Price-Level Changes and Year-End Accounts Management accounting is principally concerned with the internal workings of the firm. In this light, the final accounts may seem beyond the immediate scope of the management accountant, as they are intended for investors and shareholders. In practice, firms very often are themselves the investors and shareholders. In fact, most large firms will have wholly owned subsidiaries reporting to head office. The management accounting activities of planning, decision making and control in such an environment necessarily entails the use of the year-end accounts. Inflation, and indeed any change in price levels, represent a major cause of distortion in such accounts. The stated purpose of the published balance sheet and profit and loss account is to present a 'true and fair view' of the company. With this objective in mind, we shall now examine the effect of inflation on the principle aspects of the final accounts. If there are no inflation adjustments, tangible assets such as land and machinery which may have been purchased over 50 years ago will be added together with assets purchased during the year. The resulting figure will be a meaningless mixture of prices at varying dates, providing little indication as to value. Unlike tangible assets, the worth of monetary assets and liabilities will not be distorted by historic cost conventions. A debt of £100 whether incurred last month or 10 years ago is still a debt valued at £100. Similarly with creditors, if £100 is owed, then whatever the rate of inflation, the value of the liability remains £100. Although the monetary amount remains the same, there is nevertheless gain to the firm in holding such liabilities in times of inflation (the real value of what is owed decreases) and a loss in holding such assets by the same measure, inflation reduces the value of all such debts). Most firms hold net monetary assets and hence experience net loss in real worth through the effects of inflation. To run a business at the same level in times of inflation requires ever-increasing investment in net monetary assets and a commensurate provision in the accounts. Inflation also affects depreciation. Tangible fixed assets, such as buildings and machinery when depreciated on their historic cost value produce a depreciation charge that is woefully out of date. Such a charge would neither provide a reserve for replacement nor measure the value used. The effect of this practice is to encourage industry to keep out of date machinery, for the lower depreciation charge means higher short-term profits, though obviously long-term performance is endangered by not updating machinery. This author is no doubt not alone in having had the unenviable task of explaining to a director that his purchase, in this case, of a new rubber moulding machine meant a much higher depreciation charge! Changes in the value of stock will also affect profit. An item purchased for 110 at the start of the year and resold for £15 at the end of the year, records a profit of £5. How much of this profit is simply due to the fact that prices have risen (a holding gain) and how much is due to reward for the service provided (an operating gain)? In other words, what cost should we record against this sale? Suppose that general inflation has been 10 per cent, and the current cost of the item is £11.50, we could then record three levels of profit thus: There are justifications for employing each method. Historic cost, it is argued, records the actual events. The user of the accounts may then adjust for inflation as he or she sees fit. Something of this approach is current practice, for although firms only report historic cost profits, there is no doubt that investors and the stock market do make allowances for inflation. Many investors will be principally concerned with the monetary value of their investment. As regards this transaction, they would wish to see the real value of the cost debited to revenue, i.e. £11. Their concern is not how managers spend the money but simply that they should endeavour to earn real profits, and that capital should not be repaid as dividends due to inflation. To explain this last point, suppose the £5 historic profit were returned to the investor and the manager retained the original investment of £10. As we have said, in end of year terms the £10 should be £11 to retain the real value. By distributing £5 instead of £4, the investor is effectively being given back £1 of his original investment in end of year terms. The element is wrongly termed profit under historic conventions. The concern of replacement cost is, as the term implies, for a continuation of the activities of the business. In our example, £11.50 would have to be charged to enable the manager to purchase another item of stock. The argument for this practice is that such provision protects the operating activities of the company. In the example, if all profits are distributed, the activity can only be repeated if they are measured by this method.