When there is a significant amount of price inflation or deflation, the impact on the financial statements of a company operating in that environment can be so severe that the value of the information in the statements declines to the point of being nearly useless. Consequently, it is acceptable under GAAP to issue inflation adjusted financial statements under the following circumstances:
- The financial statements are denominated in a foreign currency; and
- The financial statements are for businesses operating in countries with highly inflationary economies; and
- The financial statements are intended for readers in the United States.
For example, the measurement of income from continuing operations on a current cost basis requires the following steps:
- Measure the cost of goods sold as of the date sold, using either its current cost or lower recoverable amount, or when those resources are used on or at least committed to a designated contract.
- Measure depreciation, amortization, and depletion based on either the average current cost of the service potential of the underlying fixed assets or their lower recoverable amount during the usage period.
It is allowable to measure all other revenue and expense items, as well as income taxes, at the amounts stated in the company’s income statement.
In essence, the restatement steps required to convert historical cost information into inflation-adjusted information are as follows:
- Review the contents of inventory at the beginning and end of the year, as well as the cost of goods sold, to determine when costs were incurred.
- Restate both inventory and the cost of goods sold, so that they are presented at current cost.
- Review fixed assets to determine when they were acquired.
- Restate fixed assets, depreciation, amortization, and depletion, so that they are presented at current cost.
- Determine the aggregate amount of net monetary items at the beginning and end of the reporting period, as well as the net change in these items during the period.
- Calculate the purchasing power gain or loss on the net monetary items.
- Calculate the change in current cost for both inventory and fixed assets, as well as the effect of changes in the general price level.
Inflation accounting is also known as general price level accounting.