inflation accounting

Definition

Adjusting financial statements to show a firm's real financial position in inflationary times. It aims to indicate how rising prices and lower purchasing power of the currency affect a firm's cost of refinancing its productive assets, and of its ability to maintain an adequate level of profit on the capital employed. One method is to adjust every figure in the balance sheet on the basis of a price index (such as consumer price index) which reflects the current purchasing power of the currency. Another method suggests to revalue tangible assets at their replacement cost. In valuation of an inventory, inflation accounting treatment can effect the firm's taxable income, cash position, and reported earnings, depending on whether the firm uses FIFO or LIFO methods. FIFO method, shows a higher profit, therefore higher tax burden and a decrease in net cash flow. LIFO method lowers the profit and tax burden and increases the net cash flow.