VII. Implications of Inflation for Business Income

8.175. In the earlier sections of this chapter the discussion has been mainly concerned with the differences which arise between net income and financial accounting profits, both determined using historical cost methods of accounting. In Chapter 6 brief reference has been made to the effect of inflation on business income and the need for the effect to be recognised in levying taxes, particularly in periods when inflation is severe. A number of submissions have requested that the tax law permit depreciation allowances to be based on replacement cost in lieu of historical cost and trading stocks to be valued using bases not now acceptable to the Revenue.

8.176. It is increasingly being recognised, that conventional accounting methods fail to take account of the increased costs of replacement of fixed assets and fail too to exclude stock appreciation in computing profits which form the basis of net income and reported financial results.

8.177. The extent to which conventional accounting methods overstate profits by failing to have regard to depreciation at replacement cost and stock appreciation in periods of high inflation is very significant. On the basis of figures issued by the Commonwealth Statistician for stock appreciation and its own estimate of depreciation at replacement cost, the University of Melbourne's Institute of Applied Economic and Social Research has recently estimated that when allowance is made for these two factors profits before tax of non-finance companies for the year 1973–74 drop from $4,325 million to $2,953 million. Since company tax is assessed on the higher figure, the rate of such tax is in effect equivalent to 66 per cent of the lower figure.

8.178. Accounting methods for adjusting business profits for inflation were discussed in Germany in that country's period of high inflation after the World War I. It was subsequently examined spasmodically in other countries but received increased attention in the early 1950s when the rate of inflation became a worldwide problem.

8.179. Since then, the professional accounting bodies in Canada, the United Kingdom, the United States and Australia have devoted considerable attention to finding an acceptable alternative to historical cost accounting. In June 1969 the Accounting Principles Board of the American Institute of Certified Public Accountants issued a statement entitled ‘Financial Statements Restated for General Price-Level Changes’, which explained the theory and practice of general price level restatement. It sought the presentation of restated accounts as a means of conveying supplementary information not available in historical accounts.

8.180. Early in 1972 the Confederation of British Industry appointed a committee on inflation and accounts under the chairmanship of Sir David Barron. This committee issued an interim report in January 1973 and a final report in September 1973. The following extract from the final report is worth noting:

‘The work of the Committee in the six months since the interim report was published has only strengthened its opinion that financial statements should be adjusted to take account of inflation… The longer present historical accounting alone is continued the more will companies and the public be deceiving themselves. The continued erosion of real capital and company earnings while inflation continues at its present pace will almost certainly lead to more critical difficulties to be faced eventually. The Committee attaches great

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importance to moving as quickly as possible consistent with allowing sufficient time for the process of education’.

8.181. It is understood that neither the United States nor the Canadian professional accounting bodies have made positive recommendations to date. In January 1973 the Institute of Chartered Accountants in England and Wales, in conjunction with other United Kingdom accounting bodies, issued a draft statement entitled ‘Accounting for Changes in the Purchasing Power of Money’. It proposed that historical cost accounts be restated in terms of pounds of current purchasing power and that the restated accounts be issued as a supplementary statement attached to the conventional financial statements. In May 1974 the draft was adopted as a provisional statement of standard accounting practice.

8.182. In December 1974 the Institute of Chartered Accountants in Australia, together with the Australian Society of Accountants, issued a draft of an accounting standard entitled ‘A Method of Accounting for Changes in the Purchasing Power of Money’, which was almost identical with the provisional standard recommended by the United Kingdom accounting bodies. In issuing the draft, the Australian bodies did not recommend the United Kingdom method of adjusting profits and financial statements for the effects of inflation. Rather, it was published as an initial step in arriving at an acceptable solution.

8.183. A cardinal problem involves tax adjustments to be made where a significant portion of the capital employed in an enterprise is financed by medium-or long-term borrowings. An approach which concentrates on the need of the business entity to make adequate provision from profits for costs of replacement and for stock appreciation will tend to ignore the gains arising from the repayment of borrowings in money which has fallen in value. On the other hand, an approach which concentrates on the interests of the holders of equity capital will have regard also to those gains.

8.184. There appears to have been a tendency for revenue authorities in most countries to remain aloof from the efforts to find an alternative to conventional accounting methods which will produce ‘true’ profits in periods of high inflation. Nevertheless, some concern has recently been shown in the United Kingdom with the appointment in early 1974 of the Committee on Accounting for Inflation (Sandilands Committee) which has not yet issued its report.

