Inflation Accounting

What Is Inflation Accounting?

Inflation accounting is a unique method used to assess the impact of changing product prices on the financial statements of businesses, ranging from small local stores to large multinational corporations. This approach has gained popularity due to widespread inflationary pressures in many countries in recent decades.

During periods of continuous price increases, traditional accounting methods may lose relevance. Historical expenses can become misleading indicators of economic value. In response, inflation accounting, also known as price level accounting, suggests rather than relying exclusively on cost accounting, financial statements are modified by price indexes to provide a clearer picture of a firm's financial status in inflationary environments. 

This specialized accounting approach is only utilized during inflationary periods when the overall level of prices has been consistently high for three consecutive quarters. It entails documenting the business's revenue and expenditure at current prices, adjusting all three company accounts, and then analyzing the firm's trend.

This accounting method aims to inject reality into financial statements by altering them to accurately and fairly reflect a company's financial performance and position over a certain period.

The balance sheet, created for a specific period, presents items like cash and debt at their actual buying power. Other goods, such as inventories, represent true buying power in monetary terms. Other balance-sheet assets, such as furnishings, land, plant, and equipment are recorded at historical cost, possibly accounting for any appreciation or depreciation.

As a result, financial statements made without accounting for changes in the buying power of the monetary unit lose importance. As a result, there is a push for businesses to provide inflation-adjusted financial statements. The subject "inflation accounting" studies the various methods for adjusting financial accounts to changing prices.

How does Inflation Accounting work?

When a corporation works in a nation with high price inflation or deflation, past information on financial accounts becomes obsolete.

To address this issue, corporations are authorized, in some situations, to utilize inflation-adjusted statistics, restating data to reflect actual economic realities.

International Financial Reporting Standards (IFRS) IAS 29 governs organizations whose functional currency is the currency of a hyperinflationary economy.

The IFRS defines hyperinflation as rates, debt, and salaries related to a price index that grows by 100 percent or more over three years.

Businesses in this category may need to modify their accounts frequently to keep them relevant to current economic and financial situations, augmenting cost-based financial statements with price-level adjusted statements.

These businesses must keep track of the changing value of their costs, profits, assets, etc. over time. This helps companies account for changes in their spending and ensure that they appropriately estimate future budgets.

Furthermore, suppose your organization manufactures goods and services vulnerable to inflation, which most are. In this case, you must utilize price level accounting to keep track of the changing prices of your costs over time.

Similarly, financial accounting should be used if your organization has fixed assets that depreciate at a specified rate.

Inflation Accounting Objectives

Price level accounting standards aim to offer consistent, understandable accounting methods in periods of inflation. 

• Consistent Accounting Methods in Inflationary Periods: Inflation accounting standards strive to provide consistent and understandable accounting methods when dealing with inflation.
• Reflecting Actual Financial Situation: The goal is to reflect a company's true financial situation by adjusting all books of accounts to current prices.
• Determining True Profitability: Inflation accounting updates records using current price indexes to accurately determine true profitability by stating all costs and income in current dollars.
• Proper Depreciation Calculation: Instead of using historical values, inflation accounting calculates depreciation based on the present value, facilitating accurate investment valuation.
• Comparing Performance: Inflation accounting helps companies compare performance over different time periods, enabling quick assessment of profitability while adjusting for price fluctuations.
• Accurate Information for Stakeholders: It provides accurate information to shareholders and employees based on the latest price level, potentially reducing demands for higher compensation due to inflation.
• Uniform Purchasing Power: The goal is to create a single economic unit with consistent purchasing power for evaluations and calculations by accounting for different monetary units' buying powers.

Inflation accounting seeks to address these objectives and challenges, helping companies present more accurate financial information during times of changing price levels.

Accounting for inflation can compromise the core goal of describing what happens inside a period or at a particular moment.

Inflation accounting Features

Inflation accounting comes with important features that help show accurate financial details when prices change. It helps compare earnings over time and makes sure decisions are well-informed.

• Reflecting Fundamental Financial Status: It makes market price adjustments in financial statements, revealing a company's core financial situation by accounting for current pricing trends.
• Enabling Accurate Inter-Period Comparison: Bringing all costs and income up to date allows for precise comparison of earnings over different time periods.
• Automated Adjustment for Price Changes: Inherent and automated method for modifying company accounts in response to price level increases, accurately depicting the company's position.
• Checking Deceptive Historical Cost Effects: Keeps a vigilant eye on historical cost concepts that might inflate profits, leading to higher taxes and employee demands.
• Removing Inaccuracies from Previous Data: Discipline of accounting that eliminates inaccuracies caused by previous data through price level reporting changes.
• Ensuring Accurate Financial Accounts: Amends statistics, and aligns current revenues with current costs, ensuring financial account accuracy.
• Robust Tool for Efficient Decision-Making: Price-level accounting provides reliable, current data that aid managers in making sound judgments after revisions.

