Inflation accounting is a process of accounting which records all items in financial statements as per their present values on a regular basis.
Financial statements which have been prepared as per the system of historical accounting, suffer from various limitations. These limits are as follows-
- Unless and until appropriate adjustments are made on the present price level, one can have wrong interpretation of financial statements.
- In historical accounting, fixed assets are maintained and presented at prices at which they have been obtained. Thus, the present modifications in the market price of these fixed assets are not taken into consideration.
- Instead of considering the prices at which they were obtained, depreciation here is charged as per the historical expenditure of fixed assets. This makes it insufficient for replacing the assets.
- Statements of income prepared as per historical cost accounting fails to depict the actual profit incurred. By recording revenues on the basis of current price and recording these expenses as per historical cost, profits become unrealistic in such situations.
- The return on capital achieved proves to be deceptive as the profits are unrealistic and valuation of fixed assets remains understated.
- Misleading findings of operating capacity.
- It affects managerial decisions by mixing up the holding gains and operating gains.
It fails to depict a true value of financial position by false comparison of inter-period and inter-firm. In fact, it gets difficult to compare the profitability of one business organization with another.