Inflation Accounting Meaning
Inflation accounting refers 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. Hence, inflation-adjusted values would go on to accurately reflect the current values.
Inflation Accounting Methods
Generally, there are two types of 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 particular conversion factor that is equivalent to a certain price index.
#2 – Current Cost Accounting
Under this method, the value of the assets at fair market value (FMV) rather than their historical cost recorded during the purchase of the fixed assetFixed AssetFixed assets are assets that are held for the long term and are not expected to be converted into cash in a short period of time. Plant and machinery, land and buildings, furniture, computers, copyright, and vehicles are all examples..
How Inflation Accounting Works?
Let us consider an illustration where Mr. John had purchased equipment in the year 2012 for a price of $50000 on the 1st of January. The Consumer Price IndexConsumer Price IndexThe Consumer Price Index (CPI) is a measure of the average price of a basket of regularly used consumer commodities compared to a base year. The CPI for the base year is 100, and this is the benchmark point. as of that day stood at 150, whereas currently, it is reflecting 300 as of 1st January 2019. We are now required to reflect the revalued value of the equipment under the CPP method.
The details are summarised as follows
|1-Jan-12||Purchase of Equipment||$5,000|
|1-Jan-12||Consumer Price Index||150|
|1-Jan-19||Consumer Price Index||300|
Applying the conversion factor formula
Conversion factor under CPP Method = Price at Current Period / Price at the Historical Period
Hence the revaluation of the equipment under the CPP method stands at $25,000 ($50000/2)
From the below-given data, compute the net monetary gain or loss as per the CPP method.
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 sheetBalance SheetA balance sheet is one of the financial statements of a company that presents the shareholders' equity, liabilities, and assets of the company at a specific point in time. It is based on the accounting equation that states that the sum of the total liabilities and the owner's capital equals the total assets of the company. =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]
- Fair View: Since the assets are shown after considering and adjusting for inflation, at their current values, the balance sheet goes on to represent an unbiased view of the financial position of the firm
- Accurate Depreciation: When the true value of the assets is represented, depreciation is calculated on the value of assets to the business and not on 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 moneyTime Value Of MoneyThe Time Value of Money (TVM) principle states that money received in the present is of higher worth than money received in the future because money received now can be invested and used to generate cash flows to the enterprise in the future in the form of interest or from future investment appreciation and reinvestment.
- 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 statementsFinancial StatementsFinancial statements are written reports prepared by a company's management to present the company's financial affairs over a given period (quarter, six monthly or yearly). These statements, which include the Balance Sheet, Income Statement, Cash Flows, and Shareholders Equity Statement, must be prepared in accordance with prescribed and standardized accounting standards to ensure uniformity in reporting at all levels. 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 claim 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 cost method.Cost Method.The cost method is a method of accounting for investments in which the investment remains at its original cost on the balance sheet. Many financial instruments, such as investments and inventory/fixed assets, are accounted for using this method.
- Never-Ending Process: The changes in prices continue for infinity as long as there is inflation or deflation in an economyDeflation In An EconomyDeflation is a decrease in the prices of goods and services caused by negative inflation (below 0%). It usually results in increased consumer purchasing power, owing to a simple supply and demand rule in which excess supply leads to lower prices.. 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. It 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 specific window dressing as per the whims and fancies of individuals owing to the subjectivity involved
- Expensive: This method is considered costly and ordinary business may not be pretty well able to afford and resort to this method
- 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 that can’t be averted.
- The system makes the calculations complicated due to many conversions and calculations.
Inflation accounting, no doubt, reflects the actual 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 real purpose of a financial statement is to provide an accurate and fair value of the business. The income statementIncome StatementThe income statement is one of the company's financial reports that summarizes all of the company's revenues and expenses over time in order to determine the company's profit or loss and measure its business activity over time based on user requirements. must show the true and accurate profit or loss of the business during a specific period, and the balance sheet must accordingly reflect the fair and true financial position again.
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.
This has been a guide to what is Inflation Accounting and its Meaning. Here we discuss the top 2 methods of inflation accounting along with examples, advantages, and disadvantages. You can learn more about Accounting from the following articles –