Merits and Demerits of Inflation Accounting

True Tamplin

Written by True Tamplin, BSc, CEPF®
Updated on June 22, 2021

High inflation results in more profits and high financial difficulties. The dividend and income taxes are paid on increased profit calculated on the basis of historical cost concept. Therefore a change from historical cost concept to price level or inflation accounting is recommended to show the correct profit and true and fair of balance sheet.

Advantages/Merits of Inflation Accounting

The major merits of inflation accounting are as under:
(i) Realistic view. Inflation accounting enables the company to present a realistic view of its profitability as current revenues are matched current costs.
(ii) Basis of Depreciation. The correct amount of depreciation be when it is charged on the current values (inflated values) and thus the replacement of assets will be more reasonable.
(iii) Check on payment of dividend out of capital. Inflation accounting enables a company to maintain its capital by checking payment of dividend and taxes out of capital due to inflated profit calculated on the basis of historical cost accounting.
(iv) True and fair Balance-sheet. The financial position of the company as shown by Balance sheet will be true and fair if it is by keeping a meaningful balance of various effects of inflation accounting in mind.
(v) Reasonable comparison of profitability. When financial statements: profit and loss and Balance sheet are presented and adjusted to the inflation accounting the profitability of two plants purchased on two different dates can be known correctly as these are calculated on the basis of their current value and not on their historical cost.
(vi) Check on Mis-leading Deeds. Inflation accounting checks the misleading deeds of historical cost concepts which shows more profits and more taxes, more salaries and wages demand by the employees keeping high profits in mind. When proper adjustment is made keeping price level accounting in mind, such demand will not arise nor more and more prospective entrepreneurs will not come for opening their units and unwanted competition will be checked.
(vii) Wrong matching concepts. Assets purchased long back is depreciated on the original cost or historical cost concept while all other revenues and expenses are shown on current prices be against matching accounting concept.
(viii) Safety of Owner’s Equity. Inflation accounting records fixed assets value according to their current values thus owner’s capital valuation will reveal its correct value.

Disadvantages/Demerits of Inflation Accounting

The following are the main demerits of Inflation Accounting:
(i) Depreciation. Depreciation is the downfall of value of fixed assets due to use and expiry of time, it should be charged on original and not on current values.
(ii) Replacement of Fixed Assets. The critic of inflation accounting says that depreciation is charged for the replacement of fixed assets, the same assets are not available for replacement due to change in model or invention or fashion the same machine is not needed thus replacement of assets does not contribute much.
(iii) Situation in Deflation. During deflation prices always falls, adjustment to price level change means charging lesser Depreciation and overstatement of profits which is also bad from many angles.
(iv) Theoretical Concept. The concept of inflation accounting is more Theoretical as it is only window dressing of accounting concept as per the suitability of individuals.
(v) Complicated System. The inflation accounting is not each approach it requires a lot of calculation and unwanted adjustment which a common man cannot understand more he can use them.
(vi) Expensive Technique. This technique is very expensive ordinary business unit cannot afford this technique.
(vii) Subjectivity in the valuation process. Inflation level accounting technique cannot be applied to know the real value of assets. Adjustment to current values is not so simple.

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