Question

Give a response justifying why NOT to adjust for inflation on financial statements. What are the positives to not adjusting?

Answer 1

Inflation's Influence on Financial Statements

Inflation can take its biggest toll on the reported profits of businesses with sizable inventories. Consider the following example:

Example
Avinash PC Shop reported sales of Rs. 2,00,000 last year. Its cost of goods sold was Rs. 1,10,000 which meant gross profits of Rs. 90,000.

Now, assume Avinash PC Shop sells exactly the same number of units this year, but— because of inflation of 5 percent—raised its prices 5 percent. Also assume that its cost of goods rose 5 percent, but that half of its sales will be made from "old" inventory purchased last year, at last year's cost.

So, for the current year, Avinash PC Shop reports sales of Rs 2,10,000 and cost of goods sold of Rs. 1,15,500 (Rs. 1,10,000 + 5% [ ¹/₂x Rs. 1,10,000]). Avinash gross profits rose by Rs.4,500—at least some of which will show up in net income—even though its level of business activity remained unchanged.

The increased profits of Avinash PC Shop in the example above cannot be attributed to improved performance. They are merely "inflation profits."

Inflation also distorts reported income when the costs of fixed assets are charged to income through depreciation. The increased costs of replacing fixed assets are not reflected in the depreciation charge.

Inflation has an impact on how a business is valued by investors and prospective purchasers who do not value inflation profits highly. A business that fails to take this factor into account in its financial planning may see the value of the business decline, despite steady or modestly rising profits.

So if we do not adjust our account with inflation our stakeholders will get true picture of our performance during the year.