What is Inflation Accounting?

What is Inflation Accounting

Inflation accounting is a special technique used to factor in the impact that soaring or plummeting costs of goods in some regions of the world have on the reported figures of international companies. Financial statements are adjusted according to price indexes, rather than relying solely on a cost accounting basis, to paint a clearer picture of a firm’s financial position in inflationary environments. This method is also sometimes referred to as price level accounting.

Understanding Inflation Accounting

Inflation or deflation can cause a significant impact on an organization’s historical information and financial reports. Due to the relative change in value from inflation/deflation, the financial data ceases to be relevant and, as a result, provides very little use or value to the individuals using them.

Inflationary accounting uses index prices to create a more realistic picture of how companies and their financial positions are doing in inflationary settings. It provides more information than basic cost accounting can supply. It allows the business income and expenses to be representative and comparable with other companies and historical information.

Depending on the location, accounting standards boards (IFRS, GAAP, etc.) allow or require adjustments of financial statements in specific situations. Depending on the company and the particular standards that apply to them, they may be required to restate their financial statements periodically in order to provide reliable and valuable information about the company.

How Inflation Accounting Works ?

When a company operates in a country where there is a significant amount of price inflation or deflation, historical information on financial statements is no longer relevant. To counter this issue, in certain cases, companies are permitted to use inflation-adjusted figures, restating numbers to reflect current economic values.

See also :  What is a Special Item?

International Accounting Standard (IAS) 29 adopted by the International Financial Reporting Standards (IFRS) is the guide for entities whose functional currency is the currency of a hyperinflationary economy. IFRS defines hyperinflation as prices, interest, and wages linked to a price index rising 100% or more cumulatively over three years.

Companies that fall under this category may be required to update their statements periodically in order to make them relevant to current economic and financial conditions, supplementing cost-based financial statements with regular price-level adjusted statements.

Inflation Accounting Methods

There are two main methods used as inflationary accounting methods. The first is current purchasing power (CCP), and the second, being current cost accounting (CCA).

The current purchasing power method involves adjusting the financial statements and associated numbers to the current price. For non-monetary items, this is done by taking the historical figures and applying a specific conversion rate based on a price index.

The conversion rate is found by dividing the index price at the end of the period by the index price at the beginning of the period. Monetary items are subject to a net gain or loss during adjustment.

The current cost accounting method takes the fair market value (FMV) instead of the historical cost. With this method, all monetary and non-monetary assets must be adjusted to their current values.

Advantages

  1. Fair View: Since the assets are shown after considering and adjusting for inflation at their current values, the balance sheet represents an unbiased view of the firm’s financial position.
  2. Accurate Depreciation: When the true value of the assets is represented, depreciation is calculated on the face value of the assets and not on their historical cost. Hence, this method facilitates an easy replacement for the business as the accurate and fair value is represented, indexed with inflation.
  3. Reasonable Assessment: When balance sheets of 2 years are presented and adjusted to inflation accounting, it becomes easy and convenient to make the essential comparison as the values reflect after considering inflation. These values are thereby current and not based on historical cost. To some extent, it also feels like the time value of money.
  4. True Value Reflection: Since inflation accounting shows the current profit based on current prices, it reflects any business’s correct and updated value. Hence, the financial statements will have the figures updated as per the current prices, factoring in inflation.
  5. No Overstatements: Under this method, the profit and loss account would not be overstating the business income
  6. Keeps a Check on Dividend Payment: Based on historical cost, there is a high possibility that the shareholders may claim higher dividend payments. The inflation accounting method helps keep a check as the dividends and taxes are not calculated on a skewed figure, unlike the cost method.
See also :  What is Zero-Based Budgeting (ZBB)?

 Disadvantages

  1. Never-Ending Process: The changes in prices continue for infinity as long as there is inflation or deflation in an economy.Hence the process is never-ending.
  2. Complicated: There is a possibility that too many calculations make the process all the more complicated. There may be a lot of adjustments that may be difficult for the common person to interpret.
  3. Subjectivity: There may be certain discretionary judgments and subjectivity involved as adjustments to current values are not as simple as dynamic.
  4. Deflationary Situation Causes Exaggeration: When there is a deflationary situation, and the prices fall, a company may charge lesser depreciation. As a result, it may cause an overstatement of the business’s profits, undoubtedly harmful.
  5. Merely Theoretical: The concept of inflation accounting is considered more of theoretical appeasement. There may be the possibility of specific window dressing as per the whims and fancies of individuals owing to the subjectivity involved
  6. Expensive: This method is considered costly, and ordinary businesses may not be able to afford it.

Limitations

  1. Though the method of inflation accounting may be of use to the firm, it is not necessarily so for the income tax authorities, as they refuse it due to low acceptance in the community.
  2. Change in the price is a continuous process that can’t be averted.
  3. The system complicates the calculations due to many conversions and calculations.

Inflation Accounting