PROJECT TOPIC- EXAMINING THE EFFECTS OF INFLATION ON REPORTED PROFITS: IMPLICATIONS FOR DECISION MAKING
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.
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.
The two financial institutions to be examined in this study are First Bank Plc. and Union Bank Plc. These two finance institutions are quoted on the Stock Exchange and are therefore, deemed to be investment opportunities. First Bank Plc formally known as British Bank for West Africa was founded in 1894. Barclays Bank now known as Union Bank of Nigeria was established in 1917. These two expatriate banks dominated the Nigerian banking scene until 1933 when National Bank of Nigeria was established. The two banks have since 1972 and 1977 been taken over first by the Nigeria Government and later privatized to the Nigerian public.
PROJECT TOPIC- EXAMINING THE EFFECTS OF INFLATION ON REPORTED PROFITS: IMPLICATIONS FOR DECISION MAKING
1.2 Statement of the Problem
Financial accounting is concerned with the external requirement of persons outside the firm as well as with internal requirements of management. A number of periodic reports are prepared for management and a summarized annual report is prepared for outside parties. There are a number of basic concepts employed in financial accounting reporting such as money measurement, business entity, going concern and cost.
The impact of price level changes, as occasioned by inflation, on accounting profits attracted increased attention in recent years. These problems arise because the financial reporting concept is based on these age old concepts which for long have ignored the presence of inflation and its implication for decision-making both by management and outside users of reported profit. Secondly, overstated profits are measured in monetary terms, rising prices will include outside users to make investment decisions without appreciating the consequences of the reduced value of their investment.
Third, since reported profits are value of the purchasing power of money thus, reducing its predictive ability. Fourth, financial institutions, which benefits from rising prices also suffer from decreases in savings and investments. This is because people have become used to the idea that rising prices reduce the purchasing power of their savings and investments. Fifth, rising prices in Nigeria have led to a fall in export (not crude oil) and an increase in imports resulting in the inflation of the country’s currency and this has led to the worsening of the country’s balance of payments, a loss of its international reserves and a constant fall in the international value of the Naira.
1.3 Objectives of the Study
The main objective of this study is to examine the Effect of Inflation on Reported Profits, and its implication for decision-making (A survey of selected Financial Institutions in Port Harcourt). To achieve this main objective, the following specific objectives shall be used:
- To determine the degree of influence of accounting conventions on reported profits to outside users.
- To examine whether reported profits induce outside users to make investment decisions.
- To examine the impact of inflation on the current purchasing power of the Naira.
- To examine impact of inflation on the savings and investment in the financial institutions studied.
- To determine the extent of the relationship between inflation and the continued fall in the international value of the naira.
1.4 Research Questions
The research question which Baridam (1990:28) called research objectives were formulated from the specific objectives of the study. These are:
- What is the degree of influence of Accounting Convention on the preparation of reported profits?
- To what extent do outside users rely on reported profits in making investment decision?
- To what extent does inflation rate impact on the purchasing power of the Naira?
- How does the rate of inflation affect the level of savings and investment on banks?
- To what extent is there a relationship between the rate of inflation in the country and the continual fall in the international value of the Naira?
1.5 Formulation of Research Hypotheses
H0: There is no significant relationship between the rate of inflation in the country and the international value of the Naira.
H1: There is a significant relationship between the rate of inflation in the country and the international value of the Naira.
1.6 Significance of the Study
The study will be significant to the researcher, to Government, to Management, to the general public and to educationists. To the researcher, this study will add to his knowledge base in the subject area of the effect of inflation on reported profit and its implication for decision making. To Management and Government, this study will spur them to have a rethink in the need for inflation accounting as is done in most developed economies. To the general public, the study will help them make more rational decisions through understanding the value of their future savings and investments. To educationists, the study will not only serve as a basis for further research into impact of inflation on investment decisions, but also add to the existing knowledge base in this crucial economic study.
1.7 Scope of the Study
The scope of this study encompasses not only the effect of inflation on reported profit, and its implication for decision-making in selected financial institutions in Port Harcourt, but also, the collection of secondary and primary data, analysis of the collected data and communicating the findings of the study.
1.8 Limitations of the Study
This study finding is limited by the boundaries of the study, i.e. what the study will include and what it will leave out. The study will examine only two banks in Port Harcourt. It will not examine any other financial institutions other than First Bank and Union Bank in Trans-Amadi Area of Port Harcourt. Other constraints which the researcher encountered in the course of conducting the study included money, time, distances traveled to obtain information, researchable topic and the unwilling co-operation of respondents. However, these constraints do not in any way affect the major findings of the study.
1.9 Definition of Terms
(1) Inflation – Any general increase in the price level of the economy in the aggregate.
(2) D.C.F. – Discount Cash Flow
(3) NPV – Net Present Value
(4) Decision-making – Choice between alternative courses of action
(5) Reported Profit – Annual report of a firm’s performance