Inflation accounting
Encyclopedia
Inflation accounting is a term describing a range of accounting systems designed to correct problems arising from historical cost
accounting in the presence of inflation
. Inflation accounting is used in countries experiencing high inflation or hyperinflation
. For example, in countries experiencing hyperinflation the International Accounting Standards Board
requires corporate financial statements
to be adjusted for changes in purchasing power
using a price index
.
accounting (also called replacement cost accounting or current cost accounting) was widely used in the 19th and early 20th centuries, but historical cost accounting became more widespread after values overstated during the 1920s were reversed during the Great Depression
of the 1930s. Most principles of historical cost
accounting were developed after the Wall Street Crash of 1929
, including the presumption of a stable currency.
By adding dollar amounts that represent different amounts of purchasing power, the resulting sum is misleading, as one would be adding 10,000 dollars to 10,000 Euros to get a total of 20,000. Likewise subtracting dollar amounts that represent different amounts of purchasing power may result in an apparent capital gain
which is actually a capital loss. If a building purchased in 1970 for $20,000 is sold in 2006 for $200,000 when its replacement cost is $300,000, the apparent gain of $180,000 is illusory.
Ignoring general price level changes in financial reporting creates distortions in financial statements such as
INFLATION ACCOUNTING
INFLATION ACCOUNTING is a system of accounting which, unlike historical cost accounting, takes into account changing prices
. Irving Fisher
's 1911 book The Purchasing Power of Money was used as a source by Henry W. Sweeney in his 1936 book Stabilized Accounting, which was about Constant Purchasing Power Accounting
. This model by Sweeney was used by The American Institute of Certified Public Accountants
for their 1963 research study (ARS6) Reporting the Financial Effects of Price-Level Changes, and later used by the Accounting Principles Board
(USA), the Financial Standards Board (USA), and the Accounting Standards Steering Committee (UK). Sweeney advocated using a price index that covers everything in the gross national product. In March 1979, the Financial Accounting Standards Board
(FASB) wrote Constant Dollar Accounting, which advocated using the Consumer Price Index for All Urban Consumers (CPI-U) to adjust accounts because it is calculated every month.
During the Great Depression
, some corporations restated their financial statements to reflect inflation. At times during the past 50 years standard-setting organizations have encouraged companies to supplement cost-based financial statements with price-level adjusted statements. During a period of high inflation in the 1970s, the FASB was reviewing a draft proposal for price-level adjusted statements when the Securities and Exchange Commission (SEC) issued ASR 190, which required approximately 1,000 of the largest US corporations to provide supplemental information based on replacement cost. The FASB withdrew the draft proposal.
. Under some (not all) inflation accounting models, historical costs are converted to price-level adjusted costs using general or specific price indexes.
Income statement general price-level adjustment example
Companies are required to restate their historical cost financial reports in terms of the period end hyperinflation rate in order to make these financial reports more meaningful.
The restatement of historical cost financial statements in terms of IAS 29 does not signify the abolishment of the historical cost model. This is confirmed by PricewaterhouseCoopers: "Inflation-adjusted financial statements are an extension to, not a departure from, historical cost accounting."
Historical cost
In accounting, historical costs is the original monetary value of an economic item. Historical cost is based on the stable measuring unit assumption. In some circumstances, assets and liabilities may be shown at their historical cost, as if there had been no change in value since the date of...
accounting in the presence of inflation
Inflation
In economics, inflation is a rise in the general level of prices of goods and services in an economy over a period of time.When the general price level rises, each unit of currency buys fewer goods and services. Consequently, inflation also reflects an erosion in the purchasing power of money – a...
. Inflation accounting is used in countries experiencing high inflation or hyperinflation
Hyperinflation
In economics, hyperinflation is inflation that is very high or out of control. While the real values of the specific economic items generally stay the same in terms of relatively stable foreign currencies, in hyperinflationary conditions the general price level within a specific economy increases...
. For example, in countries experiencing hyperinflation the International Accounting Standards Board
International Accounting Standards Board
The International Accounting Standards Board is an independent, privately funded accounting standard-setter based in London, England.The IASB was founded on April 1, 2001 as the successor to the International Accounting Standards Committee...
requires corporate financial statements
Financial statements
A financial statement is a formal record of the financial activities of a business, person, or other entity. In British English—including United Kingdom company law—a financial statement is often referred to as an account, although the term financial statement is also used, particularly by...
to be adjusted for changes in purchasing power
Purchasing power
Purchasing power is the number of goods/services that can be purchased with a unit of currency. For example, if you had taken one dollar to a store in the 1950s, you would have been able to buy a greater number of items than you would today, indicating that you would have had a greater purchasing...
using a price index
Price index
A price index is a normalized average of prices for a given class of goods or services in a given region, during a given interval of time...
