What Is Inflation Accounting?
Inflation accounting is a special technique used to factor in the impact that soaring or plummeting costs of goods in some regions of the world have on the reported figures of international companies. Financial statements are adjusted according to price indexes, rather than relying solely on a cost accounting basis, to paint a clearer picture of a firm’s financial position in inflationary environments. This method is also sometimes referred to as price level accounting.
- Inflation accounting is the practice of adjusting financial statements according to price indexes.
- Numbers are restated to reflect current values in hyperinflationary business environments.
- International Financial Reporting Standards (IFRS) defines hyperinflation as prices, interest, and wages linked to a price index rising 100% or more cumulatively over three years.
- Requirements for inflation accounting differ between IFRS and U.S. GAAP.
How Inflation Accounting Works
When a company operates in a country where there is a significant amount of price inflation or deflation, historical information on financial statements is no longer relevant. To counter this issue, in certain cases, companies are permitted to use inflation-adjusted figures, restating numbers to reflect current economic values.
International Accounting Standard (IAS) 29 adopted by the International Financial Reporting Standards (IFRS) is the guide for entities whose functional currency is the currency of a hyperinflationary economy. IFRS defines hyperinflation as prices, interest, and wages linked to a price index rising 100% or more cumulatively over three years.
Companies that fall under this category may be required to update their statements periodically in order to make them relevant to current economic and financial conditions, supplementing cost-based financial statements with regular price-level adjusted statements.
Inflation Accounting Methods
There are two main methods used in inflation accounting—current purchasing power (CPP) and current cost accounting (CCA).
Current Purchasing Power (CPP)
Under the CPP method, monetary items and nonmonetary items are separated. The accounting adjustment for monetary items is subject to the recording of a net gain or loss. Nonmonetary items (those that do not carry a fixed value) are updated into figures with an inflation conversion factor equivalent to the consumer price index (CPI) at the end of the period divided by CPI at the date of transaction.
Current Cost Accounting (CCA)
The CCA approach values assets at their fair market value (FMV) rather than historical cost, the price incurred during the purchase of the fixed asset. Under the CCA method, both monetary and nonmonetary items are restated to current values.
Requirements for inflation accounting differ between IFRS and U.S. Generally Accepted Accounting Principles (GAAP). Both IFRS and GAAP have been treating Argentina as “hyperinflationary” since 2018 because cumulative inflation there over the prior three years has exceeded 100%. However, the requirements they impose on companies operating in the country vary.
IFRS permitted international businesses with subsidiaries in Argentina to continue using the peso for their accounts, provided they restate them to adjust for inflation. In contrast, U.S. firms with activities in Argentina are being forced to use the dollar as their functional currency, costing them in foreign exchange losses.
Insurance company Assurant Inc. warned in its 2021 annual report that “management has classified Argentina’s economy as highly inflationary in accordance with GAAP accounting requirements and, as a result, the functional currency of our Argentina subsidiaries was changed from the local currency to U.S. dollars and their non-U.S. dollar denominated monetary assets and liabilities were subject to remeasurement resulting in losses.”
Advantages and Disadvantages of Inflation Accounting
Inflation accounting comes with many benefits. Chief among them, matching current revenues with current costs provides a much more realistic breakdown of profitability.
On the flip side, providing adjusted figures can confuse investors and give companies the opportunity to flag numbers that shine it in a better light. The process of adjusting accounts to factor in price changes can result in financial statements being constantly restated and altered.
What Are CPP and CCA Short for in Inflation Accounting?
CPP stands for current purchasing power; CCA stands for current cost accounting. These are the two main methods used to adjust financial statement figures in inflation accounting.
How Do You Calculate Inflation?
The percent inflation rate is calculated as the CPI at the end of the period divided by the CPI at the beginning of the period multiplied by 100.
For example, let's assume you wanted to calculate the inflation rate between January 2006 and January 2022. According to the Consumer Price Index table, January 2022 has a CPI of 281.148 and January 2006 has a CPI of 198.300. The formula to calculate the percent inflation rate is therefore 281.148 / 198.300 × 100 = 141.77%.
What Does IFRS Define as Hyperinflation?
IFRS defines hyperinflation as prices, interest, and wages linked to a price index rising 100% or more cumulatively over three years.