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What is inflation accounting?

Inflation Accounting

Inflation accounting is an accounting method designed to factor in the impact of high inflation or hyperinflation on the company earnings reports.

With high inflation coming to the forefront in 2022, rising cost of goods need to be accounted for if investors are to get a clearer picture of a company’s financial health. Read on to learn what inflation accounting means with the help of some inflation accounting examples.

Inflation is defined as the rate of increase in prices over a given period of time. In essence, inflation is also the fall in purchasing value of money. Historical cost accounting methods can distort financial statements of companies that operate in a country whose currency is suffering from devaluation due to high inflation or hyperinflation.

To correct this problem, companies are permitted to use inflation-adjusted figures that restate earnings and costs to reflect current economic conditions and values. This is also referred to as price level accounting.

According to the European Journal of Accounting, Auditing and Finance’s definition of inflation accounting, it is a financial reporting procedure that records the consequences of inflation on financial statements that a company prepares and publishes at the end of the financial year, which is based on the assumption of a stable currency.

How does inflation accounting work? 

Companies used standards set by the International Financial Reporting Standards (IFRS) Foundation as guides to report their financial statements when operating in hyper-inflated economies. According to the IFRS, hyperinflation occurs when prices, interest and wages rise by around 100% or more over three years. 

The IAS 29 ‘Financial Reporting in Hyperinflationary Economies’ standard requires figures in financial statements to be restated by applying a general price index. For example, if a country becomes hyperinflationary on 1 February 2022, companies preparing quarterly statements must apply IAS 29 standards for the quarter ended 31 March 2022.

On inflation accounting, accounting firm Ernst & Young (EY) has said:

“Accounting standards are applied on the assumption that the value of money (the unit of measurement) is constant over time. However, when the rate of inflation is no longer negligible, a number of issues arise impacting the true and fair nature of the accounts of entities that prepare their financial statements on a historical cost basis”.

EY added that inflation accounting must be used in inflationary conditions because:

  • Historical cost figures become less meaningful that what they were in a low inflation environment 

  • Holdings gains on non-monetary assets reported as operating profits do not represent real economic gains

  • Current and previous financial periods become incomparable

  • “Real” capital can be reduced because reported profits do not account higher replacement costs of resources used

The IAS 29 standard does not establish an absolute inflation rate at which an economy is considered to be hyperinflationary, “instead, it considers a variety of non-exhaustive characteristics of the economic environment of a country that are seen as strong indicators of the existence of hyperinflation,” said EY.

Companies operating in Argentina, Venezuela, Sudan, Iran, Zimbabwe and Lebanon should use IAS 29 standards when accounting their financial statements, according to the IFRS.

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