Inflation Accounting (Meaning, Examples) | Top 2 Method with Explanation

Inflation Accounting Meaning

Inflation accounting is referred to the method used to report financial statements by factoring in the impact of soaring or plummeting costs of various goods, which are adjusted according to price indexes to present a clear picture of the firm’s financial position usually in times of inflationary environments.

Usually, when a company operates in an inflationary or even a deflationary environment, in such cases, historical information may no longer be of relevance and hence inflation-adjusted values would go on to accurately reflect the current values.

Inflation Accounting Methods

Generally, there are 2 types of inflation accounting methods

#1 – Current Purchasing Power

Under this method, the monetary, as well as the non-monetary items, are separated with monetary items recording only a net gain or loss, whereas the non-monetary items will be updated into figures with a certain conversion factor that is equivalent to a certain price index

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

#2 – Current Cost Accounting

Under this method, the assets are valued at their fair market value (FMV) rather than at their historical cost which was recorded during the purchase of the fixed asset.

How Inflation Accounting Works?

Let us see how inflation accounting works along with some examples –

You can download this Inflation Accounting Excel Template here – Inflation Accounting Excel Template

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Example 1

Let us consider an illustration where Mr. John had purchased equipment in the year 2012 for a price of $50000 on the 1^st of January. The Consumer Price Index as of that day stood at 150 whereas currently, it is reflecting 300 as of 1^st January 2019. We are now required to reflect the revalued value of the equipment under the CPP method.

The details are summarised as follows

Applying the conversion factor formula

Conversion factor under CPP Method = Price at Current Period / Price at the Historical Period

(300/150=2)

Hence the revaluation of the equipment under the CPP method stands at $25,000 ($50000/2)

Example 2

From the below-given data, compute the net monetary gain or loss as per the CPP method.

Solution:

Monetary gain on holding liabilities –

Monetary gain on holding liabilities =Rs.86,250 – Rs.60,000
= Rs.26,250

Where, Value as per closing balance sheet =Credits + Public Deposits =Rs.60,000

Monetary loss on holding a monetary asset

Monetary loss on holding monetary asset = Rs70,125 – Rs49,500
= Rs.20,625

Calculation of Net Monetary Gain is as follows,

Net Monetary gain = Rs.26,250 -Rs20,625]
=Rs.5,625

Advantages of Inflation Accounting

There are certain advantages of resorting to the method of inflation accounting described as under

Fair View: Since the assets are shown after considering and adjusting for inflation, at their current values, the balance sheet goes on to represent a fair view of the financial position of the firm
Accurate Depreciation: When the true value of the assets is represented, depreciation will now be calculated on the value of the assets to the business and not on all of its historical cost. Hence this method would go on to facilitate an easy replacement for the business as the accurate and fair value will be represented, indexed with inflation
Reasonable Assessment: When balance sheets of 2 years are presented and adjusted to inflation accounting, it then becomes easy and convenient to make the necessary comparison as the values will be reflected after considering inflation. These values are thereby current and not based on historical cost. To some extent, it also considers the time value of money
True Value Reflection: Since inflation accounting would go on to show the current profit based on current prices, it reflects the correct and updated value of any business. Hence the financial statements will have the values updated as per the recent current prices, factoring in the inflation
No Overstatements: Under this method, the profit and loss account would not be overstating the business income
Keeps a Check on Dividend Payment: Based on historical cost, there is a high possibility that the shareholders may make a claim for higher dividend payment. The inflation accounting method helps to keep a check on the same as the dividends and taxes will now not be calculated on a skewed figure unlike historical cost method

Disadvantages of Inflation Accounting

There are no doubt certain disadvantages too of this system as highlighted below:

Never-Ending Process: The changes in prices continue for infinity as long as there is inflation or deflation in an economy. Hence the process is never-ending
Complicated: There is a possibility that too many calculations make the process all the more complicated. There may be a lot of adjustments which may be difficult for the common man to interpret
Subjectivity: There may be certain discretionary judgments and subjectivity involved as adjustments to current values is not so simple as it is a dynamic thing in itself
Deflationary Situation Causes Exaggeration: When there is a deflationary situation and the prices fall, a company may charge lesser depreciation. This may cause an overstatement of the profits of the business, which again is no doubt harmful
Merely Theoretical: The concept of inflation accounting is considered to be more of theoretical appeasement as there may be the possibility of certain window dressing as per the whims and fancies of individuals owing to the subjectivity involved
Expensive: This method is considered expensive and ordinary business may not be pretty well able to afford and resort to this method

Limitations

Though the method of inflation accounting may be of use to the firm it is not necessarily so for the income tax authorities as they refuse this method owing to low acceptance in the community
Change in the price is a continuous process which can’t be averted.
The system makes the calculations to complicated due to many conversions and calculations.

Final Thoughts

Inflation accounting no doubt reflects the true value of the business but suffers from certain drawbacks such as non-acceptance by authorities or complications involved in the systems and process. However, the true purpose of a financial statement is to provide a true and fair value of the business. The income statement must show the true and accurate profit or loss of the business during a certain period and the balance sheet must accordingly reflect again the fair and true financial position.

Since they are represented in monetary value and currency/money fluctuates on a regular basis, it becomes necessary that a method such as inflation accounting serves its purpose by enabling the financial statements to reflect such true and fair value accordingly. This method thus ensures that there will be no significant deviations on the part of the business.