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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)