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) correctly stated. C) overstated. D) misstated by an indeterminable amount Explain.
B. I believe. Depreciation should not be affected by inflation increases so its correctly stated.
B? nothing is affected in REAL TERMS
If service revenue can’t pass on the inflation then sales don’t reflect any inflation. Depreciation won’t have any inflation in it either because it is based on historical costs. I agree with thepinkman EDIT: and dinesh B.
Well done…it is B. My thought was that depreciation is based on historical costs so as an estimate of replacement costs, it overstates earnings.
can someone throw in a numerical example for this… i sorta understand the concept…but feel it would be drilled in if i saw the numbers… we are after all…number crunchers 
Makes sense in REAL terms because in real terms a firm’s operation is what it is and inflation should not count. What about if it were nominal terms? If you have inflation of 3% but depreciation takes into account historical prices I would assume that depreciation would be less than needed and therefore the income would be overstated. any thoughts?
Overstated in that case!