While financial experts initially expected higher levels of inflation to be transitory, the annual rate of inflation rose significantly during 2021 and 2022. Many now believe inflation is a more persistent global issue that may remain much longer. Further, inflation is a worldwide issue (see Table 1) and may rise as China’s economy emerges from COVID-related lockdowns, increasing the international demand on various resources. While news reports focus on the effects that higher levels of inflation have on individuals and the economy in general, the effect that inflation has on financial statements is often overlooked.
During time periods when the annual rate of inflation is very low, as it has been over the last 40 years, users of financial statements can rely on the information contained therein to make important management and investment decisions. As inflation rises, however, the assumptions underlying current accounting theory may not always hold. Thus, the value of information contained in financial statements may be diminished. As a result, effects of inflation on the information contained in financial statements must be evaluated by management and investors before they rely on accounting numbers to make decisions.
FINANCIAL ACCOUNTING CONCEPTS
In its Statement of Financial Accounting Concepts (SFAC) No. 8, Conceptual Framework for Financial Reporting, the Financial Accounting Standards Board (FASB) states that the general purpose of financial reporting is to “provide financial information about the reporting entity that is useful to existing and potential investors, lenders, and other creditors in making decisions about providing resources to the entity.” Oskar Bogstrand and Erik A. Larsson stated that to be useful, financial information “must both be relevant and faithfully represent what it purports to represent.” Relevance requires that information be able to make a difference in the decisions made by users, which necessitates that it has either predictive and/or confirmatory value.
The FASB also emphasizes that the usefulness of financial information is enhanced if it is reported in a timely manner and is able to be verified. Furthermore, the usefulness of financial information is enhanced if it is understandable to users of the financial statements and is able to be compared with information reported by other entities as well as with information reported by the same entity in a prior period.
Current accounting practice for many assets relies on the historical cost concept. When an asset is acquired, it’s recorded at the cost to obtain it. Following the monetary unit assumption, assets are maintained in the financial statements in nominal units of money and aren’t adjusted for changes in the purchasing power of money over time. In other words, numbers in the financial statements aren’t adjusted for inflation.
UNDERSTATEMENT OF ASSETS AND OVERSTATEMENT OF EARNINGS
While accounting standards generally require assets to be recorded at historical cost, asset costs are sometimes written down. Examples include writing down a receivable or inventory to net realizable value or an impaired fixed asset to fair (market) value. But asset costs generally aren’t changed to reflect increases in current market values.
A consequence of current accounting standards is that the usefulness of many numbers in financial statements may be reduced during prolonged periods of high inflation. Assets listed on the balance sheet may become significantly understated relative to current market values. Because asset costs become expenses on the income statement during the normal course of business operations (e.g., as inventory is sold or assets are used in the process of generating revenues), the understated asset costs lead to an understatement of expenses. As a result, while revenues reported on the income statement are generally measured in current dollars, many expenses are reported in nominal dollars from past years and don’t reflect the current cost of doing business. Consequently, earnings are generally overstated during periods of inflation.
The comparison of financial statement numbers from different years becomes increasingly more difficult if inflation extends over multiple years because no adjustments have been made for the changes in the value of a dollar. Some expenses on the income statement will reflect current costs of conducting business, and other expenses will reflect lower amounts that were recorded in prior years when costs were significantly lower. Consequently, the interyear comparability of financial information is reduced, as is the predictive value of reported earnings. Thus, the usefulness of information in financial statements will be diminished as inflation rises and persists for multiple years. Some may even argue that information reported in financial statements will at some point turn into misinformation unless adjustments are made related to the effects of inflation.
To provide a better understanding of the effects of inflation on financial information, three examples that can commonly distort earnings during times of rising prices will be discussed: interest expense on debt, depreciation on fixed assets, and sales of inventory.
