What Is Inflation Accounting?
Inflation accounting is a specialized technique employed to consider the impact that rising or falling costs of goods in various parts of the world have on the financial figures reported by international companies. Instead of solely relying on cost accounting methods, financial statements are adjusted in accordance with price indexes. This approach offers a clearer depiction of a firm’s financial position in inflationary environments, and it is sometimes called price level accounting.
Key Takeaways:
- Inflation accounting adjusts financial statements using price indexes.
- Hyperinflationary environments necessitate the restatement of financial figures to reflect current values.
- IFRS hyperinflation definition: Prices, interest rates, and wages linked to a price index rising by 100% or more within three years.
- Different standards: IFRS and U.S. GAAP have varying requirements for inflation accounting.
Understanding How Inflation Accounting Works
When companies operate in countries experiencing significant price inflation or deflation, historical financial statements become less relevant. To address this issue, companies might be permitted to use inflation-adjusted figures, ensuring numbers reflect current economic values.
The International Accounting Standard (IAS) 29, adopted by International Financial Reporting Standards (IFRS), guides companies whose functional currency is in a hyperinflationary economy. IFRS defines hyperinflation as an aggregate price rise of 100% or more over three years. Companies in hyperinflationary settings are required to update their statements periodically to stay relevant to present economic conditions. This shows a more accurate financial position by supplementing cost-based financial statements with price-level adjusted statements.
Inflation Accounting Methods
Inflation accounting employs two primary methods: Current Purchasing Power (CPP) and Current Cost Accounting (CCA).
Current Purchasing Power (CPP)
The CPP method differentiates between monetary and non-monetary items. An accounting adjustment on monetary items often results in a net gain or loss. Non-monetary items, which do not possess fixed values, are updated using an inflation conversion factor equivalent to the Consumer Price Index (CPI) at the period’s end, divided by the CPI at the transaction date.
Current Cost Accounting (CCA)
The CCA method values assets at their fair market value (FMV) instead of the historical cost incurred during purchase. Under this method, both monetary and non-monetary items are restated to reflect current values.
Special Considerations
Inflation accounting requirements vary between IFRS and U.S. Generally Accepted Accounting Principles (GAAP). Both frameworks have been treating Argentina as hyperinflationary since 2018 due to cumulative inflation of over 100% in the previous three years. However, different regulations apply: IFRS allows international businesses with Argentinian subsidiaries to continue using the peso for accounts while restating for inflation, whereas U.S. firms must use U.S. dollars as functional currency, which involves foreign exchange losses.
For instance, insurance company Assurant Inc. highlighted in its 2021 annual report that classification of Argentina’s economy as highly inflationary, in line with GAAP, necessitated changing the functional currency from the local currency to U.S. dollars, leading to foreign exchange-related losses.
Advantages and Disadvantages of Inflation Accounting
Advantages:
- Colleagues current revenues with current costs, offering a more aligned view of profitability.
Disadvantages:
- May confuse investors.
- Permits companies to present figures favorably.
- Constant restatement and alteration of financial statements.
Understanding CPP and CCA
CPP, or Current Purchasing Power, and CCA, or Current Cost Accounting, are the two primary techniques for adjusting financial statement figures in inflation accounting.
How to Calculate Inflation
The inflation rate can be calculated using the formula:
Inflation rate (%) = (CPI at end of the period / CPI at the beginning of the period) × 100.
For example, to find the inflation rate from January 2006 to January 2022 with CPI values of 281.148 and 198.300, respectively:
281.148 / 198.300 × 100 ≈ 141.77%.
What is Hyperinflation?
According to IFRS, hyperinflation is defined when prices, interest, and wages linked to a price index rise by 100% or more cumulatively over three years.
Related Terms: cost accounting, price level accounting, economic value, deflation, financial reporting.
References
- IFRS Foundation. “IAS 29 Financial Reporting in Hyperinflationary Economies”.
- PwC. “Hyperinflation in Argentina: Which Implications for Your Consolidated Financial Statements?” Page 1.
- PwC. “Hyperinflation in Argentina: Which Implications for Your Consolidated Financial Statements?” Page 2.
- Grant Thornton. “Argentina Hyperinflation May Trigger DASTM Rule”.
- Assurant. “2021 Annual Report”, Page 50.
- U.S. Bureau of Labor Statistics. “Databases, Tables & Calculators by Subject”.
