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.
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.
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:
The first step in inflation accounting is to determine the rate of inflation that is affecting the economy in which the company operates.
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.
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.
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.
The different methods of inflation accounting are:
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
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.
This method measures and reinstates all assets and liabilities at their current cost structure.
This method records the replacement cost, which is a parameter under all assets and liabilities in a balance sheet.
Here are some inflation accounting examples to help you understand this concept:
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?
= Current price index / Base price index x historical cost
= Rs.(600 / 400 x 10,000)
Hence, the current cost will be Rs.15,000 and recorded as the closing balance in the balance sheet.
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.
The details have been compiled in the following table:
|Jan 01, 2015||Purchase of Equipment||Rs.50,000|
|Jan 01, 2015||Consumer Price Index||150|
|Jan 01, 2022||Consumer Price Index||300|
Using the conversion factor formula,
Conversion factor (under CPP Method)
= Price at Current Period / Price at the Historical Period
= Historical price / Conversion factor
= Rs.(50000 / 2)
Hence, the revaluation cost of the equipment under the CPP method is Rs. 25,000.
The primary uses or objectives of inflation accounting are as follows:
The main advantages of inflation accounting are:
The limitations of inflation accounting are as follows :
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.
And if you are looking for mutual funds that can help you diversify your investment portfolio, here’s a tip. Try investing in Navi Mutual Fund schemes, starting at just ₹10, and get exposure to top Indian and foreign companies with just a few clicks. To check out our products, download the Navi App today.
The main objective of inflation accounting is to incorporate realism into financial statements. This is done to reflect an enterprise’s financial performance and position in an accurate and fair manner over a particular period.
The other name for inflation accounting is price-level accounting. This is because it is similar to converting financial statements into other currencies using exchange rates. For example, price level accounting takes place in countries facing hyperinflation or high inflation.
Yes, companies do consider inflation. It has been reported that 76% of small, 65% of medium and 54% of large organisations have been maintaining their inflation accounting. These reports have been provided by HR respondents who are aware of their organisation’s pay rise plans.
Although inflation affects everyone, it hurts poor people and those who have a fixed income source the most. On the other hand, borrowers and investors tend to gain from rising inflation.
Types of Fixed Deposit in 2023 – Know Different Types of FDs and How to ChooseFixed deposits (FDs) are a popular investment option offered by banks and other financial instituti... Read More »
10 Best National Pension Schemes (NPS) in India in April 2023National Pension Scheme (NPS) is a retirement benefits scheme launched by the Government of India f... Read More »
National Pension Scheme (NPS) – How to Open NPS Account?National Pension Scheme or NPS is a voluntary contribution-based retirement benefits scheme introdu... Read More »
Mahila Samman Savings Certificate Scheme -Interest Rate, Benefits and EligibilityThe Mahila Samman Savings Certificates, a fixed-income investment programme explicitly launched for... Read More »
What is a Tax Saving FD – Interest Rates, Benefits, Features and CalculationDid you know that tax-saving FDs (fixed deposit) can help you save up to Rs.46,800 on taxes? Consid... Read More »
What is Fixed Deposit – Best FD Interest Rates, Calculations and How to Apply OnlineFixed deposits (FDs) are known to offer guaranteed returns - one of the reasons why they are so pop... Read More »
12 Best Investment Plans in India in April 2023 – Returns & BenefitsWorking extra hard to earn money? Great! But, how about making your money work as well? Yes, we are... Read More »
Sukanya Samriddhi Yojana: Bank Interest Rates and How to Open a SSY AccountHonourable Prime Minister Narendra Modi launched SSY (full form - Sukanya Samriddhi Yojana) as an i... Read More »
Senior Citizen Savings Scheme (SCSS) – Interest Rate 2023The Senior Citizen Savings Scheme is a government savings scheme launched for the senior citizens o... Read More »