Inflation Accounting Basics

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In economics, monetary correction is an adjustment made periodically in certain base values of the economy in a period of inflation. It is aimed at compensating for the loss of value of money. And in terms of tax accounting, restatement can be referred to as active monetary variation, or passive monetary variation.

Inflation has two components, and these are monetary inflation and historical cost inflation. In an economy or firm which uses the fair value accounting model only one component of inflation applies, that is, monetary inflation. Historical cost inflation is impossible in an economy, company or group of companies making use of real value accounting model.

Monetary inflation is caused by a combination of different economic processes, for example, excessive new money supply in the economy or weaknesses in any of the other underlying value systems in the economy.

For instance, a weak central government, poor macro and micro economic measures, poor industrial development, poor economic infrastructure, a weak banking system or a reserve bank that is not 100% independent of the government.

Any combination of these problems can cause monetary inflation. There are several generally accepted solutions to monetary inflation by the authorities applied to keep inflation below 2% – the current internationally accepted right level for monetary inflation.

The acceptance of a stable unit of account is one of the basic principles of the historical cost model. The basic principle of the historical cost model is a formal act.

One of the basic principles of accounting revolves around the unit principle, which entails a basic monetary unit of the most relevant currency. The rapid devaluation of money through hyper inflation is duplicated in the massive devaluation of real values of all constant non-monetary items. Which are not fully or never adjusted as a result of the combination of hyper inflation and the consistent unit of account acceptance.

Constant real value non-monetary items are constant values because of the double entry bookkeeping system employed. In the event that their constant real values are not corrected. They are easily ravaged by the rate of inflation or hyperinflation as a consequence of the the steady unit assumption being applied as part of the historical cost model.

Constant real value non-monetary items were in the past scourged by the combination of inflation and the historical cost model in the same manner they are today, and not fully or never rectified as a result of the worldwide use of the historical cost model.

Examples of constant real value non-monetary items include issued share capital, unpaid profits, trade debtors, trade creditors, salaries, rent, interest in the profit and loss account, taxes, etc.

Inflation always destroys value. This is done in two ways: inflation destroys the value of money and it destroys the value of items whose values is not brought up to date, like the profits that a company retains and not paid out to shareholders.

Accountants recognize the danger that inflation poses, and implement relevant actions according prescribed rules to make things right with variable values. However, it is assumed that inflation has nothing to do with the constant value of things, such as unpaid profits, which are not brought up to date. Inflation destroys the constant value of things at various inflation rates in a given period. This amounts to hundreds of billions of dollars per year in the global economy.

 

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