8.185. Some recognition of the problems facing business in times of inflation has been given in a number of countries by the introduction of special allowances in respect of depreciation of fixed assets, though frequently these allowances have been employed primarily as a tool of economic management. The allowances vary in form: in some instances as investment allowances in the year the asset is acquired, in addition to normal depreciation allowances; in other instances in the form of substantial initial depreciation allowances. In the United Kingdom, for example, a taxpayer may claim 100 per cent of the cost of new plant installed.

8.186. For some time now, the need to retain sufficient profits to assist in financing the higher costs of replacing fixed assets has been acknowledged by many of the larger industrial organisations. Some have carried out revaluations of their assets at regular intervals, substituted the higher values for the historical cost values and thereafter provided for depreciation on the written-up figures. However, a tax deduction is not available for the additional depreciation thus set aside in computing financial accounting results. Others have calculated the estimated additional depreciation needed on a replacement values basis and have taken this further sum into account

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when considering profits available for distribution to shareholders. However, many businesses have largely ignored the problem, with the result that no account has been taken of the increased costs of replacement.

8.187. With inflation at high levels, the effect of stock appreciation forming part of profits falling to be taxed and the related problem of providing funds to finance the increased value of stocks are now matters of major concern. The need to have regard to stock appreciation in computing taxable income has recently been recognised in the United Kingdom where, in November 1974, a special measure was proposed. Broadly, where the increase in value of trading stock and work in progress during the financial year 1974–75 exceeds 10 per cent of a company's profit, the company is permitted to reduce the value of these assets at the close of the year so that the increase in trading stock does not exceed 10 per cent of profits. The measure is confined to companies and to instances where the increase in stocks exceeds £20,000. It results in a deferment of the tax payable on the amount by which the year end stocks are reduced. It is not as yet clear when the deferred tax will fall due for payment, but industry has been assured that it will not be payable in the subsequent income year.

8.188. In the United States where the LIFO method of valuing trading stocks is permitted, it seems that a growing number of companies are adopting this alternative basis which tends to restrict the extent to which stock appreciation arising from inflation forms part of current profits.

8.189. In Australia, at least until very recently, there have been virtually no measures to alleviate either the impact of tax or the pressure on business for finance in the current period of rapid inflation. However, in December 1974 the Australian Government announced the appointment of an independent panel to conduct an inquiry into inflation and taxation and to report by May 1975. The panel's second term of reference is:

‘To examine the effects of rapid inflation on taxation paid by companies and other enterprises and in particular: (a) to examine the various choices available to taxpayers under the provisions of the income tax law relating to the valuation of trading stock and to assess the advantages and disadvantages of providing other bases of stock valuation for income tax purposes; (b) to consider the advantages and disadvantages of alternative methods of providing allowance for income tax purposes for depreciation of plant and equipment, including allowance of deductions for depreciation calculated at flexible or accelerated annual rates; (c) to make recommendations in relation to these matters’.

8.190. A further measure proposed is the introduction of a new depreciation allowance which doubles the depreciation deduction for the current financial year in respect of new plant installed in manufacturing and certain other industries. However, this special allowance is very much less than that available in most overseas countries.

8.191. Further action to bring net income for tax purposes closer to ‘true’ profits in periods of high inflation is now urgent. In view of the inconclusiveness of endeavours by business and the accounting profession to find an acceptable alternative for conventional accounting despite considerable research and exposure of the issues involved, it would be unduly optimistic to expect that the problem will shortly be solved by a change in accounting procedures. In any case, new methods are unlikely to meet the circumstances of the whole range of business activity: though acceptable to many businesses, they may prove to be inappropriate for use in computing net income for tax purposes.

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8.192. In the circumstances the appropriate course would appear to be the adoption of measures which operate on a broad scale and which recognise to a degree the overstatement of net income currently occurring. Policies which merely result in a deferment of tax, such as the United Kingdom provision in respect of trading stock and the granting of initial allowances in respect of depreciation on new fixed assets, though helpful, will not be as effective as policies which are more lasting or permanently reduce taxes payable on business income. Measures of the latter type include reductions in rates of income tax, a LIFO method of stock valuation and investment allowances in respect of fixed assets.

8.193. In view of the appointment of the special panel and the detailed studies of which it will have the benefit, this Committee makes no recommendations as to steps which might now be taken. It stresses, however, the urgency of the need for action.