Accounting for inflation
Published accounts are commonly prepared on historical cost accounting principles. In times of inflation such accounts do not give an accurate picture of real profits or the real present value of capital employed. In order to give both the public and the investor a proper appreciation of business results it is thought desirable to eliminate, as far as possible, variations that result from, and only from, changes in the value of money. e.g. if the price level has doubled over five years or, which is to state the same point. the value of money has halved over that period, then a profit of £200,000 this year is not worth the same amount as that sum five years ago. Over such a period a business would need to have doubled its profits, just to remain on an even keel.
In order to reflect the effect of inflation on published figures various accounting measures have been proposed. However, none has yet found sufficient support in financial circles to be enshrined in law, particularly in company law inasmuch as by companies of one kind or another. Each proposed system has been attacked for a different reason and one of the more common objections relates to the fact that in times of inflation not all prices increase at the same rate and, even if they do, it is necessary to make the almost impossible distinction between increases due to inflation and increases due to improvement in the asset purchased.
Reference: The Penguin Business Dictionary, 3rd edt.
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