Why are Financial Statements Potentially Misleading?

In the course of PERIODS OF Changing Costs? Throughout a period of inflation, asset values recorded at their original acquisition charges seldom reflect the assets’ present (greater) value. Understated asset values lead to understated costs and overstated income. From a managerial perspective, these measurement inaccuracies distort (1) financial projections depending on unadjusted historical time series data, (2) budgets against which results are measured, and (3) performance data that fail to isolate the uncontrollable effects of inflation. Overstated earnings may possibly, in turn, result in:

1. Increases in proportionate taxation
2. Requests by shareholders for more dividends
3. Demands for greater wages by workers
4. Disadvantageous actions by host governments (e.g., imposition of excess profit taxes)

Ought to a firm distribute all of its overstated earnings (in the kind of higher taxes, dividends, wages, plus the like), it may possibly not maintain adequate resources to replace precise assets whose prices have risen, including inventories and plant and equipment. Failure to adjust corporate financial information for adjustments within the buying power with the monetary unit also makes it hard for financial statement readers to interpret and compare reported operating performances of companies. In an inflationary period, revenues are ordinarily expressed in currency with a lower general getting power (i.e., purchasing power in the existing period) than applies for the related costs. Costs are expressed in currency with a higher general getting power since generally they reflect the consumption of resources that were acquired a though back (e.g., depreciating a factory purchased ten years ago) when the monetary unit had more getting power. Subtracting costs depending on historical purcha ing power from revenues based on present buying power results in an inaccurate measure of earnings.

Standard accounting procedures also ignore buying power gains and losses that arise from holding money (or equivalents) through an inflationary period. In the event you held cashduring a year in which the inflation rate was 100 percent, it would take twice as substantially cash in the finish from the year to have exactly the same purchasing power as your original money balance. This further distorts business-performance comparisons for economic statement readers.

Consequently, it can be valuable to recognize inflation’s effects explicitly for quite a few reasons:

1. The effects of altering rates depend partially on the transactions and circumstances of the enterprise. Users do not have detailed facts about these elements.
2. Managing the problems triggered by changing costs depends on an accurate understanding with the problems. An accurate understanding demands that company performance be reported in terms that let for the effects of changing rates.
3. Statements by managers about the issues caused by changing prices are a lot easier to think when companies publish financial information and facts that addresses the issues.

Even when inflation rates slow, accounting for changing rates is valuable for the reason that the cumulative effect of low inflation as time passes is often substantial. As examples, the cumulative inflation rate during the last ten years was around 22 percent in extremely industrialized countries like the Eurozone, Japan, the United Kingdom, as well as the United States, roughly 61 percent for emerging e onomies in Asia, 575 percent for Latin America, and 804 percent for Central and Eastern Europe.7 The distorting effects of prior inflation can persist for a lot of years, given the long lives of a lot of assets. And, as mentioned earlier, precise value adjustments may be substantial even when the gen()eral cost level doesn't modify substantially.


See Also:
Accounting assumptions and characteristics
Recommendations for Analysis