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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.

     
     

 
  
 

    

 

  

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Fair value 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.

 
  
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
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.


ƐIn 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.Ƒ

 

    

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)

 

  


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 power. 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.

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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 rate. 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.
2001 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

(a) 30,000 x 105/100 = 31,500

(b) 30,000 x 110/100 = 33,000
(c) (30,000 x 105/100) - 30,000 = 1,500
(d) (63,000 x 110/105) - 63,000 = 3,000

   

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.

The International Accounting Standards Board defines hyperinflation in IAS 29 as:"the cumulative inflation rate over three
years is approaching, or exceeds, 100%."

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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."