As per the U.S. Bureau of Labor Statistics, consumer prices hit 8.5% over the year 2022. The consumer price index (CPI) tracks the prices of items such as housing, food, clothing, fuel, transportation, doctors’ and dentists’ services, and drugs, which are essential for day-to-day living.
The recent data from the U.S. Bureau of Labor Statistics states that the CPI has jumped by around 7% over the last 24 months.
When a firm operates in a country where there is a huge amount of market inflation or deflation, historical financial statement information is no longer pertinent. In some cases, companies are allowed to use inflation-adjusted figures to address this problem, recalculating the numbers to reflect current economic values.
Inflation may increase direct costs for your business and decrease customer demand for non-essential goods and services, resulting in lower profits unless you are able to pass on the cost increases to your customers.
In such cases, inflation accounting is the only means to get your financial statements right.
What is Inflation Accounting?
Typically, inflation takes place when the money in circulation exceeds the commodities and services production. When this happens, the purchasing power of money diminishes, and prices rise.
International companies apply a unique accounting method in such scenarios, in which the effects of soaring or plummeting costs of goods in certain areas of the world are factored in.
With inflation accounting, accountants consider price indexes rather than only accounting costs to adjust financial statements that paint a more accurate picture of a company’s financial position in inflationary environments.
In other words, inflation accounting considers price changes in light of inflationary price increases. Hence, it has become a standard accounting practice in most countries in recent decades.
What If You Don’t Use Inflation Accounting?
The financial statements are prepared on a historical cost basis, assuming that the unit of account (e.g., the dollar) has a static value. The value of money, on the other hand, alters over time.
Also, prices are not constant for economic, political, or social reasons, and inflation or deflation may account for price changes. Because financial statements must be accurate, inflation accounting is required.
In an omnipresent inflationary scenario, historical costing-based financial statements have several drawbacks.
The following are the most crucial setbacks:
Conventionally, historical costs are used for recording fixed assets on the balance sheet, resulting in an unrealistically low current value.
Because depreciation is computed on the historical cost of fixed assets, depreciation provisions are also insufficient for covering replacement costs. The firm may therefore face significant difficulties because of an inadequate provision of funds.
When prices are rising, there is a critical overstatement of earnings because the cost of goods sold is based on historical costs, and no account is taken of money’s diminishing purchasing power.
Lastly, an overstatement of profits can result in heavy financial strain for the company, resulting in unnecessary dividends, heavy taxation, and so on.
In a nutshell, when the general price level rises rapidly, the reported profits of a company with a large percentage of its assets stated at historical cost are overstated. If profits are overstated, costs and expenses are equally understated. This may result in illusory reporting of profits.
To curb such issues, the Accounting Principles Board of the American Institute of Certified Public Accountants (AICPA) suggested in June 1969 that companies’ annual statements should include supplementary information about the financial impact of changes in general price levels.
The catch is that an enterprise’s financial statements can be made more realistic by adjusting them to reflect the firm’s performance and position truthfully and equitably over a given period.
Inflation Accounting Methods?
The two most popular inflation accounting methods that are used worldwide are:
- Current Purchasing Power (CPP)
- Current Cost Accounting (CCA)
Let’s know them one by one:
Current Purchasing Power (CPP)
CPP, aka general price-level accounting, is a mixed method in which financial statements (i.e., P&L and Balance Sheet) are prepared on a historical basis and converted as per the current purchasing power of the currency based on a price index in the end.
In the US, the CPP method is endorsed by the Accounting Policy Board and the Financial Accounting Standards Board (FASB).
In contrast to the current cost accounting (CCA) method, CPP does not determine the current values of various assets; instead, only the financial statements are stated in terms of uniform value.
The CPP method treats monetary and non-monetary items differently. Non-monetary items (such as fixed assets, plants, stocks, and buildings) are translated at historical rates, while monetary items are translated at the current rate.
For example, a building was purchased for $100,000 in 2020, and the general price index at that point in time was 200. Then in 2022, considering the general price index at 400, the current value of the building will be:
($100,000/200) x 400 = $200,000
Current Cost Accounting (CCA)
The CCA approach focuses on preparing financial statements (balance sheet and profit and loss statement) on the current values of individual items rather than on original or historical costs.
Moreover, all adjustments are made in assets and expenses; and liabilities remain silent in this method.
The CCA method is the replacement of the CPP inflation accounting method. This method overcomes the CPP model’s limitation of considering a single index value for all the assets and liabilities, whereas, in reality, the change in prices isn’t the same.
For example, the change in the price of land will not be similar to the change in the price of buildings or debtors.
This is why the CCA method was created by the Inflation Accounting Committee of the UK government in 1975, and since then, it has been extensively researched and discussed. With the issuance of SSAP 16 (Statement of Standard Accounting Practice), it has finally been settled.
For example, if a machine is purchased on 10 Feb 2020 for $10,000 and can be purchased on 1 Feb 2022 for $30,000, its gross current replacement cost will be $30,000.
Inflation Adjusted Accounting Can Help Make Better Business Decisions
The primary goal of inflation accounting is to adjust historical cost figures for substantial changes in the economy’s overall level. It’ll help senior-level management in decision making the following way:
Capital Allocation: Capital is allocated through the pricing mechanism in capital markets, which relies on financial information. Therefore, inaccurate or incomplete financial information will result in poor pricing and allocation decisions. Using an inflation accounting system would benefit the various parties involved in the business.
Empower Management: In the long run, management will be better prepared to deal with the problems caused by inflation, and productivity will improve as a result.
Accurate Depreciation: When the true value of assets is reflected, depreciation is calculated on their face value rather than their historical cost.
Helps Assessment: When balance sheets of two years are presented and adjusted to inflation accounting, making the crucial comparison becomes simple and convenient. Because these values are current and not based on historical cost, it feels a bit like the time value of money.
Accurate Dividend Payment: This method is preferable to the cost method in keeping a check on dividends and taxes since dividends and taxes are not calculated based on cost.
Frequently Asked Questions
1. What is inflation?
When a currency loses value, inflation occurs, resulting in higher prices and lower demand. As a result, economic development slows down over time. However, a low rate of inflation makes it easier for the economy to recover during a recession. Hyperinflation, on the other hand, can severely damage the economy.
2. What is deflation?
In economics, deflation is a reduction in the general price level of goods and services. When the inflation rate is less than 0%, deflation occurs. Deflation reduces the currency value over time, but sudden deflation increases it.
3. What is the motto of inflation accounting?
Inflation accounting aims to provide financial statements that faithfully and realistically reflect a company’s financial performance and position over a certain period by adjusting them.
Wrapping Up
An organization may employ inflation accounting to adjust its accounting numbers and financial statements to provide a more accurate depiction of costs and earnings at a given period of time.
Accounting standards vary depending on the location and accounting methodology being used by a particular company. Hence, if permitted by their accounting standards, inflation accounting techniques can be utilized.
The two most prominent inflation accounting approaches are current purchasing power (CPP) and current cost accounting (CCA). Using both approaches may provide a more accurate understanding of a company’s financial value.
If required, outsource your accounting to a reliable accounting firm such as IBN Technologies that can handle all complexities of accounting during inflation in the US, UK, and more.
