Inflation Accounting

True Tamplin

Written by True Tamplin, BSc, CEPF®
Updated on September 15, 2021

Inflation Accounting: Definition

Inflation occurs when the money in circulation exceeds the production of commodities and services. Consequently, in an inflationary environment, the purchasing power of money falls and the prices of commodities and services rise.

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.

During periods of sustained price increases, historical costs lose their relevance. As a result, they may even become misleading as measurements of economic value.

Inflation Accounting: Explanation

For economic, political, and social reasons, prices are not constant. Changes in price may be attributable to inflation or deflation. These changes in price necessitate effective inflation accounting due to the need to present accurate financial statements.

Financial statements are prepared on historical costs on the assumption that the unit of account (e.g., the dollar) has a static value. In reality, however, the value of money changes over time. For example, since the Second World War, prices have been on an upward trend.

Financial statements that are prepared based on historical costs suffer from several shortcomings in an inflationary context. These shortcomings include:

1. Fixed assets are stated at historical costs in the balance sheet; they do not show the true current worth and are often unrealistically low.

2. Depreciation is charged on the historical cost of the assets. As a result, depreciation provision is also inadequate for financing the replacement cost of fixed assets. The firm may, therefore, have to face serious problems because of the paucity of funds.

3. In the context of rising prices, there is a significant overstatement of profits since the cost of goods sold is calculated on a historical cost basis and no allowance is made for the reduction in the purchasing power of money.

Further to the last point, it is worth adding that an overstatement of profits results in heavy financial strain for the company in terms of heavy dividends, heavy taxation, and so on.

In June 1969, the Accounting Principles Board (APB) of the American Institute of Certified Public Accountants (AICPA) recommended that supplementary statements should be appended to the annual accounts of companies so as to disclose the effect of general price level changes on the financial position.

Inflation accounting seeks to incorporate realism into financial statements by adjusting them so as to reflect, in a true and fair manner, the financial performance and the position of an enterprise over a particular period.

The balance sheet, which is prepared for a specific point in time, includes items such as cash and debtors that are stated at current purchasing power. Other items, such as inventory, are stated in monetary units that reflect the purchasing power of the recent past.

Additionally, other balance sheet items, including furniture, land, plant, and equipment, are stated at historical cost.

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. If profits are overstated, it follows that costs and expenses are understated. This may lead to reporting illusory profits.

With the above considerations in mind, accountants use inflation accounting to convert monetary units with different levels of purchasing power into a single monetary unit.

Objectives of Inflation Accounting

The fundamental objective of inflation accounting is to adjust historical cost figures for substantive changes in the general level of the economy. The following are some of the specific objectives of inflation accounting:

  • To eliminate distortions in financial statements that arise due to the use of historical cost
  • To provide for more meaningful inter-period comparisons
  • To improve the meaning and measurement of income and expenses in the face of the changing purchasing power of money
  • To improve decision-making in the organization

Furthermore, inflation-adjusted information helps decision-makers in the following ways:

1. Allocation of capital is achieved through the pricing mechanism in capital markets. Prices based on financial information that is incomplete or misleading will result in poor pricing and allocation decisions.

As inflation rates vary from year to year, an element of uncertainty characterizes the activities of the business.

Additionally, although management may be aware of the need to consider inflation when making business decisions, it is hindered from doing so due to the absence of explicit recognition of the effect of inflation in financial reports.

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).

2. Management will be better equipped to tackle the problems caused by inflation and, in turn, productivity will improve in the long run.

3. Information about specific price changes for enterprises or industries can help policymakers to understand the impact of inflation on each industry. Inflation accounting also enables clearer disclosure and, in turn, helps the government in its policy decisions.

4. The public understanding of the business, as well as the various effects of inflation, increases. This means that businesses are viewed less critically by the public, can mobilize funds for expansion, can secure new investments, and also provide employment.

Methods of Accounting for Inflation

Various methods have been proposed in accounting to reflect the true changes in the purchasing power of money. However, no consensus has yet been reached on a specific solution.

Professional bodies in various countries agree that the method used for inflation accounting should be accurate, reasonable, effective, and easy to implement. The following are the main methods that have been proposed for inflation accounting:

  1. Current cost accounting (CCA) method
  2. Current purchasing power (CPP) method

Inflation and Productivity Measurement

Productivity can be measured as the ratio of sales revenue to the number of employees.

Productivity = Sales revenue / No. of employees

If the physical output and number of employees remain the same while sales price (and, hence, sales revenue) increase by 15% due to inflation, productivity will increase by 15% despite the fact that real productivity remains the same.

Intensification of Budgeting

As a result of inflation, the preparation of budgets by an organization may need to be intensified. This can help to achieve more effective use of existing resources.

An additional form of the budget, namely the requirement budget, may need to be prepared, as is presently being done by a few organizations.

Inflation and Dividend Policy

In a period of inflation, the board of directors must ensure that they are mainly distributing current earnings as dividends. During inflation, earlier costs may have been matched against revenues, with the result that net income is higher than what it would otherwise be.

The board of directors must make sure that they are not unintentionally distributing earnings from previous years.

Limitations of Inflation Accounting

Financial statements prepared on a historical cost basis do not, as a rule, depict the real state of affairs of the organization. This is because the figures presented in such financial statements are not reflective of present-day values.

Nevertheless, accounts prepared on the basis of historical cost have the following advantages over other systems of accounting:

  1. Based on actual events and data
  2. Widely used and understood by all
  3. Easy comparison of figures over a specific period
  4. The foundation of tax assessments
  5. Manipulation of accounting records is difficult under historical costs

Thus, there is an imperative need for inflation-adjusted financial statements to be presented to shareholders and other interested parties. However, there are several objections to inflation accounting, including:

  • The financial statements lose their credibility as the concept of objectivity is violated
  • The method is not acceptable to most tax authorities
  • Inflation accounting may sometimes result in arbitrary profits

Thus, the main problem with inflation accounting is that no accounting system has been developed that satisfies everyone. As such, and the search is on for a method that accounts for inflation while still retaining objectivity and simplicity in implementation.

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