Income Measurement And Inflation

The situation of rising prices is referred to as inflation. During inflation, the purchasing power of monetary unit, that is, rupee in India, falls. Income measurement based on historical cost accounting is seriously affected because it reflects a matching of rupees of different purchasing power on the income statement. Revenues from sale of goods and services are usually expressed in current purchasing power of rupee but some of expenses matched against them may not represent current purchasing power of rupee because they are from very old transactions. Cost of goods sold may include costs of stocks purchased in earlier periods than the period of sales revenues. Similarly depreciation expense is based on cost of the assets in the distant past when rupee had a different purchasing power. So there is no proper matching of expenses and revenues because they are measured in terms of different purchasing power of rupees.

(i)    Overstatement of Income:

As the current revenues are matched against the historical costs, net income tends to be overstated. The reason is that the current charges for depreciation and for some portion of the cost of the goods sold are likely to be different from the amounts the firm will have to send or them each year to maintain the same operating level.

(ii)    Overstatement of taxable income:

As a result of overstatement of net income, the tax will have to be paid on inflated income. Business firms will have to pay tax on portions of their revenues that will have to be reinvested simply to replace the resources they are using up.

(iii)    Distortion of rate-of-return comparisons:

The rate of return on investment tends to be overstated both because income is overstated and investments in fixed assets and inventory are understated. The overstatement of rate of return is greater for firms with large investment in stock of goods and fixed assets than for those with more rapid asset-turnover ratios. It will be greater for those companies whose fixed assets are old enough.

(iv)    Misleading impression about managerial efficiency:

A misleading impression is given about managerial efficiency. The firm may report high level of profit resulting from an increase in the sales prices rather than from managerial efficiency in managing the affairs of the firm.

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