Inflation occurs whenever the supply of money exceeds the demand for goods and services. As a result, inflation reduces the purchasing power of money and raises the price of commodities and services. Recent decades have seen unprecedented price increases in many countries, resulting in inflation accounting, or accounting for changing prices. The article aims to focus on definitions, types, pros and cons, and methods of inflation accounting.
Did You Know? India's retail inflation fell to 6.77% in October 2022, its lowest level in three months.
Definition of Inflation Accounting?
Using inflation accounting, companies can factor in the impact of increasing or decreasing goods costs in some regions of the world. A company's financial position is improved in inflationary environments by adjusting financial statements according to price indexes instead of relying solely on cost accounting. In some cases, this method is also called price-level accounting.
What is the Need for Inflation Accounting?
Inflation Accounting is necessary for the following reasons:
- Using the usual accounting system, you can accurately represent the company's position.
- It is possible to differentiate between firms or companies using inflation accounting since inflation affects various firms/companies.
- You can compare companies/firms based on their performance.
- This way, the company's financial position is clear and profits are balanced.
- In addition, it helps calculate depreciation, which provides accurate information and improves decision-making.
How does Inflation Accounting work?
A company that operates in a country that experiences significant price inflation or deflation will no longer be able to use historical financial information. Certain companies can use inflation-adjusted figures to counter this issue, restating numbers to reflect current economic conditions.
International Financial Reporting Standards (IFRS) 29 guides entities with hyperinflationary currencies as their functional currencies.
Companies in this category should update their financial statements periodically to reflect current financial and economic conditions, combining cost-based financial information with price-level adjusted financial statements.
Types of Inflation Accounting
There are several types of inflation accounting methods that have been developed to address the impact of inflation on financial statements. These methods include
- Current Cost Accounting: This method adjusts the value of assets and liabilities for changes in the general price level so that the financial statements are presented in terms of current purchasing power.
- Constant Dollar Accounting: This method presents financial statements in terms of the purchasing power of a base year so that the effects of inflation are eliminated.
- General Price Level Accounting: This method adjusts both the value of assets and liabilities, as well as the income statement, for changes in the general price level.
- Hyperinflation Accounting: This method is used in situations where the rate of inflation is extremely high, and the monetary unit is not stable. It involves expressing financial statements in terms of a stable unit of measure, such as the U.S. dollar.
- Corporate Inflation Accounting: This method adjusts the value of a company's assets and liabilities for changes in the company's specific price level, rather than the general price level.
Different Methods of Inflation Accounting
Inflation accounting is done using two main methods: Current Purchasing Power (CPP) and Current Cost Accounting (CCA).
Current Purchasing Power (CPP)
The CPP method separates monetary items from non-monetary items. Using CPP, you can record a net gain or loss while making an accounting adjustment for financial entities. For non-monetary items (they do not have a fixed value), you can use a conversion factor equal to the consumer price index (CPI) at the end of the period divided by the CPI at the date of the transaction.
Current Cost Accounting (CCA)
Instead of using historical cost to value assets, the CCA approach uses fair market value (FMV). Non-monetary and monetary items are relative to current values under the CCA method.]
Advantages of Inflation Accounting
The following are some advantages of inflation accounting.
1. Observation of Fairness
The balance sheet presents an unbiased picture of the firm's financial position since the assets have been adjusted for inflation at their current values.
2. Correct Depreciation
Depreciation is calculated on face value, not historical cost when the assets' actual value is represented. Because the accurate and fair value of the business is defined and indexed with inflation, this method facilitates an easy replacement for the company.
3. Reasonable Assessment
By presenting two years' balance sheets and adjusting them for inflation, one can quickly and conveniently compare the values after deducting inflation. Since these are current values, they are not based on historical costs, which is also similar to the time value of money in some respects.
4. Reflection of True Value
Inflation accounting shows profit based on current prices and always offers a business's actual value. Thus, the current prices will be reflected in the financial statements, factoring in inflation.
