I am very happy to share with everyone, the paper which won me the ‘Best Paper Presenter’ award at the Nation Convention of CA Students held at Kolkata. Click to view the power point presentation on Inflation Adjustment.
Inflation adjustment has gained increased importance considering the fact that India is registering double digit inflation. In economics, inflation is considered to be a rise in the general level of prices of goods and services in an economy over a period of time. Inflation and the monetary unit or currency of a particular country or region is just inseparable. Inflation in other terms may be considered as the depreciation in the purchasing power of any given currency. As inflation increases, money buys less and less goods and services.
MEASURE OF INFLATION:
Inflation is usually estimated using the Inflation rate. Inflation rate is usually calculated as the percentage change in a Price Index year on year. Usually Consumer Price Index is considered the ideal price index for calculating inflation rate. But in India Wholesale Price Index or WPI released by the Reserve Bank of India is considered for calculating the Inflation rate of the Indian National Rupee. For instance, in January 2007, the U.S. Consumer Price Index was 202.416, and in January 2008 it was 211.080. The formula for calculating the annual percentage rate inflation in the CPI over the course of 2007 is
(211.080-202.416) X 100 = 4.28%
From this it is very clear that Inflation measures how costly goods and services have become over a period of time.
IS INFLATION HARMFUL?
There is a general perception that any inflation is really harmful to the economy and the consumers. But inflation though is a measure of price rise is not always harmful. Frankly speaking, for an economy to develop inflations is not only unavoidable but also essential. Inflation is never harmful with a proportional rise in the general income levels. Most modern economists favour a low but steady rate of inflation. The duty to contain inflation in a low but steady rate is vested with the Monetary Authorities. In India this function is performed by the Reserve Bank of India. The harmful effects of inflation crop up only when income level does not increase proportionally with the inflation rate or when the rapid inflation does not allow time for the income levels to rise.
At this point I am reminded of my grandmother who used to say that during the time of her marriage, a sovereign of gold could be purchased for just few rupees. This kept me wondering if gold was so cheap then, why didn’t my grandmother buy kilos of gold and save it for the future generations. Then only I realised that inflation and real income rise proportionately. Say if in those days you could buy a sovereign of gold for Rs.10/- . But today you may have to expend more than Rs.10000/-. You have to understand that the value of Rs.10 then may be same as Rs.10000 today. This is the effect of inflation. Over time the value and purchasing power of money erodes due to inflation.
ADJUSTING FOR INFLATION:
In an inflationary environment, it is necessary to adjust the prices of goods and services over time using a price index in order to make then comparable. In a hyperinflationary economy, reporting of operating results and financial position in the local currency without restatement is not useful. Money loses purchasing power at such a rate that comparison of amounts from transactions and other events that have occurred at different times, even within the same accounting period, is misleading. Without being adjusted for inflation, the comparison of prices of two different periods renders no meaning.
LIMITATION OF PURPOSE OF FINANCIAL STATEMENTS:
The basic purpose of Financial Statements of any entity is to portray true and fair view of the operations and affairs of the entity. But this basic purpose is not solved where the reporting currency is subject to hyperinflationary pressures. This is because we are following the historical cost convention of accounting. Under the historical cost convention, the assets and liabilities are reported at their historical cost. But the real purchasing power of the reporting currency could have been heavily reduced by the inflationary pressures. Thus the financial statements under the historical cost convention would over state the profits of the entity. But there would be no real profit left because the purchasing power of the money would have long been eroded by inflation. On the other hand the assets would show a lower value than their real current worth. Hence the historical cost convention in a hyperinflationary situation fails to serve the basic purpose of Financial Reporting. It presents a distorted view of the profitability by overstating it and of intrinsic worth by understating it. Hence this calls for certain adjustments.
ACCOUNTING FOR INFLATION:
At present in India we do not have an Accounting Standard that mandates for Inflation adjustment. But soon we will have one such standard. ICAI has brought out the exposure draft of AS- 34 which deals with this aspect. Internationally this aspect is presently covered by International Accounting Standard 29 – Financial Reporting in Hyperinflationary Economies. IAS – 29 prescribes the mode of adjustment of Financial Statements for inflation and the treatment of gain or loss resulting from such adjustment. IAS 29 mandates that presentation of inflation adjusted financial statements are mandatory in nature and not supplementary to Historical Cost Financial Statements. Now let us consider every aspect of IAS 29 one by one.