DEBT AND INTEREST PAYMENTS
One of the mandates of the U.S. Federal Reserve is to maintain stable prices in the economy. As inflation rises, the Federal Reserve commonly increases the federal funds rate in an attempt to increase borrowing costs throughout the economy, reduce the amount of money in the economy, and gradually stop the rise in inflation. With the rate of inflation reaching 7% at the end of 2021 and remaining between 7% and 9% during 2022, the Federal Reserve increased the federal funds rate 425 basis points during 2022 to a range of 4.25% to 4.5%. The Federal Reserve is hiking rates at the most aggressive pace since the early 1980s. At the December 2022 Federal Reserve meeting, Chair Jerome Powell indicated that while the size of the rate hikes will likely be smaller, the rate hikes will continue and the federal funds rate will remain elevated indefinitely, at least until inflation returns closer to the Fed’s 2% inflation target. On February 7, 2023, the Federal Reserve continued to take measures on inflation by again raising the federal funds rate 25 basis points to its current range of 4.5% to 4.75%. Thus, the current cost of borrowing money is increasing significantly for individuals and businesses alike.
During the past decade, entities have enjoyed the ability to borrow money at historically low rates of interest. As a result, the liability section of the balance sheet for many businesses has increased annually for many years. Current reported earnings will benefit greatly due to the low rates of interest being paid on the existing debt. These funds are being used to generate revenues that are rising with inflation, yet interest expense reported on the income statement is low due to fixed interest rates on the debt. If entities issue new debt in the future to retire existing debt, however, they will need to pay significantly higher rates of interest to attract investors and their interest expense will rise accordingly. In other words, the effect of low rates of interest on existing debt will result in reported earnings that aren’t sustainable in the future if new debt must be issued to retire the old debt.
Earnings may also be artificially inflated through the retirement of existing debt. Because rising interest rates have an inverse effect on bond prices, the market value of current corporate debt is declining. This creates an opportunity for entities to retire their own debt through market purchases and report significant gains on the retirement of the debt. While such a gain should be reported as other income below the operating income line, it may result in a significant increase in net income and earnings per share. Thus, when evaluating reported earnings, investors should consider the positive effect of debt retirements during times of rising inflation.
FIXED ASSETS AND DEPRECIATION
When buildings and equipment are purchased, the acquisition cost is capitalized to an asset account. A variety of depreciation methods may be used to allocate the cost to the periods of use, but the central concept of depreciation is to match the cost of an asset with the periods during which revenues are generated through the use of the asset. During periods of stable prices, it’s assumed that depreciation of the asset over its useful life will generate an earnings number that can be used to make management and investment decisions. In fact, investors often view operating income as being predictive of future performance of the entity.
During periods of rising prices, however, the revenues generated by use of these assets will continue to rise with inflation, but the depreciation expense will continue to be calculated based on the original acquisition cost and estimates determined at the time the asset was acquired. Thus, revenues in current dollars will be matched against expenses based on costs from a prior period that may be significantly lower than the current cost of the asset. While the effects of this mismatch may be immaterial during times of relatively stable prices, rising inflation produces greater effects in the later years of the useful life of an asset. Part of the earnings will be attributable to current operations, while part of the earnings reported on the income statement arise simply because an entity is using older assets. In other words, the predictive value of earnings will be reduced, making the reported earnings number less relevant and, thus, less useful to investors unless additional subjective calculations are made.
Calculations of financial ratios will also be affected by inflation. Take, for example, the return on assets (ROA) ratio (i.e., net income/average total assets). While inflation tends to cause revenues and net income to rise, total assets are reported using historical costs and won’t reflect the current cost of assets in this ratio. Assuming the managers of two entities are performing equally well during times of higher inflation, the ROA may be higher for the company with older fixed assets relative to one with newer fixed assets.
