Inflation accounting definition
/What is Inflation Accounting?
Inflation accounting is the process used to factor massive price increases into an organization’s financial statements. When there is a significant amount of price inflation or deflation, the impact on the financial statements of a company operating in that environment can be so severe that the value of the information in the statements declines to the point of being nearly useless. Consequently, it is acceptable under GAAP to issue inflation-adjusted financial statements under the following circumstances:
The financial statements are denominated in a foreign currency; and
The financial statements are for businesses operating in countries with highly inflationary economies; and
The financial statements are intended for readers in the United States.
However, these adjustments are not allowed if the relevant economy is not classified as highly inflationary. Thus, a business experiencing even fairly robust inflation is not allowed to use inflation accounting.
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The Inflation Accounting Process
The measurement of income from continuing operations on a current cost basis requires the accountant to complete the following steps:
Measure the cost of goods sold as of the date sold, using either its current cost or lower recoverable amount, or when those resources are used on or at least committed to a designated contract.
Measure depreciation, amortization, and depletion based on either the average current cost of the service potential of the underlying fixed assets or their lower recoverable amount during the usage period.
It is allowable to measure all other revenue and expense items, as well as income taxes, at the amounts stated in the company’s income statement.
In essence, the restatement steps required to convert historical cost information into inflation-adjusted information are as follows:
Review the contents of inventory at the beginning and end of the year, as well as the cost of goods sold, to determine when costs were incurred.
Restate both inventory and the cost of goods sold, so that they are presented at current cost.
Review fixed assets to determine when they were acquired.
Restate fixed assets, depreciation, amortization, and depletion, so that they are presented at current cost.
Determine the aggregate amount of net monetary items at the beginning and end of the reporting period, as well as the net change in these items during the period.
Calculate the purchasing power gain or loss on the net monetary items.
Calculate the change in current cost for both inventory and fixed assets, as well as the effect of changes in the general price level.
Example of Inflation Accounting
A real-world example of inflation accounting can be seen in Coca-Cola’s financial reporting This company operates in multiple countries, including some with hyperinflationary economies (where inflation exceeds 100% over three years, as defined by IFRS). Under International Financial Reporting Standards (IFRS), Coca-Cola must apply inflation accounting to adjust financial statements for inflation. This results in the following types of adjustments:
Adjusting Non-Monetary Assets & Liabilities
Coca-Cola restates its property, equipment, and inventory values to reflect the effects of inflation. For example, if inflation in Argentina was 50% in a year, a factory originally valued at $10 million might be restated to $15 million to reflect the new purchasing power.
Reevaluating Revenue & Expenses
Sales revenue and operating expenses are adjusted using a general price index to reflect real economic conditions. This prevents overstating profits when inflation devalues the local currency.
Foreign Currency Adjustments
In hyperinflationary economies, Coca-Cola often translates financial statements into U.S. dollars using inflation-adjusted exchange rates. For example, if Coca-Cola reports revenues of 100 million Argentine pesos, but the peso depreciates rapidly, the adjusted revenue in U.S. dollars may be significantly lower.
If Coca-Cola did not apply inflation accounting, its profits in hyperinflationary countries might appear artificially high due to devalued local currencies.
Terms Similar to Inflation Accounting
Inflation accounting is also known as general price level accounting.