WHEN SHOULD WE ADJUST FOR INFLATION?
IAS 29 lays down some of the situations where Financial Statements need to be adjusted for Inflation. But these situations need not always be satisfied to apply the standard and adjust for inflation. IAS 29 itself states that it is a matter of judgement when restatement of financial statements in accordance with this Standard becomes necessary. The illustrative situations given in IAS 29 are as follows:
a) When the general population prefers to keep its wealth in non-monetary assets or in a relatively stable foreign currency. Amounts of local currency held are immediately invested to maintain purchasing power;
b) When the general population regards monetary amounts not in terms of the local currency but in terms of a relatively stable foreign currency. Prices may be quoted in that currency;
c) When credit sales and credit purchases take place at prices that compensate for the expected loss of purchasing power during the credit period, even if the period is short;
d) When the interest rates, wages and prices are linked to a price index; and
e) When the cumulative inflation rate over three years is approaching, or exceeds 100%.
The above illustrations are laid down only to give guidance to identify inflationary situations and are not the only situations of hyperinflation. IAS is very clear in saying that Hyperinflation is indicated by characteristics of the economic environment of a country including but not limited to the above.
METHOD OF ADJUSTING FOR INFLATION:
IAS 29 recognises the restatement approach for inflation adjustment. The financial statements of an entity, whose functional currency is the currency of a hyperinflationary economy, are required to be restated in terms of the measuring unit current at the end of the reporting period. Measuring unit current means the adjusted value of the reporting currency using a price index. For example the entity would have purchase an asset for Rs.1,00,000/- when the price index is say 250. But as on the reporting date, the price index might have changed to say 350. Then the adjusted valued of the asset using the measuring unit current would be as follows:
Value of asset as per measuring unit current = 1,00,000 X 350 = Rs.1,40,000/-
According the asset should be restated at Rs.1,40,000/- and the depreciation claim should also be adjusted accordingly. This method is equally applicable to comparative figures of the previous year given in the financial statements. The comparative figures should also be restated to reflect the measuring unit current. The IAS 29 discusses various issues involved in restating the items in the financial statements using the above approach individually for Historical Cost Financial Statements and Current Cost Financial Statements. But since in India only Historical Cost Convention is followed, I am restricting my discussion to Historical Cost Financial Statements alone. Now let me elaborate on some of the items considered for restatement.
Monetary items are money held and items to be received or paid in money. Examples of monetary items include Sundry Debtors, Sundry Creditors etc… Monetary items are not required to be restated because they are already expressed in terms of the monetary unit current at the end of the reporting period. The amounts carried in the accounts of monetary items will be actual amount will be paid or received. Inflation does not change the amount to be paid or received. For e.g. A Ltd owes B Ltd a sum of Rs.5 lakhs towards credit purchases. At that time the price index stood at 150 at the reporting date the price index may stand at 250. Even then the liability of A Ltd towards B Ltd remains unchanged at Rs.5 lakhs. Hence non-monetary items need not be adjusted for inflation.
ITEMS UNDER AN AGREEMENT AND ITEMS CARRIED AT FAIR VALUE:
Certain assets and liabilities may be linked to some price index by virtue of some agreement. Example: Inflation adjusted bonds, loans etc. Such assets and liabilities need not once again be restated to the measuring unit current at the end of the reporting period. Further the entity may also carry certain items at their fair value or net realisable value. For example under the IFRS regime fixed assets are allowed to be carried at their fair value instead of being depreciated. Such items also need not be restated at the end of the reporting period.
OTHER NON-MONETARY ITEMS:
Other than the above items, other non-monetary items are usually carried at their historical cost or at their historical cost less depreciation. These items are required to be restated using the change in the price index from the date of recording of these items and the reporting date. In case of depreciable assets both the historical cost as well as depreciation charge is restated using a price index.
