Inflation accounting is used during times of increasing or plummeting prices in certain areas of the world, usually with respect to multinational corporations and their financial reporting. Most often, it is seen in countries with high inflation. As a result, some accounting standards boards and countries permit or require the companies to restate their financial statements.
Understanding Inflation Accounting
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.
Inflationary accounting uses index prices to create a more realistic picture of how companies and their financial positions are doing in inflationary settings. It provides more information than basic cost accounting can supply. It allows the business income and expenses to be representative and comparable with other companies and historical information.
Depending on the location, accounting standards boards (IFRS, GAAP, etc.) allow or require adjustments of financial statements in specific situations. Depending on the company and the particular standards that apply to them, they may be required to restate their financial statements periodically in order to provide reliable and valuable information about the company.
Inflation and Deflation
Inflation accounting is used directly to compensate for the effects of inflation or deflation. Inflation is the gradual decline of purchasing power each dollar has due to price increases over time. Deflation is a similar concept; it is the gradual decline in purchasing power over time. Both inflation and deflation are not specific to one product or service, but rather, entire industries and markets.
Small amounts of inflation are considered healthy for the economy. For example, the Canadian government aims to keep inflation at 2%. Such a small amount of inflation does not require inflationary accounting. When inflation (or deflation) becomes too great, often referred to as hyperinflation or stagflation, inflationary accounting becomes necessary.
Inflation Accounting Methods
There are two main methods used as inflationary accounting methods. The first is current purchasing power (CCP), and the second, being current cost accounting (CCA).
The current purchasing power method involves adjusting the financial statements and associated numbers to the current price. For non-monetary items, this is done by taking the historical figures and applying a specific conversion rate based on a price index.
The conversion rate is found by dividing the index price at the end of the period by the index price at the beginning of the period. Monetary items are subject to a net gain or loss during adjustment.
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.
Benefits and Drawbacks
Inflation accounting comes with both benefits and drawbacks. The main benefit comes from the adjusted numbers’ value to internal users, external users, and the government. It allows for more realistic and comparable data relative to other companies and historical financial statements of the same company.
Current revenues for a period are hard to compare to historical costs if inflation or deflation is too great. Therefore, inflation accounting provides a significant benefit to its users in such situations.
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. It can also create a moral hazard issue for companies that try to mislead individuals with their financials by seeing them from this different perspective. As well, it can lead to many restatements and constantly changing financial statements.
A company is using inflation accounting to adjust its equipment value in 2020. The equipment was purchased for $10,000 in 2005 when the price index was at 300. In 2020, the price index is now 600.
To find the new value using the CPP method, multiply the historical cost by the conversion factor.
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.
Inflation accounting is used in times of significant inflation or deflation. It is used to adjust accounting numbers and financial statements to reflect more accurate representations of the costs and incomes at a given time.
Inflation accounting methods can only be used if permitted by accounting standards which vary depending on the reporting location and the accounting standards being followed. The two main inflation accounting methods are current purchasing power (CPP) and current cost accounting (CCA). Both methods can result in very positive impacts on understanding the actual financial value of a company.
Learn accounting fundamentals and how to read financial statements with CFI’s free online accounting classes.
These courses will give the confidence you need to perform world-class financial analyst work. Start now!
Building confidence in your accounting skills is easy with CFI courses! Enroll now for FREE to start advancing your career!