What is Inflation Accounting and How it Depicts the Financial Position of Companies
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.
How Does Inflation Accounting Work?
When a country experiences a considerable amount of price inflation or deflation, historical information on the financial accounts of a company becomes irrelevant. However, to resolve this problem, companies are sometimes allowed to use inflation-adjusted figures, stating numbers that depict the current economic value of goods and services.
International Accounting Standard (IAS) is a guide for entities that works with a functional currency of a hyperinflationary economy. The IAS has been adopted by the International Financial Reporting Standards (IFRS), defining hyperinflation as prices linked to a 100% rise or more over three cumulative years.
Companies falling under the above-mentioned category may require updating their statements regularly to make them consistent with the current economic conditions of the country. In addition, inflation accounting helps to develop cost-based financial statements with regular price-level adjusted financial statements.
What Are the Uses of Inflation Accounting?
The primary uses or objectives of inflation accounting are as follows:
- It allows compensating for the change in expenses over time and makes sure of the accurate projection of future costs
- It eliminates distortions in financial statements due to historical costs
- It provides meaningful inter-period comparisons
- Inflation accounting is necessary for companies with fixed assets that get depreciated at a specific rate
- It improves the quality of decision-making in an organisation
- If a company is manufacturing goods and services subject to inflation, inflation accounting helps in keeping track of changing expense value over time
- It improves the measurement of revenue and expenses in the face of changing purchasing power parity
What Are the Different Methods of Inflation Accounting?
The different methods or types 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.
Examples of Inflation Accounting
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:
| Date | Details | Figures |
| 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
= 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.
What Are the Advantages of Inflation Accounting?
The main advantages of inflation accounting are:
- Inflation accounting reflects the current balance sheet of a company and not the historical one
- It is helpful during general inflation or hyperinflation, as during such cases, it delivers a lot of benefits to its customers
- It enables more realistic and comparable statistical analysis of the financial statements of other companiesProfit and loss in inflation accounting reflect the true condition of a company
- It provides meaningful financial ratios with current value adjustments
What Are the Disadvantages of Inflation Accounting?
The limiting disadvantages of inflation accounting are:
- Inflation accounting is a complicated process, making it more difficult to reinstate the figures of the company and present these to the investors.
- It creates moral hazard issues for businesses that deceive customers with their finances.
- It leads to many restatements and financial statements that are continuously changing.
- During deflation, the depreciation cost will be low, which does not reflect the actual financial situation of an entity.
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Final Word
Inflation accounting is a method of tracking the changing value of an asset that is subject to inflation. Here, 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 cost of production.
FAQs
Ans: 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.
Ans: 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.
Ans: 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.
Ans: 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.
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