What is Inflation Accounting ? – Methods, Examples, Benefits and Working

Inflation accounting is a strategy to factor the rising costs of goods around the world in the financial statements of companies during inflation. These costs are adjusted according to the figures reported by the international companies, which helps to present a clear picture of the firm’s financial position.

The reported figures rely on price indexes rather than simply depending on a cost accounting basis and are often used during times of inflation. Furthermore, this method is also referred to as price-level accounting due to its dependency on price indexes.

Read on to understand how inflation accounting works, different methods of inflation accounting, its examples, benefits and limitations. 

What is Inflation Accounting?

Inflation accounting is a type of accounting that takes into account the effects of inflation on a company’s financial statements. It adjusts the company’s financial statements to reflect changes in the purchasing power of the currency, which is necessary because inflation can distort the accuracy of financial reporting.

Inflation accounting allows for a more accurate representation of a company’s financial position and performance over time by adjusting historical financial statements to current prices, and by incorporating inflation adjustments into future financial projections. 

How Does Inflation Accounting Work?

Inflation accounting works by adjusting a company’s financial statements to account for changes in the purchasing power of the currency due to inflation. Here are the basic steps involved in inflation accounting:

1. Identify the Inflation Rate

The first step in inflation accounting is to determine the rate of inflation that is affecting the economy in which the company operates.

2. Adjust Historical 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.

3. Use Appropriate Indices

The financial statements are adjusted using appropriate inflation indices, such as the consumer price index (CPI) or the wholesale price index (WPI), depending on the nature of the company’s operations.

4. Apply the Inflation Adjustment to Future Projections

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.

Methods of Inflation Accounting

The different methods of inflation accounting are:

1. Current Purchasing Power (CPP) Method

Under this method, money and non-monetary elements are separated to only record net profit or loss. In addition, non-monetary components are updated into figures using a conversion factor equivalent to a specific price index. The formulas under this method are:

Conversion Factor (under CPP Method) = Price at Current Period / Price at Historical Period

CPP Value = Conversion Amount or Historical Value x Conversion Factor

2. Current Cost Accounting (CCA) Method

This method evaluates assets at their Fair Value Market (FMV) rather than their historical cost during the fixed asset purchase. However, this method restates both monetary and non-monetary elements to their current values.

3. Current Value Method

This method measures and reinstates all assets and liabilities at their current cost structure. 

4. Replacement Cost Accounting Method

This method records the replacement cost, which is a parameter under all assets and liabilities in a balance sheet.

Also Read

What is Accounting Conservatism in Finance and How Does it Work?

Accounting Cycle – Benefits, Limitations, Working with 5 Important Steps 

Inflation Accounting Examples

Here are some inflation accounting examples to help you understand this concept: 

Example 1

ABC Ltd. Company was involved in manufacturing and purchasing machinery in 2014 for Rs. 10000. This company is using an inflation accounting technique to reinstate its financial records for the year 2022. What will be the current cost of the machine purchased in the year 2014 if the general price index in 2014 was 400 and in 2022 was 600?

Solution

• Current price index = 600
• Base price index = 400
• Historical Cost = Rs.10,000

Therefore,

• Current Cost 

= Current price index / Base price index x historical cost

= Rs.(600 / 400 x 10,000) 

= Rs.15,000. 

Hence, the current cost will be Rs.15,000 and recorded as the closing balance in the balance sheet.

Example 2

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.

Solution

The details have been compiled in the following table:

Using the conversion factor formula,

Conversion factor (under CPP Method)

= Price at Current Period / Price at the Historical Period

= 300/150

= 2

Therefore, 

• Revaluation cost

= Historical price / Conversion factor

= Rs.(50000 / 2)

= Rs.25000

Hence, the revaluation cost of the equipment under the CPP method is Rs. 25,000.

Objectives of Inflation Accounting

The primary uses or objectives of inflation accounting are as follows:

1. It allows compensation for the change in expenses over time and makes sure of the accurate projection of future costs
2. It eliminates distortions in financial statements due to historical costs
3. It provides meaningful inter-period comparisons
4. Inflation accounting is necessary for companies with fixed assets that get depreciated at a specific rate
5. It improves the quality of decision-making in an organisation
6. If a company is manufacturing goods and services subject to inflation, inflation accounting helps in keeping track of changing expense value over time
7. It improves the measurement of revenue and expenses in the face of changing purchasing power parity

Advantages of Inflation Accounting

The main advantages of inflation accounting are:

1. Inflation accounting reflects the current balance sheet of a company and not the historical one
2. It is helpful during general inflation or hyperinflation, as during such cases, it delivers a lot of benefits to its customers
3. It enables more realistic and comparable statistical analysis of the financial statements of other companies profit and loss in inflation accounting reflects the true condition of a company
4. It provides meaningful financial ratios with current value adjustments

Disadvantages of Inflation Accounting

The limitations of inflation accounting are as follows : 

1. Inflation accounting is a complicated process, making it more difficult to reinstate the figures of the company and present these to the investors.
2. It creates moral hazard issues for businesses that deceive customers with their finances.
3. It leads to many restatements and financial statements that are continuously changing.
4. During deflation, the depreciation cost will be low, which does not reflect the actual financial situation of an entity.

Final Word

Inflation accounting is a method of tracking the changing value of an asset that is subject to inflation. One of the biggest challenges is keeping track of all the expenses subject to inflation. Moreover, it is also challenging to keep track of all the expenses related to the cost of production.

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