How to Counter Inflation’s Impact on Accounting
Inflation has skyrocketed over the past two years, throughout North America and the rest of the world. And this unsettling trend is showing no signs of going away; in fact, inflation may continue to rise throughout the rest of 2022 and into 2023.
You only have to turn on the news or take a trip to the grocery store to see the ways inflation impacts consumers. But everyday shoppers are not the only group struggling under the weight of inflation. Accounting firms — both private and corporate — are also feeling the pressure. Let’s look at how inflation and accounting are connected, how accountants have been affected by the recent rise in inflation, and how they can deal with the chaos inflationary pressures are causing.
Causes of inflation
To understand the impact of inflation on accounting, it’s important to first understand the causes of inflation. The current rate of inflation — surpassing the previous 40-year high — has left many economists scratching their heads, but increased demand, increased material costs and supply chain issues are common causes. As with many things, the pandemic has also had a huge impact.
With the COVID-19 pandemic now into its third year, many people are still staying home more often than they were pre-pandemic and buying more products online compared to purchasing services in person. The pandemic initially caused a surge in demand, followed by a number of shortages: everything from meat to toilet paper, furniture and more. On the other hand, pandemic-related layoffs, shutdowns and resignations led to slower supply chains and higher production costs.
In some cases, inflation can be the result of surplus cash. People may have found new jobs with more competitive pay, saved up during the pandemic by not going out to eat, or received extra money from economic stimulus checks. When there’s more cash being thrown around than there are products available, inflation can accelerate.
Main impacts on accounting
So how does all of this impact accounting? For one thing, inflation warps financial statements and gives a distorted view of someone's return on equity. The goal of financial statements is always to achieve stability, which can be difficult in unstable times. If your client has any debt on variable-rate loans, the interest costs are likely to go up as central banks try to fight inflation. Overhead expenses will also go up, and investments can fluctuate wildly from gains to losses.
Inflation can also make it difficult to get a sense of one’s return on assets and the value of their inventory. Under the generally accepted accounting principles (GAAP), the value of an inventory is determined by measuring the lower of either the cost of the inventory or its market/net realizable value. Inflation causes the market value to become less predictable, thus making the inventory more difficult to account for. The weight of this impact can vary depending on whether you use the first-in, first-out (FIFO) or last-in, first-out (LIFO) accounting method.
Finally, inflation essentially makes historical data irrelevant when it comes to costs, value and equity. Accountants traditionally rely on historical data — past financial statements, market trends and more — to formulate a plan for financial health. Constantly rising inflation makes the future harder to predict based on historical data. This means accountants who typically rely on historical numbers have to look to other strategies for success.
Strategies for overcoming inflation’s challenges
Fortunately, there are some accounting strategies that ride the waves of inflation more smoothly than others. You can help overcome the impact of inflation by utilizing inflationary accounting.
This strategy was, in fact, built for times of inflation. With this approach, accountants look at historical data and then adjust the numbers to reflect the current rate of inflation and the corresponding values. This requires you to frequently update financial statements as the economy changes. There are a few ways to tackle inflationary accounting.
Current purchasing power (CPP) begins with the separation of monetary assets (those with a fixed monetary value) and non-monetary assets (those without a fixed value). When it comes to monetary assets, accountants record the net loss or gain based on inflation. Non-monetary assets, on the other hand, must be given a figure that serves as a conversion equivalent for inflation. The consumer price index (CPI) for the financial period is then divided by the CPI at the time of the transaction. This gives accountants a clearer sense of inflation.
Current-cost accounting (CCA) removes historical data from the equation entirely. CCA determines the value of an asset instead by looking at its fair market value (FMV). This is a simpler method than CPP. Instead of separating monetary and non-monetary assets, CCA re-evaluates both types of assets to reflect the current FMV.
FIFO and LIFO are two different methods of inventory accounting. There is also average cost, which takes the average of all items sold. With FIFO, the first items that are purchased are the first items that are recorded on the inventory report as sold. With LIFO accounting, the most recent items purchased are the first items recorded as sold. LIFO can show a lower net income than FIFO or the average, but it also makes taxes a little simpler. With LIFO, there are fewer inventory write-downs to be recorded.
How technology can help
Technology can assist your accounting firm in handling the hurdles of inflation in less time with fewer errors. Automated accounting software, like that from Caseware, streamlines the process. It pulls data from all departments to give a clearer and more comprehensive view of your clients' transactions.
Not only that, it also uses data analytics to report on patterns and trends in a company’s expenses. These patterns paint an accurate picture of the effect inflation has had on the company so that you can tackle its accounting accordingly. Cloud software also helps accounting departments adjust to the recent uptick in work-from-home situations by allowing you to access your data from any device.
Need to mitigate the impact of inflation on your financial statements and accounting processes? Contact us today to learn more or to request a trial.