The important effects of inflation on financial statements are given below:
(a) Over Statement of Profit:
Fixed Assets shown on the basis of historical cost are depreciated on the basis of acquisition cost of Fixed Assets. As the historical cost of F A. is usually understatement of current value, depreciation charged on historical cost basis may under or over will distort the profit figures being shown in income statement.
Over statement of profits creates number of problems as stated under:-
ADVERTISEMENTS:
(i) Overstatement of profits lead to over-declaration of dividend and over-distribution of dividend disturbs capital of the organisation.
(ii) Wages are settled on the terms and conditions which organisation actually, cannot afford.
(iii) Over statement of profits leads to under pricing of sales.
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(b) Unrealistic Book Values of Fixed Assets:
ADVERTISEMENTS:
Since assets are shown on cost of acquisition less depreciation and current values of these assets are different due to prevailing prices in market does not reflect true picture, for instance, any land acquired in 1980 at a price of Rs. 40000 may continue to be shown on this value. But, current value of that price of land may be more than 10 times of its actual acquisition cost.
(c) Distorted figures on Inventories in Balance Sheet:
Traditional basis for Accounting System requires inventories to be shown at cost or market price whichever is less. In the period of rising prices, inventories will be always shown on cost if the inventory value is not adjusted as per changes in price level.
(d) Capital does not remain intact:
Over stated profits lead to over distribution of dividends. Which means there are not real profits or sufficient profits to be distributed as a dividend among shareholders?
(e) Sufficient funds are not available for replacement of fixed assets:
Ignorance of inflation in a system of accounting, depreciation charged to income statement remains undercharged It implies that after the expiry of an asset only amount equal to original cost will be available for replacement.