Definition of Inflation Accounting
It is a newly introduced concept in the financial world. Inflation accounting refers to the adjustment of the financial statements during inflationary periods. This special accounting technique is only used in inflationary periods where the general level of prices is usually high for three consecutive quarters.
It involves the recording of the income and expenditure of the business at the current prices and reinstating all the three statements of the company and analyze the cost and the trend of the current company.
Types and Components of Inflation Accounting
There are various kinds of techniques that are involved in inflation accounting and there are various methods attached to it.
- Current Purchasing Power Method: This technique involves the adjustment of the financial statements to the current price changes. It involves recalculating the historical financial figures of the company at the current purchasing power which is done by applying a certain conversion factor.
- Current Cost Accounting: Under this method, the cost categories and the various cost items and the items in the balance sheet are shown at the current cost rather than the historical cost and the profit is determined on the actual cost period and not on the basis of the sales.
- Current Value: Under this method, all assets and liabilities are measured and are reinstated at their current cost structure.
- Replacement Cost Accounting: The cost of replacing is the parameter under which all the assets and the liabilities on the balance sheet are recorded.
Examples / Calculation
Below are some examples of inflation which are as follows:
ASD company is involved in manufacturing and have purchased a Machinery in 2001 for $10,000. ASD company is using an inflation accounting technique to reinstate its financial records in the year 2009. Find the current cost of the machine purchased in the year 2001 if the general price index in 2001 was 400 and it is 600 in the year 2009.
The Current price index = 600
Base price index = 400
Historical Cost = $10,000
Current Cost = 600/400 X 10,000 = $15,000. The current cost would be $15,000 and it would be recorded as the closing balance of the land in the balance sheet.
XYZ company is involved in construction purchased a parcel of land in 1999 for $5,000. XYZ company is using an inflation accounting technique to reinstate its financial records in the year 2000. Find the current cost of the land parcel purchased in the year 1999 if the general price index in 1999 was 200 and it is 300 in the year 2000.
The Current price index = 300
Base price index = 200
Historical Cost = $5,000
Current Cost = 300/200 X 5000 = $7,500. The current cost would be $7,500 and it would be recorded as the closing balance of the land in the balance sheet.
Advantages of Inflation Accounting
The following are the advantage of Inflation Accounting:
- It reflects the current and not the historical cost of the balance sheet.
- It is highly effective in times of general inflation or hyperinflation.
- Depreciation of the business is valued and cost on the current price and not on the historical or the carrying value of the asset which is the correct method.
- Profit and loss will reflect the true condition of the company.
- Financial ratios based on figures, adjusted to the current value, are more meaningful.
Disadvantages of Inflation Accounting
The following are the disadvantage of Inflation Accounting:
- Changing in price is a never-ending process hence it becomes difficult every time to reinstate the figures of the company and present the financial statements.
- Inflation accounting is a complicated process and it involves too much calculation and the data gathering process.
- In times of deflation, the depreciation cost will be on a lower side hence it does not reflect the true picture.
Inflation accounting has its own merits and demerits due to which the use of inflation accounting is not still very much prevalent in the industry. But as time will progress there is no doubt that inflation accounting will speed up and the development will lead to the future of accounting which is inflation accounting.
This has been a guide to Inflation Accounting. Here we discussed the types, examples, advantages, and disadvantages of Inflation Accounting. You can also go through our other suggested articles to learn more –