.
Historical cost basis in financial statements
Fair valueFair value
Fair value, also called fair price , is a concept used in accounting and economics, defined as a rational and unbiased estimate of the potential market price of a good, service, or asset, taking into account such objective factors as:* acquisition/production/distribution costs, replacement costs,...
accounting (also called replacement cost accounting or current cost accounting) was widely used in the 19th and early 20th centuries, but historical cost accounting became more widespread after values overstated during the 1920s were reversed during the Great Depression
Great Depression
The Great Depression was a severe worldwide economic depression in the decade preceding World War II. The timing of the Great Depression varied across nations, but in most countries it started in about 1929 and lasted until the late 1930s or early 1940s...
of the 1930s. Most principles of historical cost
Historical cost
In accounting, historical costs is the original monetary value of an economic item. Historical cost is based on the stable measuring unit assumption. In some circumstances, assets and liabilities may be shown at their historical cost, as if there had been no change in value since the date of...
accounting were developed after the Wall Street Crash of 1929
Wall Street Crash of 1929
The Wall Street Crash of 1929 , also known as the Great Crash, and the Stock Market Crash of 1929, was the most devastating stock market crash in the history of the United States, taking into consideration the full extent and duration of its fallout...
, including the presumption of a stable currency.
Measuring unit principle
Under a historical cost-based system of accounting, inflation leads to two basic problems. First, many of the historical numbers appearing on financial statements are not economically relevant because prices have changed since they were incurred. Second, since the numbers on financial statements represent dollars expended at different points of time and, in turn, embody different amounts of purchasing power, they are simply not additive. Hence, adding cash of $10,000 held on December 31, 2002, with $10,000 representing the cost of land acquired in 1955 (when the price level was significantly lower) is a dubious operation because of the significantly different amount of purchasing power represented by the two numbers.
By adding dollar amounts that represent different amounts of purchasing power, the resulting sum is misleading, as one would be adding 10,000 dollars to 10,000 Euros to get a total of 20,000. Likewise subtracting dollar amounts that represent different amounts of purchasing power may result in an apparent capital gain
Capital gain
A capital gain is a profit that results from investments into a capital asset, such as stocks, bonds or real estate, which exceeds the purchase price. It is the difference between a higher selling price and a lower purchase price, resulting in a financial gain for the investor...
which is actually a capital loss. If a building purchased in 1970 for $20,000 is sold in 2006 for $200,000 when its replacement cost is $300,000, the apparent gain of $180,000 is illusory.
Misleading reporting under historical cost accounting
“In most countries, primary financial statements are prepared on the historical cost basis of accounting without regard either to changes in the general level of prices or to increases in specific prices of assets held, except to the extent that property, plant and equipment and investments may be revalued.”Ignoring general price level changes in financial reporting creates distortions in financial statements such as
- reported profits may exceed the earnings that could be distributed to shareholders without impairing the company's ongoing operations
- the asset values for inventory, equipment and plant do not reflect their economic value to the business
- future earnings are not easily projected from historical earnings
- the impact of price changes on monetary assets and liabilities is not clear
- future capital needs are difficult to forecast and may lead to increased leverage, which increases the business's risk
- when real economic performance is distorted, these distortions lead to social and political consequenses that damage businesses (examples: poor tax policies and public misconceptions regarding corporate behavior)
INFLATION ACCOUNTING
INFLATION ACCOUNTING is a system of accounting which, unlike historical cost accounting, takes into account changing prices
History of inflation accounting
Accountants in the United Kingdom and the United States have discussed the effect of inflation on financial statements since the early 1900s, beginning with index number theory and purchasing powerPurchasing power
Purchasing power is the number of goods/services that can be purchased with a unit of currency. For example, if you had taken one dollar to a store in the 1950s, you would have been able to buy a greater number of items than you would today, indicating that you would have had a greater purchasing...
. Irving Fisher
Irving Fisher
Irving Fisher was an American economist, inventor, and health campaigner, and one of the earliest American neoclassical economists, though his later work on debt deflation often regarded as belonging instead to the Post-Keynesian school.Fisher made important contributions to utility theory and...
's 1911 book The Purchasing Power of Money was used as a source by Henry W. Sweeney in his 1936 book Stabilized Accounting, which was about Constant Purchasing Power Accounting
Constant Purchasing Power Accounting
Constant-purchasing-power accounting is:a consistent method of indexing accounts by means of a general index which reflects changes in the purchasing power of money. It therefore attempts to deal with the inflation problem in the sense in which this is popularly understood, as a decline in the...
