IMPACT OF INFLATION IN FINANCIAL REPORTING (A CASE STUDY OF INFLATION AND FINANCIAL REPORTING IN DEVELOPING ECONOMY)

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1 IMPACT OF INFLATION IN FINANCIAL REPORTING (A CASE STUDY OF INFLATION AND FINANCIAL REPORTING IN DEVELOPING ECONOMY) ABSTRACT DR. ABHINN BAXI BHATNAGAR*; ATUL KUMAR** *Assistant Professor, DAU University, Riyadh, Saudi Arabia. **Associate Professor, Galgotias Business School, Greater Noida, U P, India. Financial reporting depicts the financial positions of any business organization and fulfills the basic objective of accounting by highlighting the financial facts. It is mainly comprises of position statement, Income Statement and statement of change in financial position. But each country has its own system of reporting and presenting financial statements. The term Inflation in economics context means a rise in the general level of price of goods and services in a country over a period of time. International Financial Reporting Standards (IFRS) is trying to bring uniformity between various accounting practices of different countries but inflation is ignored in International Accounting Standards. As we know that some work has been done in the field of Inflation Accounting, but still it is in the developing stage. Inflation Accounting refers to a range of accounting systems designed to correct problems arising from historical cost accounting in the presence of Inflation. Pinnacle Research Journals 37 Inflation is a common problem especially for developing and under developing economies. The rate of Inflation is generally very high and business organization operating their business under such conditions have to consider the effect of inflation while preparing the financial statements for a true and fair view of the state of affairs. The main objective of the paper is to find out the impact of inflation on financial statements indicating how profitability varies after considering the treatment of Inflation in Accounting. For the purpose of the study a sample of five companies from steel industry of India has been taken and profitability variance is measured after considering inflation into accounting treatment. Efforts have been made to outline the remedial measures and concrete suggestion with supportive recommendations. KEYWORDS: Financial Reporting, Inflation Accounting, IFRS (International Financial Reporting Standards), CPI (consumer Price Index), WPI (Wholesale Price Index), GAAP (Generally Accepted Accounting Principles), Profitability Variance.

2 INTRODUCTION The main objective financial reporting is to highlight the financial position of business organization, but the significance of such data diluted, if the financial statement ignored the change in purchasing power of the monetary units. In terms of accounting financial statements are mainly comprises of position statement, income statement and the statement of change in financial position published by corporate houses in their annual reports at the end of the financial year. These statements are prepared on the number of accounting assumption, principles and postulates technically known as GAAP (Generally accepted accounting principles). Among these principles and assumptions, one of the prime assumptions is that there is no change in the purchasing power of the monetary unit, but in case of developing and under developing economies inflation problem is very common. In case of India the problem of inflation is critical because of frequently change in inflation rate, not only yearly but even monthly some times and in such situation application of Inflation accounting (also known as accounting for price level changes ) is recommendatory for the better financial decision making. There is no standard or uniform method to be adopted for adjusting the financial statement for price level change. Each economy has different inflation rates and broadly we can classify it into general price level change and specific price level changes. The first one reflect the overall increase or decrease in the value of monetary unit, example of such price level changes is (WPI) wholesale price index and consumer price index(cpi). On the other hand specific price refers to change in the price of specific assets. In case of India, the WPI has shown fluctuation from 5% to 14 % in the last decade, such types of situation definitely required implementation of Inflation accounting. RESEARCH METHODOLOGY Pinnacle Research Journals 38 OBJECTIVE OF THE STUDY: The main objective of the paper is to measure the variance in profits before and after implementation of Inflation. REVIEW OF LITERATURE Inflation accounting is not new concept since 19 th century it was observed that there is something lacking for stabilized accounting. In the era of early nineteen century the significance of index number was recognized and in this regards various theories and models were developed. The concept and theories of Purchasing power was well discussed by Irvin Fisher in his book The purchasing power of money (1911). Later on, in 1936, inspired by Irving Fisher, Henry W. Sweeney discussed purchasing power concept and about constant purchasing power accounting in his book Stabilized Accounting. In the early sixties the model of Sweeney was used by the American Institute of certified Public accountant for the well known research studies (ARS-6) Reporting the financial effects of price level changes. After wards large number of Accounting boards and bodies of different countries contributed for inflation accounting. Later on International Accounting Standards laid down some standards and Norms mainly known as IAS- 29 comprises the accounting standards about financial reporting in hyperinflationary economies

3 implemented w.e.f. 1 st June Afterwards in the year 1994, it was reformatted and at last in the year 2008, 22 May it was amended for annual improvement to IFRS INFLATION AND ITS IMPACT ON PROFIT: A COMPARATIVE STUDY OF 5 FIRMS OF STEEL INDUSTRY IN INDIA The present study is focused on the impact of inflation on financial statements. The study mainly highlights how the profit is changed after the implementation of inflation accounting. SAMPLING For the purpose of the study, a random sample of five companies from public and private sector of steel industry of India has been taken for their respective financial statements of the previous five years (from the year 2005 to 2010). METHODS USED FOR THE STUDY There are four methods to study the impact of inflation on financial statements, for the purpose of the present study we have used consumer Purchasing Power (CPP).In this method again we have two techniques to measure the profitability variance of the company. The first technique is the Net income Technique in which, we try to measure the profitability variance by bringing all the heads of the Balance sheet to the current price level. The difference in the net reserve would be the profitability variance. The mathematically, profit variance can be expressed as- (P.V) Profit variance = Net profit after adjustments net profit before adjustments. Pinnacle Research Journals 39 The second technique is the conversion of Income Method, in these techniques all the heads of income statement are converted to present price level. In the present paper for the profitability variance we have used the conversion of income method. Under this method, we calculate the conversion factor; the conversion factor is basically the value of WPI at the end of the year divided by the value of WPI in the beginning of the year. Mathematically it can be expressed as- Conversion factor (C.F) = WPI at the end of the year/wpi at the beginning of the year. Following assumption has been taken for the calculation of P.V The following heads of the company is considered to be even throughout the year. Sales COS(Cost of Sales)

