial statements. Inflation accounting is used in countries with high inflation.

TERMS

• Financial Accounting Standards Board

  private, not-for-profit organization whose primary purpose is to develop generally accepted accounting principles (GAAP) within the United States in the public's interest

• historical cost basis

  Under this type of accounting, assets and liabilities are recorded at their values when first acquired. They are not then generally restated for changes in values. Costs recorded in the Income Statement are based on the historical cost of items sold or used, rather than their replacement costs.

• hyperinflation

  In economics, this occurs when a country experiences very high, accelerating, and perceptibly "unstoppable" rates of inflation. In such a condition, the general price level within an economy rapidly increases as the currency quickly loses real value.

Inflation's Impact on Financial Statements

In most countries, primary financial statements are prepared on the historical cost basis of accounting without regard either to changes in the general level of prices. Accountants in the United Kingdom and the United States have discussed the effect of inflation on financial statements since the early 1900s .

General price level changes in financial reporting creates distortions in financial statements such as:

• Many of the historical numbers appearing on financial statements are not economically relevant because prices have changed since they were incurred.
• Since the numbers on financial statements represent dollars expended at different points of time and, in turn, embody different amounts of purchasing power, they are simply not additive. Hence, adding cash of $10,000 held on December 31, 2002, with $10,000 representing the cost of land acquired in 1955 (when the price level was significantly lower) is a dubious operation because of the significantly different amount of purchasing power represented by the two identical numbers.
• Reported profits may exceed the earnings that could be distributed to shareholders without impairing the company's ongoing operations.
• The asset values for inventory, equipment and plant do not reflect their economic value to the business.
• Future earnings are not easily projected from historical earnings.
• The impact of price changes on monetary assets and liabilities is not clear.
• Future capital needs are difficult to forecast and may lead to increased leverage, which increases the risk to the business.
• When real economic performance is distorted, these distortions lead to social and political consequences that damage businesses (examples: poor tax policies and public misconceptions regarding corporate behavior).

Inflation accounting, a range of accounting systems designed to correct problems arising from historical cost accounting in the presence of inflation, is a solution to these problems. This type of accounting is used in countries experiencing high inflation or hyperinflation. For example, in countries such as these the International Accounting Standards Board requires corporate financial statements to be adjusted for changes in purchasing power using a price index.