This lesson describes what inflation is and the various categories of inflation. It discusses the effect that inflation in an economy has on a firm's earnings and financial statements.
General price level changes creates distortions in financial statements. Inflation accounting is used in countries with high inflation.
Discuss how inflation can impact a company's financial statements
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Under this type of accounting, assets and liabilities are recorded at their values when first acquired. They are not then generally restated for changes in values. Costs recorded in the Income Statement are based on the historical cost of items sold or used, rather than their replacement costs.
In economics, this occurs when a country experiences very high, accelerating, and perceptibly "unstoppable" rates of inflation. In such a condition, the general price level within an economy rapidly increases as the currency quickly loses real value.
In most countries, primary financial statements are prepared on the historical cost basis of accounting without regard either to changes in the general level of prices. Accountants in the United Kingdom and the United States have discussed the effect of inflation on financial statements since the early 1900s .
Hyperinflation Graph: German Hyperinflation Data
General price level changes in financial reporting creates distortions in financial statements such as:
Inflation accounting, a range of accounting systems designed to correct problems arising from historical cost accounting in the presence of inflation, is a solution to these problems. This type of accounting is used in countries experiencing high inflation or hyperinflation. For example, in countries such as these the International Accounting Standards Board requires corporate financial statements to be adjusted for changes in purchasing power using a price index.
Source: Boundless
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