. This model by Sweeney was used by The American Institute of Certified Public Accountants
American Institute of Certified Public Accountants
Founded in 1887, the American Institute of Certified Public Accountants is the national professional organization of Certified Public Accountants in the United States, with more than 370,000 CPA members in 128 countries in business and industry, public practice, government, education, student...
for their 1963 research study (ARS6) Reporting the Financial Effects of Price-Level Changes, and later used by the Accounting Principles Board
Accounting Principles Board
The Accounting Principles Board is the former authoritative body of the American Institute of Certified Public Accountants . It was created by the American Institute of Certified Public Accountants in 1959 and issued pronouncements on accounting principles until 1973, when it was replaced by the...
(USA), the Financial Standards Board (USA), and the Accounting Standards Steering Committee (UK). Sweeney advocated using a price index that covers everything in the gross national product. In March 1979, the Financial Accounting Standards Board
Financial Accounting Standards Board
The Financial Accounting Standards Board is a private, not-for-profit organization whose primary purpose is to develop generally accepted accounting principles within the United States in the public's interest...
(FASB) wrote Constant Dollar Accounting, which advocated using the Consumer Price Index for All Urban Consumers (CPI-U) to adjust accounts because it is calculated every month.
During the Great Depression
Great Depression
The Great Depression was a severe worldwide economic depression in the decade preceding World War II. The timing of the Great Depression varied across nations, but in most countries it started in about 1929 and lasted until the late 1930s or early 1940s...
, some corporations restated their financial statements to reflect inflation. At times during the past 50 years standard-setting organizations have encouraged companies to supplement cost-based financial statements with price-level adjusted statements. During a period of high inflation in the 1970s, the FASB was reviewing a draft proposal for price-level adjusted statements when the Securities and Exchange Commission (SEC) issued ASR 190, which required approximately 1,000 of the largest US corporations to provide supplemental information based on replacement cost. The FASB withdrew the draft proposal.
Inflation accounting models
Inflation accounting is not fair value accounting. Inflation accounting, also called price level accounting, is similar to converting financial statements into another currency using an exchange rateExchange rate
In finance, an exchange rate between two currencies is the rate at which one currency will be exchanged for another. It is also regarded as the value of one country’s currency in terms of another currency...
. Under some (not all) inflation accounting models, historical costs are converted to price-level adjusted costs using general or specific price indexes.
Income statement general price-level adjustment example
- On the income statement, depreciation is adjusted for changes in general price levels based on a general price index.
30,000 x 105/100 = 31,500 30,000 x 110/100 = 33,000 (30,000 x 105/100) - 30,000 = 1,500 (63,000 x 110/105) - 63,000 = 3,0002001 2002 2003 Total Revenue 33,000 36,302 39,931 109,233 Depreciation 30,000 31,500 (a) 33,000 (b) 94,500 Operating income 3,000 4,802 6,931 14,733 Purchasing power loss 1,500 (c) 3,000 (d) 4,500 Net income 3,000 3,302 3,931 10,233
Constant dollar accounting
Constant dollar accounting is an accounting model that converts nonmonetary assets and equities from historical dollars to current dollars using a general price index. This is similar to a currency conversion from old dollars to new dollars. Monetary items are not adjusted, so they gain or lose purchasing power. There are no holding gains or losses recognized in converting values.International standard for hyperinflationary accounting
The International Accounting Standards Board defines hyperinflation in IAS 29 as:"the cumulative inflation rate over three years is approaching, or exceeds, 100%."Companies are required to restate their historical cost financial reports in terms of the period end hyperinflation rate in order to make these financial reports more meaningful.
The restatement of historical cost financial statements in terms of IAS 29 does not signify the abolishment of the historical cost model. This is confirmed by PricewaterhouseCoopers: "Inflation-adjusted financial statements are an extension to, not a departure from, historical cost accounting."
See also
- Philosophy of AccountingPhilosophy of accountingThe philosophy of accounting is the conceptual framework for the professional preparation and auditing of financial statements and accounts. The issues which arise include the difficulty of establishing a true and fair value of an enterprise and its assets; the moral basis of disclosure and...
- Constant Purchasing Power AccountingConstant Purchasing Power AccountingConstant-purchasing-power accounting is:a consistent method of indexing accounts by means of a general index which reflects changes in the purchasing power of money. It therefore attempts to deal with the inflation problem in the sense in which this is popularly understood, as a decline in the...
- Real versus nominal value (economics)