Tax Accounting For Inflation And Devaluation: The Case Of Indonesia

The adjustment required to correct “generally accepted accounting principles” for the impact of inflation or devaluation, has been the subject of a protracted debate in accounting and taxation literature. As an outcome of that discussion, it is now generally recognized that inflation affects the estimation of income and taxes using conventional accounting procedures in at least five different ways. First, depreciation expenses or capital cost allowances become underestimated because they are usually calculated as a fraction of the historical cost of fixed assets, not their current inflated values. Second, the cost of goods sold tend to be underestimated, and income over-estimated, if goods used from inventories are valued on a first in first out basis rather than at their current (adjusted for inflation) costs. Third, nominal interest rates tend to rise due to the compensation required by lenders for the decrease in the real value of the principal outstanding due to inflation. This tends to create a significant immediate increase in the cash outflow of the business relative to the increase in cash inflow due to inflation.