Effects of Inflation in Financial Statements - Essay Example

FINANCIAL STATEMENTS AND REPORTING The Effects of Inflation Critically discuss the effects of inflation on company financial statements and how that will affect their usefulness to users of them. The Historical Cost Concept The historical cost concept is one of the fundamental conventions upon which accounting theory is based. Historical cost accounting convention is defined as “an accounting technique that values an asset for balance sheet purposes at the price paid for the asset at the time of its acquisition” (Morgensen & Campbell, 2004). Essentially, what it means is that assets and services that the company acquires or purchases are recorded in the accounting books at cost, or at the price they were acquired or purchased. The alternatives to historical cost accounting are current cost accounting and general purchasing power (GPP) accounting. Current cost accounting takes into account the changes in the current or prevailing values of the asset or service based on market fluctuations. The GPP is also known as the General Price-Level-Adjusted Historical Cost Accounting (GPLAHC) and in fine requires purchasing power gains and losses to be included in the computation of net income. Current cost and GPP accounting are also known as fair value accounting (Doupnik & Perera, 2007). For financial statements to be meaningful, amounts of dissimilar items must be stated in similar units, which is the reason why a monetary figure must be assigned for each item (Day, 2008). Stating the value of different types of assets in terms of monetary amounts enables them to be dealt with arithmetically. But more than this, the amounts may not be subjectively determined, otherwise there would be little sense in trying to establish a standard by which they could each be equally treated and subjected to mathematical operations. Market values, on which current and replacement costs are based, have a strong element of subjectivity. Under the historical cost convention, the value of an asset is held constant as of the time it was acquired – that is, at the price that was actually paid for it. Impact of Inflation on Financial Statements The historical cost concept has the effect of holding an asset’s value at the acquisition price, although the asset may have a long life, during which time the asset’s economic value may have changed. One influence on the economic value of an asset is inflation. Technically, “inflation is a persistent increase in prices, often triggered when demand for goods is greater than the available supply or when unemployment is low and workers can command higher salaries” (Dictionary of Financial Terms, 2008). Viewed alternatively, it is the loss in the purchasing power of money (Evans and Evans, 2007). Inflation affects the market price of goods and services, such that in monetary terms, the goods and services become more expensive over a period of time. Moderate inflation is generally acknowledged to accompany economic growth. However, extreme levels of inflation can be detrimental in the use of historical costs in determining the financial position and result of operations of a company. Double-digit inflation, hyperinflation (when prices rise by 100% or more annually), and deflation (widespread decline in prices) tend to create distortions particularly in the recording of costs of assets and services over a period of time. Among the underlying distortions created by inflation under the historical cost-based system of accounting is that the information conveyed by prices lose their relevance quickly in the context of a high inflation rate environment. The various purchases would be recorded against the varying purchasing power of money, creating differing bases among the costs. Since the numbers appearing in the financial statements represent currency expended under different amounts of purchasing power, strictly speaking they are not additive. For instance, in the balance sheet adding cash worth £10,000 held on the 31st of December with £10,000 representing real estate cost of a piece of land acquired in 1960 would yield an entirely inaccurate value of the assets, since the land valued in 1960 would have a significantly different value in today’s terms, maybe by a factor of 100 or more, without taking into account the effect of development of the surrounding real property. Other repercussions of this distortion are the following: 1. In the income statement, profits that would be reported during a period of inflation would generally be overstated, that is, would convey a higher perceived value than the new purchasing power level would impose. 2. The asset values for fixed assets such as plant and equipment, and current assets such as inventory, will not reflect (i.e., will understate) their economic value to the business. Non-monetary assets retain their true and intrinsic value inspite of inflation, but their expression in monetary terms based on the previous purchasing power level creates a distortion when viewed under the current purchasing power after inflation, making them appear less valuable. 3. Monetary assets would tend to erode in real value during high inflation, creating losses for the company; on the other hand, monetary liabilities will tend to create profits, because the real value of the debt is reduced by inflation. 4. The effect of inflation on the account for inventory stocks would depend on accounting policies. Firms that use the last-in, first-out (LIFO) inventory cost valuation would most closely match costs and prices during inflation, because it understates inventory value, overstates the cost of sales, and thus lowers reported earnings. On the other hand, the first-in, first-out (FIFO) inventory valuation method, because it tends to accomplish the opposite of the LIFO, would tend to make the company more vulnerable to distortionary information in an inflationary environment. Distortionary Effects on Decision Making The distortions created by a high inflation rate regime would tend to cause errors, some major, in managerial decision making based on the figures in the financial statements. For instance, since the profits reported for the period would be overstated, this could result in: (1) the overpayment of taxes, since net income is the basis of tax computations; and (2) the inopportune declaration and distribution of dividends to shareholders. Since the cost of operations and capital acquisitions looking forward would cost more, the company may actually be distributing more in dividends than it could afford, thereby impairing the continued operations and financial health of the company. Had the true current value been assessed after inflation, the company may have decided to retain more of the earnings instead of distributing it, in order to internally finance continued operations and planned expansions. Another difficulty introduced during inflationary economic conditions is the forecasting of future capital requirements, since the future prices for capital equipment would alter depending on market supply and demand. This would generally lead to increased leverage in the form of debt financing, and since high inflation rates tend to lead to higher interest rates and more stringent credit terms, this increases the financing risk to which the business is exposed. Furthermore, inflation would have different impacts across different companies. These usually introduce discrepancies among the accounts of that various companies, resulting in a lack of comparability among their financial statements, or even the financial statements of the same company prepared at different years or for different fiscal years. Inflation also has impacts on supplies and materials as well as capital equipment to varying extents. Those supplies and materials that are more closely correlated to the inflation index will experience greater price volatility than the mere change in purchasing power. Conclusion Historical cost accounting provides a stability to accounting processes that enhances the reliability of financial statements. However, there are economic phenomena that would tend to create distortions in financial statements prepared on the basis of historical costs. These include foreign exchange rate volatility, interest rate changes, and most importantly, inflation rates. These factors tend to change the purchasing power of currencies, and since assets are either monetary or expressed in monetary terms, the information conveyed by historical values tend to differ from real values in an inflationary regime. Care must thus be taken in the interpretation of financial statements, that accounts be first adjusted for inflationary effects before they are made the basis of financial analysis. References Brown, C C 2002 Conference Paper: Effects of Inflation in Financial Statements. Banco Central de Chile. Dictionary of Financial Terms 2008 Lightbulb Press, Inc. Doupnik, T & Perera, H 2007 International Accounting. McGraw-Hill Higher Education. Evans D L & Evans, O W 2007 The Complete Real Estate Encyclopedia. The McGraw-Hill Companies, Inc. Loth, R 2009 What You Should Know About Inflation. Investopedia. Accessed 2 January 2010 from http://www.investopedia.com/articles/01/021401.asp Morgensen, G & Harvey, C R 2004 The New York Times Dictionary of Money and Investing. Accessed 2 January 2010 from http://www.duke.edu/~charvey/. Scott, D L 2003 Wall Street Words: An A to Z Guide to Investment Terms for Today's Investor. Houghton Mifflin Company. Read More