Inflation accounting

Inflation accounting
See also
Sum of the parts valuation Net asset value per share Asset valuation RAROC GDP deflator Market growth Return on equity (ROE) Average annual growth rate Market performance

Inflation accounting is an accounting method used to adjust the financial statements of a company in order to better reflect the true economic performance of the company in the context of an inflationary environment. This method of accounting takes into account the effects of changing prices on purchasing power of money and adjusts the financial statements accordingly. This method of accounting is generally used in countries where inflation is high, and it is intended to provide a more accurate picture of a company’s performance over time. The main components of inflation accounting are:

• Constant Dollar Accounting: This method of accounting adjusts the financial statements of a company to reflect changes in the purchasing power of money due to inflation. This can be done by converting all of the values in the financial statements to a common base year and then adjusting the figures for inflation.
• Purchasing Power Accounting: This method of accounting adjusts the financial statements of a company to reflect the changes in the purchasing power of money due to inflation. This can be done by adjusting the values of the financial statements so that they represent the same amount of purchasing power in the current year as the base year.
• Current Cost Accounting: This method of accounting takes into account the effects of inflation on the current cost of assets. This can be done by taking the current cost of an asset and adjusting it for inflation so that it reflects the cost of the asset in the current year.

Inflation accounting is an important tool for businesses operating in an inflationary environment, as it provides a more accurate picture of the true economic performance of the company over time. By taking into account the effects of inflation on financial statements, it can provide better insights into the performance of a company and help guide management decisions.

Example of Inflation accounting

Lets say a company purchases machinery for $100,000 in the base year. Under the current cost accounting method, the financial statements would be adjusted for inflation so that the cost of the machinery reflects the current cost in the current year. This would be done by using the following formula:

${CurrentCostofMachinery}=\$100,000\times {\frac {CurrentYearPriceIndex}{BaseYearPriceIndex}}$

In this example, the current cost of the machinery would be adjusted for inflation, providing a more accurate reflection of the true economic performance of the company over time.

In conclusion, inflation accounting is an important tool for businesses operating in an inflationary environment, as it provides a more accurate picture of the true economic performance of the company over time. By taking into account the effects of inflation on financial statements, it can provide better insights into the performance of a company and help guide management decisions.

Formula of Inflation accounting

The formula for inflation accounting is:

${\text{Inflation adjusted figure}}={\text{Original figure}}\times {\frac {\text{Cost of living in current year}}{\text{Cost of living in base year}}}$

The formula for inflation accounting is used to adjust the financial statements of a company to reflect changes in the purchasing power of money due to inflation. This formula takes the original figure from the financial statements, multiplies it by the cost of living in the current year divided by the cost of living in the base year, and produces an inflation-adjusted figure. This adjusted figure can then be used to provide a more accurate picture of a company’s performance over time.

When to use Inflation accounting

Inflation accounting is generally used in countries where inflation is high, such as in emerging markets or countries with high inflation rates. In these countries, inflation can have a significant impact on the financial statements of a company, making inflation accounting a necessary tool. In addition, companies may also choose to use inflation accounting in order to provide investors and other stakeholders with a more accurate picture of the true economic performance of the company.

Types of Inflation accounting

Inflation accounting entails a number of different methods, each of which is designed to adjust the financial statements of a company to better reflect the true economic performance of the company given the effects of inflation. These methods include: Constant Dollar Accounting, Purchasing Power Accounting, and Current Cost Accounting.

Constant Dollar Accounting: Constant Dollar Accounting adjusts the financial statements of a company to reflect changes in the purchasing power of money due to inflation. This can be done by converting all of the values in the financial statements to a common base year and then adjusting the figures for inflation.

Purchasing Power Accounting: Purchasing Power Accounting adjusts the financial statements of a company to reflect the changes in the purchasing power of money due to inflation. This can be done by adjusting the values of the financial statements so that they represent the same amount of purchasing power in the current year as the base year.

Current Cost Accounting: Current Cost Accounting takes into account the effects of inflation on the current cost of assets. This can be done by taking the current cost of an asset and adjusting it for inflation so that it reflects the cost of the asset in the current year.

Steps of Inflation accounting

Inflation accounting involves the following steps:

• Calculating the Inflation Rate: First, the inflation rate for the base year and the current year must be calculated. This can be done by comparing the Consumer Price Index from the base year to the Consumer Price Index from the current year.
• Adjusting the Financial Statements: Once the inflation rate has been calculated, the financial statements must be adjusted for inflation. This can be done by converting the figures in the financial statements to a common base year and then adjusting them for inflation.
• Analyzing the Adjusted Financial Statements: After the financial statements have been adjusted for inflation, they should be analyzed to determine the true economic performance of the company in the current year. This can be done by comparing the adjusted financial statements to the financial statements from the previous year or analyzing the current financial statements against industry averages.

Advantages of Inflation accounting

• Improved Decision Making: Inflation accounting allows managers to make more informed decisions by providing a more accurate picture of the economic performance of the company.
• Improved Financial Reporting: By taking into account the effects of inflation on financial statements, inflation accounting allows companies to accurately report their financial performance to stakeholders.
• Increased Transparency: Inflation accounting also increases transparency by providing a more accurate picture of the economic performance of the company.

Limitations of Inflation accounting

Inflation accounting is not without its limitations. For example, it does not take into account any changes in the underlying economic environment, such as changes in interest rates or exchange rates. Additionally, it can be difficult to accurately adjust financial statements for inflation due to the complex nature of the calculation. Lastly, inflation accounting is a relatively new concept, and as such, there are few established standards for its use.

Other approaches related to Inflation accounting

• Historical Cost Accounting: This method of accounting records assets and liabilities at their original cost, and does not take inflation into account. This method has been criticized for not providing an accurate picture of the current value of assets and liabilities due to inflation.
• Indexing Accounting: This method of accounting adjusts the financial statements of a company to reflect changes in the purchasing power of money due to inflation. This can be done by indexing the financial statements to a price index, such as the Consumer Price Index, and adjusting the figures for inflation.

Inflation accounting is an important tool for businesses operating in an inflationary environment, as it provides a more accurate picture of the true economic performance of the company over time. By taking into account the effects of inflation on financial statements, it can provide better insights into the performance of a company and help guide management decisions. While there are various approaches to adjusting for inflation, the main components remain the same: constant dollar accounting, purchasing power accounting and current cost accounting.

Suggested literature

• Thies, C. F., & Sturrock, T. (1987). What did inflation accounting tell us?. Journal of Accounting, Auditing & Finance, 2(4), 375-391.
• Arsoy, A. P., & Gucenme, U. (2009). The development of inflation accounting in Turkey. Critical Perspectives on Accounting, 20(5), 568-590.