What are the consequences of inflation on accounting?

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Inflation impacts us in glaringly obvious ways, such as the time value of money. Repercussions can extend further and show up in more understated ways than end-user prices. It poses several consequences for accountants, from calculating profits, expenses and debts to financial reporting, investing, and inventorying.

Profits

Inflation causes the cost of goods and services to rise, leading to higher inventory and asset costs. In turn, this can lead to increased revenue and profits.

However, it could also lead to lower net income if revenues don’t keep pace with production costs, such as when a business can’t or won’t immediately pass along price increases onto the final price of their product. Plus, there are wage increases to consider, too.

Reporting and Evaluating

Inflation changes the value of money. For example, looking back at how “cheap” gas was decades ago isn’t a fair assessment of its value now because wages also increased over those years. As a result, comparing financial statements from one period to another is more complex, which affects reporting, planning and budgeting. Accounting becomes even more complex if a company’s budget contains components that might change at a different rate than general inflation.

Results based on pre-inflation pricing can be less accurate than those produced by inflation accounting. Experienced accountants turn to the proper price index during inflation to better reconcile data.

Inflation impacts financial reporting and assessments. As prices rise and the purchasing power of money declines, businesses need help correctly presenting and evaluating data (e.g., discount rates used to communicate the time value of, forecasting, going concern assessments, impairment reviews, etc.)

Accounting techniques vary in response to economic changes. Relying on historical data without adjusting for price change can be misleading. Furthermore, historical accounting depreciation methods tend to be problematic because they often understate the decline in asset values and overstate profits and tax liabilities. Varying cost-flow inventory valuation methods can skew balance sheet data in different ways. Clients and employers will likely need expert guidance to make the best sense of the numbers and apply them to sound business decisions.

Investing

Escalating prices lead to a more volatile stock market, causing businesses to reconsider the amounts and intensities of investments. Investing in stocks now could lead to handsome returns. Or it could be the height of a market getting ready to correct itself. If buying in at the wrong time, a company will overpay, causing diminishing Returns on Equities (ROE).

Investors should consider the ROE as it is influenced by earnings per share to determine the sustainable growth rate. This can impact the price of equity security as seen in the price-to-earnings (P/E) ratio.

Fluctuating investments affect the handling and reporting of realized and unrealized gains and losses. The resulting impacts on deferred assets and tax liabilities might require a switch to different accounting methods. Accountants must ensure that notable disclosures get included on financial statements.

Debt

Inflation affects interest rates and trickles down to those with variable interest rate loans. A company's debt rises as its interest rates on loans climb. Those affected may be able to switch to fixed-rate loans or apply for additional credit to lock in lower rates before they get any higher. Reducing debt continues to be a good move.

Reporting debt so that it best reflects and serves the company and investors is a challenge. Debtors have restructuring options – extinguishments, modifications or troubled-debt restructuring.

Inventory

Methods for determining inventory costs vary (LIFO, FIFO, average overall, etc.). Inflation affects profits and the ending valuation of inventory, which, in turn, affects tax liabilities. Companies may need to shift inventory accounting methods to better handle current market values and determine present costs.

Expenses

Inflation increases production costs. As an aside, it also negatively impacts the company’s discretionary goods and services. Businesses must choose to pass costs on to clients or shoulder shrinking gross margins.

Businesses need to keep an eye on vendors and service providers, which may increase their rates during times of inflation. They should also watch their long-term contracts and leases, which can change due to escalation clauses within those agreements.

Infographic

Inflation affects us in noticeable ways, such as the diminishing value of money over time. However, its consequences can also manifest in more subtle ways beyond the increase in end-user prices. For accountants, it can have several implications, ranging from calculating profits, expenses, and debts to financial reporting, investing, and inventory management.

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