Question

Why is it important that, in countries with high inflation, financial statements be adjusted for inflation? Consider understated asset values, understated expenses, overstated income, and overstated equity and how these may affect a company’s overall strategy when responding.

Answer 1

The countries which are affected by higher inflation, it becomes pertinent for those countries to make an adjustment for such inflation in the financial books of account in order to show true and fair picture of their financial records.

assets which are recognised under the historical method of accounting get significantly undervalued, when a countries is experiencieng inflation. some of the major understated assets such as inventory and fixed assest result in diminition or undervaluation of expenses like depreciation expenses , cost of goods sold etc, further this result in the overstatement of income and shareholder equity.

There is negative implication on the company ability to borrow funds from financial institution , when there is the understatement in the value of the assets. As these assets are pledge to the lender in order to secure a term loan. when the value of the assets is depreciated than the company couldnot fetch the required amount of loan to do business.

when under valued assets price does not meet the market price of the company stock which is trading in the stock market, then the circumstances may arise that company assets may go for the hostile takeover.

when the income statement of an enterprise is over stated then this result in showing higher profit and similarly result in the payment of higher taxes to the government. when this higher payment of taxes got refleted in the financial books of accounts, then the shareholder of the compamy preassumes that the company is generating huge profit from the business , and may demand their right of dividend. so when the company pays the taxes and the dividend out of the inflated value of income, which result in huge cash outflow ,the company may got stuck into cash crunch.

Further it also become difficult to judge the financial performance of the company which are affected by the different rates of inflation, therefore it become hard for the stake holder to take economic decision just based on the company performance.

Therefore, the stake holder must pay attention to the accounting treatement done by the company for the assets , liability , equity, and ensure that this treatement are as per the recognised accounting standard, and reflects the true financial position of the company.