Market fluctuations are an everyday element of the accountant’s life. They come and go, subject to the economics, markets, and policies of countries and governments. As an economy enters a period of inflation and sees the cost of everyday products rise, the impact can be felt not only by the individual consumer but also on the business balance sheet. That’s when the accounting industry comes into its own, offering experience and insight into a company’s reporting.
Here are 5 ways inflation affects the accounting industry, and how that impacts business.
1. Preparation for Change Becomes a Priority
Throughout history, periods of inflation and conversely deflation, have made their presence known. For the accounting industry, this presents something of an opportunity. As the pressure mounts on individual sectors, the accounting industry feels the call to action.
As interest rates begin to climb, consulting accountants should have adequately prepared management for the impact this will have on costs. As inflation erodes purchasing power, this is likely to have a knock-on effect on the cost of raw materials, and purchased services. In order to maintain profitability, this cost will have to be passed on to the consumer.
How can the accounting industry help CFOs and in-house finance officers get ready for a period of inflation? By learning the lessons found in a company’s financial records.
What happens when the business is put under pressure? What is the character and shape of the management structure and C-suite? In times of inflation, the accounting industry becomes more than just the number crunchers, it takes on the role of analyst and strategist as it helps the business navigate the market.
2. Profit Can Be Overstated
Traditionally, inventory balance sheets are recorded at cost or market price, whichever one is less. In times of high inflation, the gap between cost and market price (i.e. replacement cost) can be large. If profits are skewed due to not taking the replacement cost of materials into account, then it’s easy to under-price your product. In times of inflation, getting unit sale prices correct to reflect production costs and interest rates is absolutely crucial. Critical analysis by the accounting professional at this stage, must take into consideration the challenge of meeting increased operating costs due to inflated materials costs.
3. Fixed Asset Values are Understated
Fixed Assets most commonly appear on the balance sheet as property, plant, and equipment (PP&E). Most often they are reported at historical cost. In times of inflation as costs spike, the historical cost of the fixed asset is understated compared to its current market value. Information about a corporation’s fixed assets helps create accurate business valuations. Investors and creditors use these values to decide whether to buy shares in a company or to lend money to the business. By understating fixed assets it can make the company appear less valuable than it actually is. Often hostile takeovers result when an individual or company sees hidden value in a company that is unrecognized by the market at large. For example, a lumber producer might want to acquire a totally unrelated company simply because it has timberland on the books at the cost they paid for it 30 years ago. They may then split off the timber assets and resell the rest of the company, often resulting in difficulty or even bankruptcy for the company. This could have been avoided if the timberland had been marked to market.
4. Accounting Consistency Becomes Vital
When it comes to accounting procedures and trends, it becomes more critical that accounting principles are adhered to for an accurate overall picture.
Legally, accountants are required to follow Generally Accepted Accounting Principles (GAAP). As you’re no doubt aware, this set of rules incorporate all the complex legalities of corporate accounting. They are under the control of the Financial Accounting Standards Board (FASB) which is an independent nonprofit organization responsible for establishing accounting and financial reporting standards for companies and nonprofit organizations in the United States.
Inflationary forces can affect the type of inventory policy an accountant uses. The two basic types are first-in, first-out, (FIFO) which escalates the price as time goes on and makes inflationary forces less apparent in the long run or conversely last-in, first-out (LIFO) which uses the higher cost materials first but leaves the lower-cost materials on the books to skew inventory values.
5. Accountants Must Act as the Voice of Reason
Perhaps an unusual point to end on but in times of economic pressure, it falls to the professional accountant to keep a lid on panicking executives, leading to poor decision making. Take, for example, the idea that printing currency always leads to higher inflation. Recent experience over the last decade has shown that this isn’t always the case. By balancing the deflationary forces of a collapsing stock and bond market against the inflationary forces of money printing the U.S. FED has been able to maintain a fairly stable inflation environment. But that is not always the case.
For instance, the hyperinflation in Bolivia, which crippled the country from 1983-1985 and increased prices by about 23,000 percent was the result of decades of irresponsible fiscal policy in which they covered government budget deficits by printing money without any counteracting deflationary forces.
In the face of inflationary forces but a lack of hyperinflation, some CEOs might consider pushing forward with capital investments they might otherwise be more cautious about. This rush to buy can be risky and at times backfire, the voice of reason that proceeds from the accounting industry must sound loud and clear. It must show that spending and investing can lead to malinvestment and help owners strike a balance between inflation-proofing their business in the present and guarding against long-term risk.
There’s no doubt that inflation puts pressure on the accounting industry. Many will find their voices lost in the hurly-burly of reacting to events while still others will find themselves leaned on heavily for advice and bearing more responsibility for ultimate profitability.
Unfortunately, it’s something that just comes with the territory. It’s this thought that brings us back to the first point we made regarding preparation. There’s nothing new about inflation nor its effects. In many ways, inflation is one of the more predictable economic trends. We broadly know how it will affect business, consumer spending, and prices. We have a good idea of what we need to do to balance its effects and how to weather the storm as long as we can accurately predict the level of inflation to expect in the future. And yet it can still strike fear into even the most experienced CEO because if inflation levels change rapidly it is difficult to adjust policies in time.
About the Author: Caroline Kelly is a journalist and copywriter who loves to write and run. Trained up in the newsrooms of her native East Sussex, England, she has lived and worked in Switzerland and Singapore. Obsessed with research and story-telling, Caroline writes in financial niches for print and online publications. Her website can be found here.