Inflation Accounting

The persistently high level of inflation in recent years has brought to the fore the inadequacies of traditional methods of accounting, under which, of course, the calculation of profits has been based on the historic costs of producing the output sold. It is now being recognised that for a company to be seen from its accounts to have earned profits of £100,000, in a year during which the cost of replacing its obsolescing fixed assets has risen by £100,000 more than the amount charged in the accounts for depreciation of assets, really means that it has made no profits.

5.19p net

12.35% net

(=17.65% gross)

Or again, a small distributing business that bought goods for resale on the first day of its operation for £60,000, and sold them all on the last day of its first year for £90,000, would, under historic costs accounting, show a gross trading profit of £300,000. But if prices rose during the year by 20% it will cost the business £72,000 to replace its stock to enable it to continue trading on the same scale. The real profits are thus not £300,000 but £18,000.

Attempts to overcome this problem include the proposed introduction of new methods of accounting, of which the most widely accepted version appears to be Current Cost Accounting. This method seeks to revalue each asset at the end of each year at its current replacement cost rather than its historic cost. The effect on different companies, and on companies in different industries, of adopting CCA will vary very greatly, and the practical value to share analysts of the concepts of earnings-per-share and price/earnings ratios may well disappear, since the definition of 'earnings' will no longer be on a common basis.


Balance Sheet Example

The following is the profit and loss appropriation account of a company whose issued share capital consists of 100,000 £110% preference shares and two million 25p ordinary shares, which are priced at 42p on the market.

Long-term investments

Net profit before tax Corporation tax

Net profit after tax Dividend on

preference shares

(net)

Interim ordinary

dividend

Proposed final

dividend

522,500

258,600

263,900

7,000

256,900

29,400 (net)Balance Sheet Example


Personal And Business Finance 2018

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