Assume a simple service firm earns only service revenue and incurs depreciation as its most significant expense. In the current year, there is 3 percent inflation. However, due to government regulations, the firm is unable to pass on any of the inflation to its customers. In real terms, the firm’s net income is: A) understated. B) overstated. C) misstated by an indeterminable amount. D) correctly stated.
Edit: Agreeing with above now.
D. Revenues aren’t inflation because they can’t pass on their costs and depreciation is a historical number so it won’t be affected.
I agree(D), the question seems like it should ask about P/E which would be LOWER since they can’t pass on the inflation increase.
you guys are awesome. D is correct, Depreciation expense is an example of historical cost accounting (no inflation taken into account). If there is also no inflation reflected in the service revenue, then from an economic and real standpoint, the net income is correctly stated.