The following example illustrates the effects that fixed assets can have on accounting information during times of inflation. Assume that in 2020, a corporation has $100 million in revenues, $30 million in depreciation expense, and $60 million in other expenses, and its tax rate is 30%. (In other words, 21% federal income tax rate plus 9% state income tax rate; state income tax rates range from zero to 12%. For simplicity, a 9% rate is assumed, thus creating the 30% corporate tax rate used in this example.) Income before taxes is $10 million, and after-tax income is $7 million. Thus, before-tax profit margin is 10%, and after-tax profit margin is 7%. This example assumes that no new fixed assets are purchased, straight-line depreciation is used, and inflation is 8% annually. Thus, while the depreciation expense remains constant over the four-year period, revenues and other expenses increase 8% each year (see Table 2).
This example illustrates how constant depreciation on assets that haven’t been replaced can have a significant effect on reported financial numbers. While revenues increase by only 25%, both income before taxes and net income more than double. Financial ratios are also affected. Before-tax profit margin increases from 10% to 16.2%, while profit margin increases from 7% to 11.3%. Both the reported financial information and the related financial ratios are distorted by inflation. As a result, decision making during times of rising prices becomes increasingly difficult.
INVENTORY AND COST OF GOODS SOLD
Inventory represents one of the largest items on the balance sheet of most retailers. When prices are stable, gross profit on the sale of inventory generally results from the process of buying and selling. During times of rising prices, however, gross profit inherently contains two distinct components: (1) profit generated from buying and selling inventory and (2) profit caused by holding the inventory. When first-in, first-out (FIFO) is used to determine the cost of goods sold, the costs of the oldest inventory are placed on the income statement and generate higher earnings. The faster prices rise, the greater the potential that holding gains will result in an overstatement of reported earnings during the current period.
Last-in, first-out (LIFO) places the most recent inventory cost into cost of goods sold on the income statement. Thus, LIFO results in a measure of profit that’s closer to the actual amount of earnings generated from buying and selling inventory during the current period. LIFO, however, generally results in an undervaluation of inventory reported on the balance sheet. Because the oldest costs are placed on the balance sheet, businesses that have been using LIFO for an extended period of time may report an inventory amount on the balance sheet that’s significantly lower than its current replacement cost. When calculating financial ratios such as inventory turnover and ROA, the denominator will be understated and cause each of these ratios to be artificially high. Thus, use of different cost-flow assumptions will reduce the comparability of earnings and financial ratios of businesses more during times of rising prices than when prices are stable.
“LIFO reserve” represents the difference between the cost of inventory reported using LIFO and the cost of inventory that would have been reported using FIFO (or an alternative cost-flow assumption). During periods when a business is expanding, the LIFO reserve will generally continue to increase as required inventory levels are increased. On the other hand, if inventory at the end of a year decreases relative to the inventory that existed at the end of the prior year, part of the LIFO reserve is liquidated. Liquidation of old LIFO layers results in low costs from prior years being included in cost of goods sold and matched against higher revenues from the current year, thus increasing gross profit on sales. The higher the rates of inflation and the older the cost numbers, the more likely liquidation of LIFO layers will significantly overstate the earnings for the current year.
To see how inflation impacts inventory turnover ratio comparisons under FIFO and LIFO, consider the following example. Assume a company maintains inventory levels of 10,000 units while purchasing and selling 60,000 units per year. At the end of 2020, inventory cost is $10 per unit and annual inflation is assumed to be 8% during each of the next three years. Under FIFO, the company would report in its annual financial statements the cost of goods sold sections shown in Table 3. In contrast, under LIFO the company would report the cost of goods sold sections shown in Table 4 in its annual financial statements.
This example shows that during periods of inflation, cost of goods sold increases at a faster rate under LIFO than under FIFO. This causes net income to be lower under LIFO than under FIFO and creates the incentive for the company to use LIFO to reduce its tax liability. In addition, however, the use of LIFO during times of rising prices also causes the inventory turnover to increase relative to companies using FIFO. With each succeeding year, comparability in financial reporting is further reduced.
