Inflation Accounting

Updated on January 3, 2024

Inflation Accounting Meaning

Inflation accounting is 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 deflationary environment, historical information may no longer be relevant. Hence, inflation-adjusted values would go on to accurately reflect the current values.

Key Takeaways

  • Inflation accounting refers to the method used to rectify issues arising from historical cost accounting during high inflation and hyperinflation and adjust the financial statements according to price indexes. 
  • Inflation accounting comprises two methods: Current Purchasing Power and Current Cost Accounting.
  • Currency/money fluctuates regularly. Therefore, an accounting method like inflation accounting provides financial statements to show accurate and fair value accordingly. 
  • The inflation accounting method is a technique that may complicate the calculations due to many conversions and calculations. 

Inflation Accounting Methods

Generally, there are two types of methods:

Inflation Accounting Methods

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Inflation – Explained in Detail

 
 

#1 – Current Purchasing Power

Under this method, the monetary and the non-monetary items are separated so that monetary items record only a net gain or loss. At the same time, the non-monetary items are updated into figures with a particular conversion factor that is equivalent to a specific price indexIndexIndexation is a method of adjusting the purchase price of an investment (bonds, debentures, or any other asset class) to account for the effect of inflation over the investment term, lowering the capital gain and reducing taxable income.read more.

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 fair market value (FMV) rather than their historical cost during 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.read more purchase.

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How Does Inflation Accounting Work?

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

Example 1

Let us consider an illustration where Mr. John purchased equipment on 1st January 2012 for $50,000. As of that day, 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.read more stood at 150, whereas it reflects 300 as of 1st January 2019. Due to this, we are now required to reflect the revalued value of the equipment under the CPP method.

The details are summarised as follows: –

  Date  Details  Figures
1-Jan-12Purchase of Equipment$50,000
1-Jan-12Consumer Price Index     150
1-Jan-19Consumer Price Index     300

Applying the conversion factor formula,

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

(300/150=2)

Inflation Accounting Example 1-1

Hence, the revaluation of the equipment under the CPP method stands at $25,000 ($50,000/2).

Example 2

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

Inflation Accounting Example 2

Solution:

Monetary gain on holding liabilities:

monetary gain
  • Monetary gain on holding liabilities = ₹86,250 – ₹60,000

= ₹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.read more = Credits + Public Deposits = ₹60,000

Monetary loss on holding a monetary asset

monetary loss
  • Monetary loss on holding monetary asset = ₹70,125 – ₹49,500

= ₹20,625.

The calculation of net monetary gain is as follows:

net monetary gain
  • Net Monetary gain = ₹26,250 – ₹20,625

= ₹5,625.

Advantages

  1. Fair View: Since the assets are shown after considering and adjusting for inflation at their current values, the balance sheet represents an unbiased view of the firm’s financial position.
  2. Accurate Depreciation: When the true value of the assets is represented, depreciationDepreciationDepreciation is a systematic allocation method used to account for the costs of any physical or tangible asset throughout its useful life. Its value indicates how much of an asset’s worth has been utilized. Depreciation enables companies to generate revenue from their assets while only charging a fraction of the cost of the asset in use each year. read more is calculated on the face value of the assets and not on their historical cost. Hence, this method facilitates an easy replacement for the business as the accurate and fair value is represented and indexed with inflation.
  3. Reasonable Assessment: When balance sheets of 2 years are presented and adjusted to inflation accounting, it becomes easy and convenient to make the essential comparison as the values reflect after considering inflation. These values are thereby current and not based on historical cost. To some extent, it also feels like 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.read more.
  4. True Value Reflection: Since inflation accounting shows the current profit based on current prices, it reflects any business’s correct and updated value. 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.read more will have the figures updated as per the current prices, factoring in inflation.
  5. No Overstatements: Under this method, the profit and loss accountThe Profit And Loss AccountThe Profit & Loss account, also known as the Income statement, is a financial statement that summarizes an organization's revenue and costs incurred during the financial period and is indicative of the company's financial performance by showing whether the company made a profit or incurred losses during that period.read more would not be overstating the business income.
  6. Keeps a Check on Dividend Payment: Based on historical cost, there is a high possibility that the shareholdersShareholdersA shareholder is an individual or an institution that owns one or more shares of stock in a public or a private corporation and, therefore, are the legal owners of the company. The ownership percentage depends on the number of shares they hold against the company's total shares.read more may claim higher dividend payments. The inflation accounting method helps keep a check as the dividends and taxes are not calculated on a skewed figure, unlike the 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.read more.
Inflation Accounting

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Disadvantages

  1. 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 defined as an economic condition whereby the prices of goods and services go down constantly with the inflation rate turning negative. The situation generally emerges from the contraction of the money supply in the economy.read more. Hence, the process is never-ending.
  2. Complicated: There is a possibility that too many calculations make the process all the more complicated. There may be a lot of adjustments that may be difficult for the ordinary person to interpret.
  3. Subjectivity: Certain discretionary judgments and subjectivity may be involved as adjustments to current values are not as simple as dynamic.
  4. Deflationary Situation Causes Exaggeration: When there is a deflationary situation, and the prices fall, a company may charge lesser depreciation. As a result, it may cause an overstatement of the business’s profits, undoubtedly harmful.
  5. Merely Theoretical: The concept of inflation accounting is considered more of theoretical appeasement. There may be the possibility of specific window dressing as per the whims and fancies of individuals owing to the subjectivity involved
  6. Expensive: This method is considered costly, and ordinary businesses may not be able to afford it

Limitations

  1. Though the method of inflation accounting may be of use to the firm, it is not necessarily so for the income taxIncome TaxIncome tax accounting recognizes the income tax payable in the books of account and determines the current period's tax expenses. It has to be paid either before or after the end of the financial year and recognized in the books of account accordingly. read more authorities, as they refuse it due to low acceptance in the community.
  2. Change in the price is a continuous process that can’t be averted.
  3. The system complicates the calculations due to many conversions and calculations.

Final Thoughts

Inflation accounting undoubtedly 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 to the business. Therefore, 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.read more must show the company’s actual and precise profit or loss during a specific period, and the balance sheet must reflect the fair and proper financial position.

Since they are represented in monetary valueMonetary ValueMonetary value refers to the value of a product or service measured in terms of money. read more. Currency/money fluctuates regularly, so it becomes necessary that a method such as inflation accounting serves its purpose by enabling the financial statements to reflect accurate and fair value accordingly. This method thus ensures that there will be no significant deviations on the part of the business.

Frequently Asked Questions (FAQs)

What is the need for inflation accounting?

The reasons for the need for inflation accounting are-
It helps to form the correct financial operations structure and the company’s position represented by the usual accounting system.
As inflation affects various firms/companies, inflation accounting can provide differentiation of inter firms/companies.
It can provide comparisons of the performances of the firms/companies.
It shows the actual position of the company’s finance and avoids profit overstatement.
It is also helpful to calculate depreciation, providing accurate information, and also helps to improve decision-making.

What are the features of inflation accounting?

The following are the features of inflation accounting: 
Eliminates financial statements distortions that occurred when using the historical cost.
Improves the income and expenses measurement in the face of money’s constantly changing purchasing power. 
It helps to improve the decision-making process.

What is inflation accounting another name?

Another name for inflation accounting is price-level accounting.

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This article has guided what inflation accounting is, and it is meaningful. We have discussed the top 2 methods, examples, advantages of inflation accounting, and disadvantages. You can learn more about accounting from the following articles: –

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