Accountants, auditors and directors called to account for inflation

Stakeholders are at serious risk of being misled because accountants who prepare annual reports and auditors and directors who sign off on them are oblivious to the effects of inflation, a Deakin academic has warned.

In an editorial to be published in the Management and Accounting Research Journal, Dr Trevor Wise from Deakin University's Business School called on the accounting profession to once again tackle the 'accounting for inflation' issue.

"At the moment accountants take the economic reality that is a business and convert (measure transactions) it into a representative financial report consisting primarily of statements of profit, financial position, changes in equity and cash flow," Dr Wise explained.

"Accountants do this using a nominal measuring unit – money. Money is the only factor that is common to all the transactions that are reported in these statements. It is the only practical measuring unit that can produce financial data that are alike, comparable and (at least potentially) serviceable. ''

Dr Wise said all relevant transactions were initially recorded in nominal money units. However, accountants then made an illusory assumption that the measuring unit was stable over time. That is, they made no allowance for real changes occurring in the measuring unit - changes in its general purchasing power - due to inflation. As inflation occurs, the value of money falls.

"This is important as money of one date can only be meaningfully related to money of another date if there has been no change in the general purchasing power of money between the various dates. Reported dollar amounts should always be real (inflation adjusted) amounts.

Dr Wise said instead accountants added together money amounts that represented different general purchasing power for example a 1970-dollar amount to a 2008-dollar amount.

"It is known as the fallacy of mixed measurement and it produces uninterpretable outcomes in the financial report similar to adding $US100 to $A100 and reporting $200 or, alternatively, of adding 10 inches to 10 centimetres and reporting 20," he said.

"This approach is both surprising and unacceptable given the Group's members are charged with ensuring financial reports are free from material misstatement, fair and reasonable and that accounting policies are appropriate. "

Dr Wise said the accounting profession in various parts of the world looked extensively at the 'accounting for inflation' issue during the 1970s and early 1980s. However, eventually it was set aside because accountants got themselves into a tangle over the best index to use.

"Some suggest the CPI is not objectively accurate enough to apply in financial reports. There is even a view that a separate index should be established for each business. Certainly the CPI is a bit hit-and-miss and capable of being challenged. It probably doesn't precisely reflect the inflation actually experienced by any business.

"Despite any deficiencies it might have in accountants' minds, the CPI is sufficiently reliable to be serviceable within financial reports given that it is serviceable elsewhere (including in each of our own diverse lives)."

Dr Wise said there was also a view that if inflation was less than (say) five per cent per annum it was immaterial and not worth accountants worrying about.

"Now we know better," he said. "Today, annual inflation of just two or three per cent per annum is described as 'chilling' and a 'dangerous elixir'."

"Few can bear to think about these questions again. Yet if business stakeholders are to make good decisions and take efficient action they need to be well informed about the financial effects of inflation. Currently, stakeholders are at risk of being significantly misled. The Group has a responsibility to act."