What Is Inflation Accounting?
Inflation has an effect on consumer prices, to be sure, but there are effects on corporate finance as well. Typically, in developed countries, inflation rates are fairly steady and somewhat predictable. However, in times of hyperinflation, prices soar and corporate financial reports can be misinterpreted without accounting for inflation. Inflation accounting offers a more accurate view of a company or individual’s financial situation because it looks at those finances through the lens of inflation. According to Investopedia “Inflation accounting requires statements to be adjusted according to price indexes, rather than rely solely on a cost accounting basis.”
Inflation raises prices, thereby decreasing purchasing power. The same amount of money will not purchase the same amount of goods ten years later when inflation is taken into consideration. For instance, what would happen if an individual planning for retirement calculated the number of years he or she expected to live after retirement and multiplied their current salary by that number of years to come up with the sum total they would need to save to cover their Cost of Living for retirement? If they did not account for inflation, their retirement nest egg would dwindle long before their life ended.
Adequate Nest Egg?
Assume the current income for the person mentioned in the previous paragraph is $50,000. They plan to live 20 years after retirement, so they assume $1 million would be a sufficient nest egg. They would be sadly mistaken. For example, the purchasing power of $50,000 in 1992 is the same as the purchasing power of $81,824.51 in 2012. If said individual retired in 1992, assuming they could live off $50,000 in 2012, they would find themselves deeply in debt or with a significantly reduced standard of living because they actually need almost $82,000 to maintain their standard of living.
Corporate Inflation Accounting
Obviously that example is simplistic. Inflation is based on a variety of economic factors, such as the consumer price index, and it is easier to factor looking backward on previous years than it is looking ahead to a future economic situation. Additionally, corporate financial reporting using inflation accounting will reveal differences in expenditures, sales figures and profit margins based on inflation rates. For this reason and others, it is important for accountants to include the index they used when calculating those differences with inflation in mind and should show the math in order to stay above reproach with investors and regulating officials.
As beneficial as inflation accounting may be for understanding the actual financial situation of a company or individual, it leaves a considerable amount of room for fraudulent reporting under the guise of inflation accounting and thus the concept is surrounded by controversy.
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This article was provided by Nixon Williams, contractor accountants with integrity.