Advantages and Disadvantages of Inflation Accounting

By definition of it, Inflation accounting, also referred to as the purchasing power accounting method, means companies restating their financial records following adjustments for inflation, thus providing a more accurate representation of their current financial state. Didn’t get what these words mean? Well, simply put, it’s kinda a technique of reflecting the actual present costs of assets, liabilities, revenues, and costs instead of using their historical price records, you know? Therefore, when businesses go through periods of increasing prices, they can ensure that the reports that they give to the public correctly represent the true value of money today, you know, by implementing a proper inflation accounting method, which also results in enhancing the quality of their reports. So, now let’s see the primary reasons why so many companies or businesses out there utilize inflation accounting, and why exactly it is not a good fit for many. Here we go.

Advantages of Inflation Accounting

1. A Much Clearer Financial Picture

You see, using inflation accounting techniques, companies can show a more truthful account of their financial health. When we talk about the standard way of accounting, you see, financial statements are derived solely from the original pricing of the assets at their time of purchase, which could be unrealistic if inflation were high at that time. Right? But by using the inflation accounting methods, the right value of a company’s profitability and overall financial status can be calculated with precision.

2. Accurate Depreciation

Depreciation is the reduction in an asset’s value over time, like the wear and tear of machinery or buildings over time, you know? And, when inflation accounting is used, depreciation is determined according to the current and thus higher value of these assets than the previous or historical original prices. And that can be super helpful for many companies and organizations out there in a number of different ways.

3. No More Inflated Profits

Profit is by far the most important thing for a business, or even for an investor looking forward to investing in a company or business, right? Well, the profit numbers under the scenario of inflation accounting change as the economy changes, rescuing the company from the false sense of having more cash to invest than it actually has. And that’s what makes the financial statements more accurate and adjusted with the inflation rate.

4. Much Smarter And Better Decision-Making

Inflation accounting encourages the management to come up with strategies based on the true financial circumstances of the company. If really done right, this can help out the business in the long run and this is one thing that a lot of businesses out there just straight out ignore, which is a big mistake.

5. Easier Comparisons

You see, when considering inflation accounting, an analyst is able to use this accounting method in order to determine the financial health of the company in comparison with previous years of financial performance or the performance of competitors. This is because all financial figures have been adjusted so that they reflect the prices of currencies over time.

6. Protecting Your Capital

One important benefit of inflation accounting is that it helps protect the firm’s capital from depreciation, and how’s that? This practice ensures that the dividend paid out comes from the actual profit of the enterprise rather than the inflated figures, you know? This way, companies make sure that they aren’t just straight-up donating the dividends.

Disadvantages of Inflation Accounting

1. Can’t Ignore The Complexity

There is a noticeable distinction between regular accounting and inflation accounting regarding complexity, and what’s that? Well, just so you know there are quite a few calculations to be made as well as adjustments to be done in response to various fluctuations in the economy, thus it is not a small task at all. This technicality can cause misstatements and errors, that’s what makes it a bit too complex and too much time-consuming as well.

2. The Cost Factor

And just because of its complexity, inflation accounting can be costly to implement. Businesses might need to hire specialized accountants or invest in new software to handle the necessary calculations. This can be kinda a heavy financial burden, especially for smaller companies that may not be able to accept these extra costs.

3. Theoretical and a Bit Subjective

Inflation accounting often involves making assumptions and subjective judgments about the current value of assets and profits, and that’s how it is for now. This thus not-objective truth leads to the fact that many adjustments are done based on estimated values and not on real data, you know?

4. The Never-Ending Task

Price fluctuations caused by inflation are rapid and continuous which means full price lists are not possible. And as you may know, it is said that inflation accounting is not a one-off task, but rather an ongoing process since it requires continuous upgrades of financial statements all the time. This never-ending process can be a burden for businesses, as they need to continuously adjust their records to play by the current economic circumstances, or else the balance sheets start to see some bad figures down the line.

5. Issues During Deflation

Okay, so inflation accounting only tends to work like a charm when the costs of goods and services are on the rise, you know? But what if there’s a deflation period or when the economic conditions are such that the general price levels of goods and services are declining? Well, it is not much of a help in that case. That’s not it though, based on this inaccurate information about various investments, spending, and things like that, a business or company can go down the path of making bad decisions without realizing it.

Comparison Table for Advantages and Disadvantages of Inflation Accounting