Accounting is based on the traditional concept of cost and revenue. Money is the yardstick for measuring profits and losses and financial health of the business – operating results and financial position. The basic objective of accounting is the preparation of financial statements in a way that they give a true and fair view of the business. That is, the income statement should disclose the true profit or loss made by the business during a particular period while the balance sheet must show a true and fair view of the financial position of the business on a particular date.
Financial statements are prepared in monetary units i.e., rupee. The medium of expression is the money value. The value of money is itself fluctuating; any measurement with an unsteady scale cannot be finite and comparable. The record-ing of business transactions under the assumption that monetary unit is stable is known as historical accounting. However, it has been our experience that over a period of time, the prices have not remained stable. There have been inflation-ary as well as deflationary tendencies. Rise in general price level, termed inflation erodes the intrinsic value of money, conversely, fall in general prices called deflation, raises its purchasing power. Inflation is a concept which every human being is not only aware of, but also painfully experiencing. The direct effect of inflation is the erosion in the purchasing power of money. The root cause of the problem is the change in the value of money.
Monetary unit is never stable and all types of countries have been experiencing high rates of inflation. The prices change as a result of various economic and social forces and such changes bring about a change in the purchasing power of money. Unless the necessary adjust-ments are made, price level changes produce distortions in the financial statements and suffer serious limitations. Financial statements, prepared according to conventional or historical ac-counting system, do not reflect current economic realities. The assumption of stable money value subject to which the financial statements are prepared is fallacious in the context of rising prices. By Inflation, we mean a rise in general price level and a fall in the value of money. Because historical rupee is not comparable to the present day rupee. Unlike physical units, such as kilogram, metre etc. is stable units in measuring weight and distance, monetary units i.e., rupee is an unstable unit of exchange value.