NON-AVAILABILITY OF DETAILED RECORDS OF FIXED ASSETS:
In some extreme situations, the detailed records about the date of acquisition of fixed assets may not be available. If only the date of acquisition is known, the price index may be applied on the historical cost and the monetary unit current may be estimated. In the absence of such records, it will be virtually impossible. Hence in such cases an independent professional assessment of the value of the items may be considered as the basis for restatement.
NON-AVAILABILITY OF GENERAL PRICE INDEX:
A general price index may not be available for the periods for which the restatement of fixed assets is required. Since in many cases, fixed assets would have been acquired decades ago when there was no general price index available. In these circumstances, it may be necessary to consider a rough estimate of a price index. For example, the movements in the exchange rate between the reporting currency and a relatively stable foreign currency may be considered for restatement. This is based on the assumption
Some non-monetary items may be carried at amounts other than that of acquisition or historical cost, for example fixed assets may have been revalued at some earlier date. In these cases, the carrying amounts are restated from the date when the revaluation was effected. For e.g. if a fixed asset was revalued on 31/05/2005, for the year ended 31/03/2010, the revalued asset should be adjusted using the price index as on 31/05/2005 and 31/03/2010. The price index as on the acquisition date should not be considered.
RESTATED AMOUNTS EXCEED NET REALISABLE VALUE:
It may so happen that the restated amounts of non-monetary items may exceed their net realisable value. In such cases, the entity should be careful so that only the net realisable value is considered in the financial statements. In no case the restated amounts should exceed the net realisable value. This is in line with the prudence principle.
COMPONENTS OF EQUITY:
At the beginning of the first period when inflation adjustment is commenced, the components of owners’ equity, except retained earnings and any revaluation surplus are also required to be restated by applying the price index from the dates the components were contributed or otherwise arose. Any revaluation surplus that arose in previous periods is required to be eliminated. Restated retained earnings are derived from all the other amounts in the restated statement of financial position. That is to say that the retained earnings should be the balancing figure of the opening equity and the restated equity excluding retained earnings.
COMPONENTS OF PROFIT OR LOSS A/C:
IAS 29 requires that all the items in the statement of profit or loss be expressed in terms of the measuring unit current at the end of the reporting period. Therefore all amounts need to be restated by applying the change in the general price index from the dates when the items of income and expenses were initially recorded in the financial statements. According if an expense is recorded initially at Rs.5000/- when the index is 300 and if at the end of the reporting period, the index stands at 350, the expense needs to be restated as 5000*(350/300) =5833.
GAIN OR LOSS ON INFLATION ADJUSTMENT:
The net gain or loss arising from the restatement of non-monetary items need to be charged to the statement of Profit or Loss. By doing this the financial statements now reflect the real purchasing power of the entity. This process should be repeated every year till the reporting currency of the entity ceases to be hyperinflationary. When the currency ceases to be hyperinflationary, the inflation adjusted carrying amounts need to be carried forward thereafter. The entity should not revert back to the original historical cost figures. However the restatement process need not be done thereafter.
In order to understand the adjustment for inflation better, IAS 29 mandates the following disclosures:
a) the fact that the financial statements and the corresponding figures for previous periods have been restated for the changes in the general purchasing power of the functional currency and, as a result, are stated in terms of the measuring unit current at the end of the reporting period;
b) whether the financial statements are based on a historical cost approach or a current cost approach; and
c) the identity and level of the price index at the end of the reporting period and the movement in the index during the current and the previous reporting period.
These disclosures aide the users of financial statements to have a better understanding about the inflation adjusted financial statements and also the adjustment process. These disclosures should essentially form part of the Notes to Accounts.
The current inflationary situation in our country is showing no signs of calming down even after continuous efforts by the RBI. It remains still date above 13%. But our Institute has always been very proactive in all its approaches and triggers the change in most situations. Even in issues involving students, the institute is very proactive and very accommodating. I heard that our Institute is considering doubling out stipend considering the current inflationary situation in India, even though inflation rate is not 100%. I take this opportunity to thank our institute in advance on behalf of all the students for this. Though we are registering double digit inflation presently, I positively hope that we do not end up in a situation requiring us to adjust our financial statements for inflation according to IAS 29. That is a situation where the aggregate inflation exceeds 100%. I thank the Board of Studies and the EICASA for having granted me this wonderful opportunity to present a paper at this National Convention.