EXAMINING THE EFFECTS OF INFLATION ON REPORTED PROFITS: IMPLICATIONS FOR DECISION MAKING
ABSTRACT
The purpose of this study is to examine the effect of Inflation on Reported Profits: Implication for Decision Making [A survey of financial institutions in Port Harcourt]. Financial Accounting information is provided to external investors and to Management. For Management, periodic report are prepared for decision making purposes while for external investors, a summarized report profits is what they get. These reported profits are not screened for inflation. Consequently, the accounting conventions and inflationary rate impact negatively on investment decisions by external investors of the banks. To achieve these general objectives, a number of specific objectives were derived directly from the general objectives and a hypothesis was formulated. These research questions and the hypothesis guided the development of the instrument tests or items. This instrument is titled “Effect of Inflation on Decision Making Descriptive Questionnaire”. The Study findings revealed that: Accounting conventions influence the preparation of reported profits, thus, creating diversity which is at variance with the objective of efficient resource allocation; External users of these reported profits rely heavily on the information they provide for their investment needs; Inflation rate in the country has impacted negatively on the purchasing power of the Naira; Savings and investment rates have fallen due to inflation; There is a relationship between the rate of inflation and fall in the value of the Naira. The study concludes that there is now more than ever, the need for inflation accounting in reported profits; the effect of generally accepted conventions on reported profits create a degree of diversity which is at variance with the objective of efficient resource allocation. Therefore, reported profits should not strictly adhere to accounting convention because information provided for management decisions do not adhere to accounting conventions; There is now need to introduce an Account for Inflation as done in most advanced countries for example, the UK and USA. In the UK, the current purchasing power method is used to produce for shareholders a supplementary statement in terms of value of their investment. There is the need to do some for investors in this country; Savings and investments will rise again if investors know what the value of their present investment will fetch in the future; Operating profits should be decided after charging the value to the business of assets consumed during the period, this should include holding gains.
CHAPTER ONE
1.0 Introduction
1.1 Background of the Study
Inflation may occur in one or two possible forms. It may be demand inflation or it may be cost inflation. According to Maddison (1970:93):
- Demand Inflation: Takes place at a time of stable prices. Additional expenditure is generated with the effect that given full employment, prices of goods and services rises. This will eventually lead to higher rewards for factors of production as well i.e. wages and profits will go up.
- Cost Inflation: This kind of inflation, on the other hand originates in higher factor prices. Example is in wage awards which are not justified by increases in the productivity of labour. High costs will then lead to higher prices of goods and services. Whichever form inflation may take, however, it will have a snowballing effect i.e. the inflationary spiral will set to work. Higher prices will lead to demands by the factors of production for higher rewards to maintain the real value of their incomes and these higher factor rewards will mean higher costs of production. And so, it will go on. This is the main danger of inflation. Once it has started, it is difficult to put a stop to it without being unfair to one particular section of the community, namely that section whose incomes have not yet been adjusted to the higher prices prevailing all round.
Gill (1973:339) posited that inflation means any general increase in the price level of the economy in the aggregate. He observed that this macroeconomic concept include certain prices in the United State. The three main indices of inflation in common use are:
- The index of consumer prices
- The wholesale price index and
- The GNP price labour
This third index reflects the distinction between the real GNP and changes merely in money GNP. Inflation in whatever form have certain serious negative effect on decision-making.
Sizer (1989:52) posited that accountant measure profit by finding the difference between the net asset at the beginning and end of accounting period. They match the actual revenues of the period with the actual expenses of the period and to the extent that revenue exceeds expenses, there is a profit. However, under the historical cost accounting system the matching process may be of revenue of the period with cost of earlier periods, they do not necessarily match current values. Furthermore, the balance sheet is made up of a mixture of Naira of different periods, depending upon the mix of assets; the age structure of the assets and depreciation policies.
Thus, in the period of rising prices there would be an overstatement of profit and an understatement of assets employed. This situation arises because the output costs of one data are matched with output revenues of a later date. If assets are shown in the balance sheet at their historical cost basis and stocks and work-in-progress on a first-in-first-out [F.I.F.O] or similar basis, part of what accountant calculate as profits will be required to maintain the capital of the business; infact, part of the profit will be required to cover the increased cost of replacing fixed assets and stocks which were bought or produced at prices considerably lower than those ruling at the date of consumption. If a company distributed as dividends the whole of its historical cost profit, it will have insufficient cash left to maintain its present level of stocks and work-in-progress and replace its fixed assets. Furthermore, if reported profits which result merely from a change in the value of money, or capital gains arising from the same reason are taxed as if they are real income to the business, then, the ability of the company to maintain the capital of the business intact and sustain real growth will be diminished.
Decision-making requires information which is measured on an appropriate basis. Gluatier and Underdown (1986:35) argued that the monetary unit of measurement decreases in value because its purchasing power falls according to the degree of inflation. The consequences of the instability in the dimension of the unit of measurement in accounting are that objects and events which were measured in one period of time cannot be compared with similar goods and events which were measured in a subsequent period. Yet, accountants are still unwilling to provide information to external users about future expectations, which would be useful for decision-making, since this will mean abandoning a tradition based on objectivity. The development of accounting as an information science concerned with the needs of decision-makers requires measurements which are relevant and useful for these needs. In particular, such measurements should posses a high degree of predictive ability. Unfortunately, accounting tradition in this country poses serious obstacles to the use of reported profits for decision-making by external users.