When the sale of inventory is a major source of income for business, it’s very important to examine the footnotes to determine the cost-flow assumption being used and to consider its effect on the financial statements. During times of rising inflation, this becomes even more important.
PAST ATTEMPTS TO DEAL WITH INFLATION
In 1979, the FASB released Statement of Financial Accounting Standards (SFAS) 33, Financial Reporting and Changing Prices, to deal with the high levels of inflation the United States experienced during the 1970s. While SFAS 33 maintained the use of nominal historical cost numbers for the financial statements, it required larger public enterprises to disclose supplemental information on the effects of inflation in the footnotes to the financial statements. Rather than requiring a comprehensive restatement of each item on the income statement, the FASB only required restatement of the items most affected by inflation (e.g., cost of goods sold, depreciation, depletion, and amortization). In addition, entities that used LIFO were generally not required to restate cost of goods sold because it was assumed to be very close to the current dollar cost of the inventory sold. Significant flexibility was allowed with respect to the methods of calculating current cost numbers that were required to comply with SFAS 33. Due to the expected complexities of compliance, the FASB also exempted certain industries (e.g., motion pictures, mining, oil and gas, and real estate) from making current cost disclosures.
The creation of current cost accounting reporting standards proved to be difficult. For example, while the FASB opted for the use of the consumer price index to measure inflation, credible cases could be made for the use of other price indices. Also, because prices change continuously throughout the accounting cycle, the wisdom of using average prices during the year or prices at year-end wast debated. Various methods were developed, and each had its own merits and deficiencies. Over the next five years, the FASB released numerous SFASs modifying the current cost reporting requirements. By 1984, however, the rate of inflation had declined significantly. Soon thereafter, the FASB modified the current cost reporting standards, opting to encourage them rather than require them.
INFLATION EFFECTS ON INCOME TAX RETURNS
In addition to the effects of inflation on financial accounting information, it should be noted that the overstatement of earnings will also appear in tax returns. The U.S. Congress has enacted legislation mandating the indexation of many tax numbers (e.g., tax brackets, standard deductions, and various credits) to mitigate “bracket creep” and prevent inflation from pushing taxpayers into higher tax brackets without experiencing any increase in purchasing power of their income. While indexation of many numbers in the Internal Revenue Code began in the 1980s, Congress has never enacted indexation of the tax basis of assets. As a result, taxable income is increased by inflation when investments are sold because the amount realized on sale is stated in current dollars while the deduction for the amount invested is measured in old dollars. Thus, part of the gain realized on the sale of investments is merely due to inflation.
Likewise, tax depreciation deductions on assets acquired in prior years are often understated, leading to a similar overstatement of taxable income. Although many have often argued for the indexation of investment costs for tax purposes, Congress has never enacted such a law. Thus, rising and persistent inflation causes taxpayers to pay more taxes even though much of the income may not reflect any real increase in purchasing power.
If inflation persists, the usefulness of financial accounting information will be diminished. Interest expense based on low interest rates on older debt would understate the reported interest expense compared to the interest cost that would be incurred in the future on new borrowed money. Depreciation based on outdated asset prices would understate the real cost of using fixed assets. Gross profit from the sale of goods would include both profit from buying and selling the goods and gains from holding the inventory. Thus, earnings reported on income statements would likely be overstated by the effects of inflation. The FASB may feel increased pressure to modify accounting methods (or mandate additional disclosures) in an effort to maintain the ability of users to interpret the reported earnings. Developing new accounting rules or disclosures that better reflect the results of operations, however, would again be a difficult task and would require the resolution of many implementational challenges.
In the meantime, the impact of inflation should be carefully considered by users of financial information. For example, users should read the footnotes in annual reports and look for disclosures related to the effects of inflation. In addition, users could prepare a vertical analysis of the income statement and compare the results with the ratios from prior years to help identify anomalies that may have been caused by inflation.
April 2023
