Inflation Accounting- Meaning, Top 2 Methods, Examples

Inflation accounting is crucial for businesses, investors, and policymakers, especially in economies experiencing high inflation rates. It allows for better comparison over time, giving a more realistic view of a company’s profitability, operational efficiency, and value. Without inflation accounting, financial statements can significantly overstate or understate the value of assets, equity, and income, potentially leading to misinformed decisions by investors, creditors, and other stakeholders. 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. The accounting adjustment for monetary items is subject to the recording of a net gain or loss.

Constant-dollar accounting

1. Inflation accounting is a form of accounting that adjusts financial statements to account for inflation’s effects on the purchasing power of money.
2. When the general price level increases rapidly, the reported profits of a company that has a major proportion of its assets stated at historical cost are overstated.
3. This is very difficult to do with information based on the historical cost that is no longer applicable.
4. IFRS permitted international businesses with subsidiaries in Argentina to continue using the peso for their accounts, provided they restate them to adjust for inflation.
5. However, the real purpose of a financial statement is to provide an accurate and fair value to the business.

Consider a company that purchased a piece of machinery five years ago for $100,000. In traditional accounting, this machinery would still be valued at its historical cost. However, if there has been significant inflation since the purchase, the current replacement cost of the machinery might be $150,000.

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. Chief among them, matching current revenues with current costs provides a much more realistic breakdown of profitability. This method measures and reinstates all assets and liabilities at their current cost structure. The first step in inflation accounting is to determine the rate of inflation that is affecting the economy in which the company operates.

The aim is to ensure that financial statements offer a true representation of a company’s financial health during inflationary periods, allowing stakeholders to make more informed decisions. To ensure that the company’s financial statements accurately reflect the expected effects of inflation on its operations, the inflation rate is factored into future financial projections. It requires selecting an appropriate method and indices for adjustment, which can be complex and subjective. Furthermore, inflation accounting can increase the complexity of financial reporting and might not be easily understood by all stakeholders. Also, there can be discrepancies in how different companies apply inflation accounting principles, making it harder to compare financial statements.

The company’s historical financial statements are adjusted to reflect the effects of inflation. This involves restating the values of assets, liabilities, revenues, and expenses to their current values based on the inflation rate. As noted earlier one of the effects of inflation is that over time prices become meaningless. Assets purchased long ago may have a historical cost that is meaningless in today’s money. The objective of inflation accounting, in this case, is to record values of assets, liabilities, income and expenditure at levels commensurate with the present value of money. CPP stands for current purchasing power; CCA stands for current cost accounting.

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Thus, there is an imperative need for inflation-adjusted financial statements to be presented to shareholders and other interested parties. Professional bodies in various countries agree that the method used for inflation accounting should be accurate, reasonable, effective, and easy to implement. Additionally, other balance sheet items, including furniture, land, plant, and equipment, are stated at historical cost. Due to the unprecedented pressure of inflationary price increases in most countries in recent decades, accounting for changing prices, which is known as inflation accounting, has become synonymous with accounting for inflation. From the below-given data, compute the net monetary gain or loss per the CPP method.

In a hyperinflationary environment capital employed at historical cost would be a small number giving the illusion objectives of inflation accounting of high performing management. The objective of inflation accounting is to present a realistic capital employed figure to measure performance against. The Current Cost accounting approach values assets at their fair value in the market rather than the price incurred during the purchase of the fixed asset. Under this method, both monetary and non-monetary items are restated to current values. This is not always practical especially in a hyperinflationary environment where prices can move daily or hourly. Using a similar method to CPP of applying a conversion factor based on the index is more appropriate though it may not always be accurate.

What Are CPP and CCA Short for in Inflation Accounting?

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The process of adjusting accounts to factor in price changes can result in financial statements being constantly restated and altered. Usually, when a company operates in an inflationary or deflationary environment, historical information may no longer be relevant. Hence, inflation-adjusted values would go on to accurately reflect the current values. Contrary, inflation accounting can actually complicate the financial statements and make it harder for investors and other users of the statements to understand what the numbers mean.

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Historical cost accounting has a bias towards recent figures while understating older figures. 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. Financial statement users do not stop at looking at the absolute figures shown in the financial statements. It is customary to conduct financial statement analysis through financial ratios to determine the performance, profitability and efficiency of a business. One of the most important of these is Return on Capital Employed which tells users how well management has utilised capital available to them.

The percent inflation rate is calculated as the CPI at the end of the period divided by the CPI at the beginning of the period multiplied by 100. Although inflation affects everyone, it hurts poor people and those who have a fixed income source the most. Here’s an illustration showing that Mr. X purchased equipment on January 01, 2015, for Rs. 50,000. On that day, the consumer price index was at 150, whereas it changed to 300 on January 01, 2022. Due to this, it is necessary to reflect the value revaluation of the equipment under the CPP method. A financial professional will offer guidance based on the information provided and offer a no-obligation call to better understand your situation.

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The new value of the equipment in 2020 would be $20,000 based on the conversion factor of 2 (600/300). The new value would be recorded on the balance sheet as the closing equipment balance at the end of the period. Financial statements prepared on a historical cost basis do not, as a rule, depict the real state of affairs of the organization. The system of inflation accounting, if introduced, will help the various parties who have an interest and stake in the business (e.g., shareholders, employees, external users, management, and government).

In the balance sheet, it adjusts the values of assets, liabilities, and equity to reflect current values. In the income statement, it impacts the calculation of cost of goods sold, depreciation, and could lead to the recognition of gains or losses due to holding net monetary items. The aim is to ensure that both the performance and financial position of the company are not distorted by the effects of inflation. Inflation accounting is a form of accounting that adjusts financial statements to account for inflation’s effects on the purchasing power of money.

The objective of inflation accounting is to counter this by bringing values up to today’s levels. Hyperinflation also creates a bias towards more recent income which creates an opportunity for window dressing financial statements. One of the key requirements of financial statement information is that it be comparable to other organisations and also to the same organisation through time. In high inflation or hyperinflationary environments, this is not possible because of the aforementioned distortions. The objective of inflation accounting methods here is to make information comparable through time. This adjustment is not limited to assets only but also affects the valuation of inventories, depreciation, and even capital.