Inflation is on the persistent rise because of this, the general price level of goods and services is increasing. However, it offers significant implications for financial reporting. Here, if you talk about traditional accounting methods, they do not fully capture the impact of inflation on a company’s financial statements, leading to the development of inflation accounting.
Here, inflation accounting comes into action as its main aim is to offer a more correct representation of a company’s financial position and performance in an inflationary environment.
So, keeping this in mind, let’s explore all about inflation accounting and its objective of inflation accounting in detail.
What is Inflation Accounting?
It is a kind of accounting that offers the effects of the inflation on overall business financial statements. However, it helps in adjusting the business financial statements so that it will reflect all changes in the buying power of the currency. This is very important so that inflation can show the overall accuracy of financial reporting.
In simple words, it delivers a correct representation of the organization’s financial position as well as performance with the time.
What are the Inflation Accounting Objectives?
1. Real Financial Reporting
One of the primary objectives of inflation accounting is to present financial information in real terms. With time, inflation is eroding the purchasing power of money by making it essential for businesses to adjust the companies financial statements to reflect the changing value of money.
Regards to this, real financial reporting helps stakeholders, especially investors and creditors, make informed decisions by offering a clear picture of a company’s actual economic performance and position.
On top of that, inflation accounting achieves this objective by restating historical cost financial statements into constant currency units by eliminating the distortions caused by inflation. However, by expressing financial data in terms of constant purchasing power, businesses can accurately compare their performance over different periods, enabling better decision-making and strategic planning.
2. Helps in Facilitating Long-Term Planning
Inflation accounting plays an essential role in facilitating long-lasting planning for companies. Due to an inflationary environment, traditional accounting methods are not powerful regarding the future purchasing power of money.
However, by offering correct and reliable financial information, businesses can make long-term investment decisions easily, set realistic goals, and create effective strategies to cope with inflation-related challenges.
Moreover, inflation-adjusted financial statements enable companies to analyze the real return on investments and assess the viability of long-term projects. This information is invaluable for management when making decisions about capital expenditures, research and development, and other strategic initiatives.
3. Helps in Enhancing Credibility and Transparency
Credibility and transparency are paramount in financial reporting. Inflation accounting enhances both by ensuring that financial statements correctly reflect the economic reality of a business. Almost every company who is adopting inflation accounting demonstrates a commitment to providing transparent and reliable financial information to their stakeholders.
Enhanced credibility can lead to increased investor confidence, lower borrowing costs, and improved relationships with creditors and regulatory authorities. By adopting inflation accounting practices, companies signal their awareness of economic challenges and ability to adapt to changing market conditions, fostering trust among investors and other stakeholders.
4. Helps in Preserving the Wealth of Shareholders
Another vital objective of inflation accounting is to protect the wealth of shareholders. Inflation can significantly impact the value of a company’s assets and liabilities, leading to misleading financial statements if not properly adjusted. By restating the financial statements in real terms, inflation accounting ensures that shareholders’ wealth is preserved and allows them to make investment decisions easily based on reliable information.
When inflation erodes the value of a company’s reported earnings and assets, shareholders might be misled into believing the company is performing poorly. Inflation accounting rectifies this distortion, enabling shareholders to assess the true financial health of the company and make investment decisions accordingly.
What are the advantages of Inflation Accounting?
The approach of inflation accounting offers a number of benefits. They are: –
- The company’s assets are shown at real value in a uniform way instead of fake values, as it is done in historical rupee values.
- Inflation accounting enables the maintenance of cash intact, which is very important in the case of limited liability companies.
- Both profit and loss are determined by correctly matching the total cost and the revenue at the current values, and they are comparable. However, this offers a real assessment of the performance of the business.
- Employees, stakeholders, trade unions, etc, are not misled by showing exaggerated profit value.
- By indicating the real value of all the fixed assets, inflation accounting enables the company to establish the realistic price of the organization’s shares.
Inflation Accounting Example
XYZ company does manufacturing and buying machinery in the year 2014 for Rupees 10,000. However, it is taking the help of an inflation accounting method to reinstate all its financial statements in the year 2022. Now, what is the real cost of machines that are purchased in 2014 in case the general CI was 400 and the year 2022, it’s 600?
Solution
Current price index = 600
Base price index = 400
Historical Cost = Rs.10,000
Now, the Current Cost
= Current price index / Base price index x historical cost
= Rs.(600 / 400 x 10,000)
= Rs.15,000.
Hence, the current cost will be Rs.15,000 and recorded as the closing balance in the balance sheet.
The Bottom Line
Inflation accounting serves as a vital tool for businesses operating in inflationary environments. However, its main objectives are deeply rooted in providing accurate, reliable, and transparent financial information, essential for informed decision-making by shareholders, investors, and other stakeholders.
However, by restating financial statements in real terms, inflation accounting preserves shareholders’ wealth, facilitates long-term planning, and enhances the credibility of financial reporting. In an ever-changing economic landscape, the adoption of inflation accounting practices is not just a best practice but a necessity for businesses striving to thrive amidst inflation-related challenges.
Frequently Asked Questions
1. What is the main objective of inflation accounting?
The main objective of accounting is to add realism into all the financial statements. This is important as it reflects the business’s financial performance and position correctly over a particular period.
2. What is the other name of inflation accounting?
The other name of inflation accounting is price-level accounting.
3. Who is most affected by inflation?
No doubt inflation affects every class of people, but it mostly hurts poor people and those who have fixed sources of income. On the contrary, investors and borrowers gain from rising inflation.
4. Do businesses account for inflation?
Yes, businesses do consider inflation. According to the report, it has been found that around 76% of small, 65% of medium, and 54% of big companies have been maintaining their inflation accounting.