Advantages/Merits of Inflation Accounting
The main merits of inflation accounting are:
(i) Realistic view. Inflation accounting enables the company to present a realistic view of its profitability as current revenues are matched to current costs.
(ii) Basis of depreciation. The correct amount of depreciation is 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 dividends out of capital. Inflation accounting enables companies to maintain capital by checking payment of dividends and taxes out of capital (due to inflated profit calculated based on historical cost accounting).
(iv) True and fair balance sheet. The company's financial position, as shown by the balance sheet, will be true and fair if it keeps a meaningful balance of various effects of inflation accounting in mind.
(v) Reasonable comparison of profitability. When financial statements consider inflation accounting, the profitability of two plants purchased on two dates can be known concretely. This is because they are calculated based on current value and not on historical cost.
(vi) Check on misleading deeds. In inflation accounting, higher wage and salary demand is less likely to arise, more and more prospective entrepreneurs will not come to open their units, and unwanted competition will be checked.
(vii) Wrong matching concepts. Assets purchased in the past are depreciated at the original cost or historical cost concept, while all other revenues and expenses are shown on current prices against matching accounting concept.
(viii) Safety of owner's equity. Inflation accounting records fixed asset values according to their current values. Hence, the owner's capital valuation will show its correct value.
Disadvantages/Demerits of Inflation Accounting
The following are the main demerits of inflation accounting:
(i) Depreciation. Depreciation reduces the value of fixed assets due to use and the passage of time. It should be charged on original and not on current values.
(ii) Replacement of fixed assets. Critics of inflation accounting state that depreciation is charged for the replacement of fixed assets. The same assets are not available for replacement due to change in models, inventions, or fashion, and the same machine is not needed. Thus, replacement of assets does not contribute much.
(iii) Deflation situation. During deflation, prices always fall. Adjusting to the price level change means charging lower depreciation and overstating profits, which is also negative from many perspectives.
(iv) Theoretical concept. The concept of inflation accounting is more theoretical compared to other accounting concepts. This is because it is only window dressing the accounting concept, as per the suitability of individuals.
(v) Complicated system. Inflation accounting is not the easiest approach. It requires extensive calculations and unwanted adjustments, which inexperienced accountants and bookkeepers cannot use effectively.
(vi) Expensive technique. The technique is very expensive. Ordinary businesses can rarely afford to use it.
(vii) Subjectivity in the valuation process. Inflation accounting cannot be applied to ascertain the real value of assets. Adjustment to current values is not straightforward.
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Merits and Demerits of Inflation Accounting FAQs
The main merits of inflation accounting are that it provides a realistic view of profitability, ensures the correct amount of depreciation is charged, checks on payment of dividends out of capital, results in a true and fair balance sheet, allows for reasonable comparison of profitability, and checks on misleading deeds.
The main demerits of inflation accounting are that it can be complicated and expensive to implement, and there is subjectivity in the valuation process. Additionally, during periods of deflation, this approach can result in overstating profits.
Businesses that are expanding rapidly or that have high levels of inventory turnover are most likely to benefit from using inflation accounting. This approach can also be helpful for businesses operating in volatile or inflationary environments.
During deflation, prices always fall. Adjusting to the price level change means charging lower depreciation and overstating profits, which is also negative from many perspectives. In contrast, during periods of inflation, prices generally rise, so adjustments to current values would result in an understatement of profits.
Inflation and deflation are economic opposites: when the prices of goods and services rise, we have inflation; when they decrease, we have deflation. An economy can quickly swing from one condition to the other.
True Tamplin is a published author, public speaker, CEO of UpDigital, and founder of Finance Strategists.
True is a Certified Educator in Personal Finance (CEPF®), author of The Handy Financial Ratios Guide, a member of the Society for Advancing Business Editing and Writing, contributes to his financial education site, Finance Strategists, and has spoken to various financial communities such as the CFA Institute, as well as university students like his Alma mater, Biola University, where he received a bachelor of science in business and data analytics.