The Evolution of Inflation Accounting - A Comprehensive Overview

It comes with no such surprise that this article focuses not only on Accounting but also on economics (thanks to inflation). First things first, let us start from the very basics. An economy can be classified into

two types, a developed economy and a developing economy. The best example that can be quoted for a developed economy would be the United States of America, the largest economy in the world and an example for a developing country would be India.

Irrespective of the types of economy, every nation has to prepare its budgets, which can be a balanced budget, where the government revenues are equal to the government expenditures, or it can be an unbalanced budget, where the government revenues are not equal to the government expenditures. When the government revenues are greater than the spending, it will be considered as a Surplus budget, and in case of the opposite, it will be regarded as a Deficit Budget. With this in reference, it can be said that the Developed economies like the US have a Surplus budget and underdeveloped or developing economies have a deficit budget.

This helps us with a clear understanding of economies, but you may ask, what does it have to do with inflation? Or inflation accounting?

Well, lets consider an example. If the government were to spend on certain goods like Aircrafts, it would increase its spending, increase the public income (obviously because public would manufacture the air crafts). Due to increase in income, people would now be more willing to spend money on goods and services, increasing the demand for goods which in turn increases the price. This state of an economy with rising prices is referred to as inflation. So, government spending does have a vast effect on inflation, but it depends on the type of economy, that would determine the amount of spending by the government.

Under normal circumstances, companies will have to prepare their financial statements, which are nothing but their Profit and Loss A/c and Balance Sheet. But how would companies react during such period of inflation? Well, here is where inflation accounting comes into picture.

Besides preparing their normal books of accounts, companies would have to prepare another set of accounts which are adjusted for price level changes (in simple terms, inflation). Financial statements are prepared on the assumption that the currency is stable, but it is not true for some countries which experience hyperinflation or even inflation as a matter of fact. The adjustments have to be made to such statements according to the purchasing power of the people.

How Inflation Accounting evolved over time

The history of inflation accounting is a long but significant one. The evolution of this method of accounting was done when it was realized that using the historical cost basis of accounting led to various problems, main one being it did not depict an accurate picture of the value of items in the financial statements, especially in areas of inflation and hyperinflation.

Inflation accounting and the principles underlying it have been discussed for over 50 odd years now. Ironically, this topic was practically implemented during the Great Depression where various companies had to revise and restate their financial statements in order to comply with the situation that they were dealing with (thanks to Germany).

Although the first mentions of it were seen in Irving Fisher’s 1911 book, “The Purchasing Power of Money” renowned lawyer and accountant, Henry Whitcomb Sweeney drew inspiration and published his book in 1936 called “Stabilized Accounting” which was about Constant Purchasing Power Accounting and sheds light on preparation of financial statements, adjustments for changes in the value of money are also included. This is basically what inflation accounting actually is.

In a timeline of events we can see how the very first countries to be concerned with reporting price changes are the UK and US. It mainly began in 1969 in the US and then in 1974, the Financial Accounting Standards Board (FASB) issued an Exposure Draft (document to state the new Accounting practice) which proposed a mandatory disclosure of financial statements adjusted according to the inflated prices.

After this draft gained widespread attention, in 1976, the Securities and Exchange Commission started with a lot of changes. Later the FASB withdrew their Exposure Draft and in 1974, issued another one, followed by SEC changing them again and this cycle kept repeating.

In the United Kingdom, an initial attempt was made to implement inflation accounting by implementation of Accounting Practice in 1974 which favored constant purchasing power accounting. In 1975 the government appointed a committee on inflation accounting headed by Francis Sandilands who proposed a cost system having no provisions for the accounting of general inflation on monetary items. This was faced with a lot of backlash and a new committee called the Steering group was formed. They tried to bring about reforms and improve upon the propositions laid down by the previous committee but were also criticized because they had inadequate treatments for monetary items and the financial institutions were not pleased so this was also abandoned. Finally came the Hyde Committee, which proposed a fair treatment of monetary items during inflation called the Hyde Guidelines. This refined approach became the basis for inflation accounting in the UK.

Inflation Accounting in the Modern System of Accounting

In the modern system of accounting, accountants and economists are sharply focusing on the economical changes that take place each and every single day. Accountants are mainly encouraged to make use of such method during such tensed periods of an economy with the main intent of portraying a fair, overall view of operations of the entity. But of course, these operations will not be stable during periods of inflationary or hyper inflationary situations. If companies are going to report their assets and liabilities in their historical costs, they are simple overstating their profits because the purchasing power of the companies would have been heavily impacted due to inflation which brings down the real profit. Now, both these cases would turn to be a problem for the companies, hence it calls for certain adjustments, to display the real financial position of the firm during such hard times.

As the world faces the challenges of a global pandemic, the economy of every nation suffers. With lock downs, travel restrictions and social distancing economies are experiencing deep recessions. Although it is speculated that the real problem of inflation is going to arise in the years to come as a post pandemic effect.

Covid has affected the livelihood of each and every person with unemployment rates unexceptionally high, commodity prices falling and oil prices collapsing. Although incorporation of inflation into the financial statements is going to be the least of the problems that companies are going to have to deal with, as many of them are struggling to survive and barely able to make ends meet, while there are various others that are discontinuing operations. Policy makers of nations are going to have to carefully and thoughtfully implement strategies to deal with these unprecedented times and manage future inflationary pressures.

Thus, the future does look somewhat bleak but there’s always hope that things turn out to be better than expected.

---

References

1. https://bbamantra.com/inflation-accounting/

2. https://www.writemypapers.org/examples-and-samples/research-paper-on-inflation-accounting-in-the-system-of-modern-accounting.html

3. Research Paper : A STUDY OF RELATIONSHIP BETWEEN INFLATION ACCOUNTING AND COMPANY’S PERFORMANCE MEASUREMENT Authors: Dr B Nagaraju, Zakiyeh Ghavinezhad Lotf Abadi, Behnaz Neshati

4. Research Paper : RECENT DEVELOPMENTS IN INFLATION ACCOUNTING Author: Mohinder N kaura

5. Research Paper : INFLATION ACCOUNTING AND NON CORPORATE PROFITS

Authors: John B Shoven, Jeremy Bullow