4 Other Manufacturing expenses Nonrecurring item Other cash adjustments. For the calculation of depreciation expense the price index of 1995 has been taken. ANALYSIS OF TATA STEEL From the table no-1, it is highlighted the Income statement of Tata steel from the year to (Table is attached in the excel format) From the Income statement of Tata steel it is indicated that profit variance for all the years i.e to 2010 is negative and is approximately 10 percent. This shows that company in each year on an average is showing a high profit figure ANALYSIS OF SAIL (STEEL AUTHORITY OF INDIA LIMITED) From the table no-2, it is highlighted the Income statement of SAIL from the year 2005 to (Table is attached in the excel format) In this case also the P.V for all the years from 2005 to 2009 is negative, the company on an average is reporting a net 12 percent higher profit figures. ANALYSIS OF ESSAR Pinnacle Research Journals 40 From the table no-3, it is highlighted the Income statement of Essar from the year 2005 to (Table is attached in the excel format), in this case the company shows a very high negative profit variance in the years. On an average Co. is reporting 40 percent high net profit. ANALYSIS OF RASTRIYA ISPAT From the table no-4, it is highlighted the Income statement of Rastriya Ispat from the year 2005 to (Table is attached in the excel format),in this case the P.V for all the years is negative. The company is reporting 11 percent high profits on an average. ANALYSIS OF LLOYDS From the table no-5, it is highlighted the Income statement of Lloyds from the year 2005 to (Table is attached in the excel format), In this case the P.V for all the years is negative, e company is reporting on an average 100 percent high profit figure. FINDINGS AND SUGGESTIONS (1) In all the cases, except Lloyds, the companies paying high taxes for the inflated profits. It simply states that a Tax authority has not give priority to inflation accounting.

5 (2) Lloyds is not much affected by this technique because the company has reported losses in the previous five years, so therefore there is no change in the tax liabilities of Lloyds. (3) The inflated profits also encouraged the company to give high dividends, which might have an adverse affect on capital impairment of the company. (4) An inflated profits figures to tempt the company to take the casual approach in managing their corporate affairs. In actuality, the company might be in real and serious problem and this approach would prevent the company to take any proactive measures. (5) Due to the inflated profit figures the company would tent to ignore the high overheads. (6) The ICAI (The Institute of Chartered Accountants of India) should draft Accounting Standards for addressing the inflation Accounting. (7) Initially at recommendatory level the inflation accounting should be implemented in financial reporting. (8) Though there are some norms framed by International Accounting bodies for inflation accounting, but there is a need to strengthen them. (9) For the purpose of transparency between stakeholder and the company, the principal of full disclosure, incorporating the effect of inflation accounting for the financial reporting. (10) Customized software could be developed for the converting the conventional financial statement inflationary adjusted financial statements. Though SAP AG release 4.6 C software is developed, but the proper implementation of this is still pending. LIMITATION OF STUDY Pinnacle Research Journals 41 (1)Though from last century, lot of work has been done on inflation accounting, but still no standard and uniform method has been developed. So still the study is lacking implementation of appropriate method. (2) Changes in the price level are continuous process and it is not easy to implement stabilized accounting. (3) Tedious calculations with conversion factor of various financial variables is a constraint in accuracy. (4)Implementation of inflation accounting does not signify the abolition of historical cost method; even this is stated by price water cooper that Inflation adjusted financial statements are an extension to, not a departure from Historical cost accounting. (5)The price of the particular assets may not follow the same trend as WPI and CPI. But in India the inflation is measured mainly by WPI.

6 (6) In the present study, we have analyzed only revenue and expenditure part, but on the other hand impact on assets, liabilities and capital is ignored. REFERENCES BOOKS (1) Geoffrey Whittington, Inflation Accounting: An introduction to the debate, Cambridge University Press, (2) S. Davidson, C.stickney, R. Lweil, Inflation accounting: A guide for accountants and financial analyst, Mac Graw Hill, New York, (3) Gupta K, Sharma, R.K, Management Accounting, Kalayani Publications, New Delhi, India, (4) Bhattacharya S.K, Dearden, J, Accounting for Management, 1996, Vikas Publishing House, New Delhi, India, REPORTS (1) Reserve Bank of India, Annual Reports, 2005 to 2010, India WEBSITES Www. money.rediff.com Pinnacle Research Journals 42 ANNEXURE (1) Excel file format for data, named as Annexure-1 Dr. Baxi containing Table No-1 to Table No-5, attached.

7 TABLE NO-4 INCOME STATEMENT OF RASHTRIYA ISPAT NIGAM LTD. (FROM THE YEAR 2005 TO 2010) Unadjusted Conversion Factor Adjusted Income Operating income 9, , , , , , , , , , Expenses Material consumed 5, , , , , , , , , , Manufacturing expenses Personnel expenses 1, , , , Selling expenses #VALUE! Adminstrative expenses Expenses capitalised Cost of sales 7, , , , , , , , , , Operating profit 1, , , , , , , , , , Other recurring income Pinnacle Research Journals 43 Adjusted PBDIT 2, , , , , , , , , , Financial expenses Depreciation Other write offs Adjusted PBT 2, , , , , , , , , , Tax charges , Adjusted PAT 1, , , , , , , , , , Non recurring items Other non cash adjustments Reported net profit 1, , , , , , , , , , Earnigs before appropriation 4, , , ,