5. No Overstatements
The profit and loss account would not overstate the company's income with this method.
6. Ensures Dividend Payment
Historical costs indicate a high possibility of shareholders receiving higher dividends. The inflation accounting method allows dividends and taxes to be calculated without skewed figures, unlike the cost method.
Disadvantages of Inflation Accounting
Inflation accounting has the following disadvantages.
1. It is a Never-Ending Process
Prices change forever as long as an economy experiences inflation or deflation. As a result, there is no end to this process.
2. Complicated Process
The process may become more complex with too many calculations. Ordinary people may have difficulty understanding all the adjustments.
3. Involves Subjectivity
Since adjustments to current values are not as straightforward as dynamic adjustments, you may need to apply some discretionary judgments and subjectivity.
4. Deflation Causes Exaggeration
Companies may charge less depreciation when prices fall because of deflation. Consequently, it may overstate the business's profits, which is undoubtedly harmful.
5. It is only Theoretical
Most economists consider inflation accounting a theoretical appeasement concept. Due to the subjectivity involved, there may be specific window dressing to suit individual whims and fancies.
6. It is Expensive
Most businesses cannot afford this method because it is expensive.
Limitations of Inflation Accounting
As a rule, historical cost-based financial statements do not accurately reflect an organisation's actual state of affairs. These financial statements do not reflect current values because they are based on historical figures.
However, historical cost accounting has the following advantages over other accounting systems:
- Based on real-world events and data
- Everyone understands and uses it
- Comparing figures over a specific timeframe is easy
- A tax assessment's foundation
- Historical costs make it challenging to manipulate accounting records
For shareholders and other stakeholders, inflation-adjusted financial statements are imperative.
There are, however, several objections to inflation accounting, including:
- When the concept of objectivity is violated, financial statements lose their credibility
- Most tax authorities do not accept the method
- Profits resulting from inflation accounting can sometimes be arbitrary
Therefore, no accounting system satisfies everyone with inflation accounting. Therefore, a method that accounts for inflation while maintaining objectivity and simplicity is being sought.
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Example of Inflation Accounting
A manufacturing company ABC purchased machinery for ₹10,000 in 2001. In 2009, ABC Company reinstated its financial records using inflation accounting. In 2001, the general price index was 400; in 2009, it was 600. Find the current cost of the machine purchased in 2001.
The current price index is 600
The base price index is 400
The historical cost is ₹10,000
Current costs = 600/400 X 10,000 = ₹15,000.
In the balance sheet, the closing balance of the land would be ₹15,000, which is the current cost.
The XYZ company, involved in construction, purchased the land for ₹5,000 in 1999. In 2000, the XYZ company reinstated its financial records using inflation accounting. Based on a 200 general price index in 1999 and a 300 general price index in 2000, calculate the current cost of a land parcel purchased in 1999.
As a result,
There is a current price index of 300.
The base price index is 200.
The historical cost is ₹5,000.
300/200 X 5000 = ₹7,500 is the current cost.
The current price would be ₹7,500, and the closing balance of the land would be recorded as ₹7,500 on the balance sheet.
Inflation Vs Deflation
- An economy experiences inflation when the general prices of goods and services rise.
- Conversely, deflation occurs when price levels for goods and services fall below zero per cent, indicative of a general price decline.
- According to the underlying reasons and the rate at which prices change, both can be detrimental to the economy.
Inflation accounting reflects the actual value of a business but has several drawbacks, including non-acceptance by authorities or complicated systems and processes. A financial statement's purpose is to provide a business with an accurate and fair value. Accordingly, an income statement should show the company's actual and precise profit or loss for a specific period, while a balance sheet should indicate the company's true financial position. Due to regular fluctuations in currency and money, a method such as inflation accounting is necessary to reflect accurate and fair value in financial statements. So, the business will not experience significant deviations due to this method.
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