According to my naked eye, the U.S. is afflicted with significant inflation. Food prices are up. Gasoline and transportation prices are up. Healthcare prices are up. Clothing prices are up. Entertainment prices are up. Higher education tuition is up. Everything is up, except my mortgage payments. These are increasingly difficult to pay given that higher education wages have remained constant for the past ten years and I have less left over at the end of the month.
But is inflation large enough to impact the interpretation of financial statements? As I discuss in this essay, the answer is YES!
To address the issue of the impact of inflation on financial statements, we need a not too biased estimator of the rate of inflation.
According to information released by the Bureau of Labor, inflation (as measured by the CPI) has been relatively low over the past ten years, usually averaging 2-3% per year. I have always been skeptical of these reports, for three reasons. First, the reported government figures don’t agree with my perception of the change in prices. I think that inflation has been higher. Second, the U.S. government has significant incentives to under report inflation. A low reported inflation rate means that government transfer payments (such as social security) are minimized. Also, a high reported inflation rate has adverse impacts on the ruling party’s (Republican or Democrat) to remain in power. Third, I’m aware that the methods used to calculate the CPI have changed during the past 30 years. For example, volatile changes in prices are minimized in the weighted average index.
So, how high has been inflation using non-government supplied computations? Such a computation would remove the government bias, but possibly introduce new biases.
I use Shadow Government Statistics, which is owned by American Business Analytics & Research LLC, a company founded by John Williams. It uses his methods to recompute the rate of inflation using the same government methodologies in place in 1980. According to his data, inflation has been averaging about 10% per year for at least a decade.
Inflation data provided by SGS feels about right to me, and I view it as credible. If inflation is this high (≥ 10%), then analysis of financial statements should be based on inflation adjusted numbers. For example, if a company has been reporting an upward trend in revenues, adjusting the numbers for constant dollars might reveal a real decreasing trend in revenues.
Moreover, we need guidance from accounting standard setters as to the principles to use in financial statement preparation so that inflation adjusted numbers can be used for comparisons. Unfortunately, this is not about to happen anytime soon under the leadership of Hoogervorst (IASB) and Seidman (FASB), because something this useful would run counter to government policy.
Never-the-less, if you are a financial statement analyst, you should be performing some inflation adjustments.
For guidance, you might refer to a copy of the obsolete Statement of Financial Accounting Standards #33 or the outdated IAS #29 (which predates IFRS). Be aware that the IAS standard doesn’t require inflation adjusted information until inflation hits 100% over a three year period (about 26% per year).
Debit and credit – - David Albrecht