Inflation accounting's features enhance financial accuracy and decision-making in changing price scenarios.

Inflation Accounting Methods

There are two main methods to perform inflation accounting:

1. Current Purchasing Power (CPP)

Current purchasing power requires businesses to record and report their financial accounts using historical statistics. A universal price index converts various statistics from a company's financial statements.

The purchasing power of money is prioritized in this strategy, whereas changes in item prices are ignored. The CPP technique entails restating historical figures at current buying power. Historical statistics must be multiplied by conversion factors for this purpose.

It divides all assets and obligations into two categories: monetary items and non-monetary items. 

Monetary items are assets and liabilities whose values are only receivable or payable at their present financial worth, for example,

• Cash
• Accounts payable
• Accounts receivable

Non-monetary objects cannot be stated in a set monetary value. These are assets and liabilities that do not have particular financial claims—for example,

• Land
• Construction
• Other non-monetary accounts

2. Current Cost Accounting (CCA)

Under the current cost accounting approach, assets are reported in financial statements, such as the balance sheet and income statement, at their current price rather than their historical cost or original value.

Profit is calculated using the asset cost at the time of sale rather than the actual cost. Depreciation is added to current values, preventing profit overvaluation and preserving capital. 

A comprehensive inflation accounting system provides a more accurate perspective of the company by effectively accounting for all price increases.

The business’ profit under CCA can reveal how the company has benefited financially from the increase in the price level, something neglected by historical cost accounting.

Proponents of CCA claim that distinguishing operating profit from holding profits and losses improves the relevance of the information it provides.

Advantages of Inflation accounting

Some of the advantages are: 

• Firms may provide a more accurate picture of their financial status using price level accounting. It is the process of making changes to reconcile current revenues with current costs.

• It makes firm profit comparisons fairer by updating all financial accounts to the current value. The profitability of two different plants acquired at separate times may be quickly compared since it is determined at present value rather than historical cost.

• It lets a corporation offer a realistic image of its balance sheet by adjusting it for inflationary effects. As in historical accounting, all assets are displayed at their current valuations rather than distorted values.

• It helps the company preserve its actual capital by keeping an eye on dividend payments to its shareholders. It guarantees that dividends and taxes are paid based on current adjusted profits rather than profits exaggerated in previous accounting.

• It aids in computing the correct amount of depreciation by using the asset's current value as the basis for charging depreciation rather than its one-time cost. Furthermore, precise depreciation computation allows organizations to replace assets easily.

• It eliminates the possibility of financial statements over or understating firm income. Under this accounting method, all financial statements are modified to reflect the present economy based on the current price index.

Disadvantages of Inflation accounting

Some of the disadvantages are: 

• The major disadvantage of price level accounting is that price changes are a never-ending process that occurs indefinitely. Changing financial statements for every period as inflation or deflation occurs becomes a time-consuming operation.

• It may result in an overstatement of strong earnings during deflationary periods, which is damaging. 

• Prices decrease abruptly during periods of deflation; modifications to the price level at this time will result in the corporation charging less depreciation, leading profits to be exaggerated.

• It is just a theoretical practice since it involves the window dressing of accounting ideas to fit the needs of consumers.

• This accounting method is quite costly. As a result, small firms cannot afford to include it in their operations.

• It is a difficult skill to master since it necessitates several modifications to financial statements. 

• Multiple computations and possibly undesired changes must be done, making it a challenging chore for the average person. In addition, price changes are ongoing, making it challenging to restate the company's data and show the financial statements each time.

• Extensive computations and modifications are required. These cannot be performed by unskilled accountants and bookkeepers.

Inflation accounting Example

The first example of price level accounting is as follows. Company ABC is in the manufacturing business and purchased machinery in 2003 for $15,000. 

The company used the price level accounting method to restore records in 2010. Find the current cost of the machine purchased in the year 2001.

The general price index in 2003 was 500 and 800 in 2010. This means that:

Historical cost = $15,000

Basic price index = 400

Current price index = 800

Current cost = (Current price index/Basic price index)*historical cost = (800/400)*15,000 = $30,000

So, the current value is $30,000, which would be recorded as the closing balance on the balance sheet.

The second example is as follows. Company XYZ operated in construction and acquired a plot of land in 2002 for $10,000. XYZ is employing inflation accounting to restore its financial information to 2003. 

Determine the current cost of a property lot acquired in 2002 if the general price index in 2002 was 400 and 500 in 2003. This means that:

Historical cost = $10,000

Basic price index = 400

Current price index = 500

Current cost = (Current price index/Basic price index)*historical cost =(500/400)*10,000 = $12,500

So, the current cost is $12,500, which would be recorded as the closing balance on the balance sheet.

Researched and authored by Ajay Kumar Sahoo | LinkedIn

Reviewed and edited by James Fazeli-Sinaki | LinkedIn

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