Inflation Accounting: How the Economy Adjusts to Price Increases

Economists sounded alarms when the Bureau of Labor Statistics announced that the Consumer Price Index rose by 1.2% percent.

The economic roller coaster has reached its highest peak in decades. However, do not let the fear of a sudden drop mess with your head. The economy has recovered from inflation before. It will do so again.

What is Inflation?

Inflation occurs when a currency declines in value. This causes a rise in prices and a decrease in purchases. Over time, economic growth slows down.

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This is not always a bad thing. A low rate of inflation makes it easier for the economy to adapt during a recession. But, hyperinflation can have devastating impacts on the economy.

Companies facing profit losses must shift their focus from meeting demand to recovery. This leads to lower product production and employee layoffs.

What Causes Inflation?

The forces that drive inflation change in different situations. There are three main types of inflation:

Cost-Push Inflation: Occurs when prices rise to meet increasing production costs. When the demand rate remains the same, purchasers must pay more for goods. A recent example is the increase in gas prices caused by the recent sanctions on Russian oil.

Demand-Pull Inflation: When there is a higher demand for goods without an increase in supply. This often occurs in economies with low unemployment rates. The disposable income people have is spent on goods with previously lower demand. Since there isn’t enough supply to meet demand, consumers must pay more.

Built-In Inflation: This inflation builds upon existing inflation. Elevated prices led consumers to demand higher wages from their employers. Employers raise the prices of their goods to meet their employees’ demands for more pay. In time, this creates an increased price cycle.

How to Calculate Inflation

Inflation can be calculated using the inflation rate formula: ((starting price-finishing price) / starting price) x 100.

How Does Inflation Affect Accounting?

When the economy changes, so do accounting strategies.

A fatal mistake accountants make during inflation is relying on historical data. Previous account statements do not reflect a reality where supply doesn’t meet demand. Statements that use historical data tend to overstate profits.

Experienced accountants instead turn to the price index during inflation. This method, known as price-level accounting, measures the average price of a good across the economy. Price-level accounting creates more accurate results than ones based on pre-inflation prices do.

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Inflation Accounting Strategies

Accountants use these tried-and-true methods when accounting during inflation:

Current Purchasing Power (CPP): This method uses the general price level to adjust the historical costs. This allows investors to see what their current general purchasing power is. CPP uses the conversion method to adjust numbers from pre-inflation rates:

o Current PI number/Previous PI number = Conversion Rate

Current Cost Accounting (CCA): Balance sheets using this technique do not factor in historical costs. They instead use current individual values considering price changes relevant to the industry rather than economy-wide changes.

Learn More about Inflation in an Accounting Degree Program

Florida National University’s accounting program gives you the flexibility to adjust to inflation and everything else life throws at you.

Visit our website for more information on our accounting degree.