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.
credit: Shadow Government Statistics.
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
Hmm…seconding lucadiborgo comment about sloppiness. Remember, inflation is a rise in the overall price level NOT a change in relative prices. And I’m sure you’re not suggesting giving management leeway to pick their favored definition of inflation, right?
The Shadowstats metric is also completely unconvincing. 10%? Really, that doesn’t pass the smell test. And if you look at, for example, MIT’s Billion Prices metric, it actually mirrors CPI pretty closely (http://www.econbrowser.com/archives/2010/11/bpp_us2_nov_10.jpg).
As do most measures of inflation (http://cr4re.com/charts/charts.html?CPI#category=CPI).
If you’re worried that government measures aren’t good enough, or trust market forecasts more, why not use something like (yield on 5 yr treasuries) – (yield on 5 year TIPS)? Or some other observable market measure of inflation? All of these yield very, very low inflation values both over the last few years and into the foreseeable future.
Which makes me question why the current accounting of “nominal prices only” isn’t working. Leave it up to investors to make their own judgments about future inflation. We accountants have a difficult enough time getting the nominal values right.
Thanks for the link to the MIT econbrowser.com. I’ll have to check it out. Never-the-less, I have philosophical differences with the government computation of CPI.
My thesis was for investors to remember to make inflation adjustments. I would do so, as I think inflation is a bit higher.
Inflation accounting was so poorly done back in 1980, nobody trusted the numbers. Perhaps it’s a good think that now we’re leaving it up to investors.
Inflation accounting became a moot issue in the early 80s when inflation was brought under control. But is it under control now?
Luca, thanks for being kind with your criticism. My “measurement” of inflation is not carefully done. I knew that, absent much reading in the area for which I don’t have time, I was leaving myself open to criticism on that dimension. So, I decided to keep it simple.
My main point is that investors and lenders should be doing some sort of adjustments in their analyses so as to account for the effects of inflation. Given that any formal measurement is going to be unsatisfactory, using an estimated rate of inflation is probably the best one can do.
I definitely think we need to take inflation into account – however, I’m not sure which level of inflation I find more credible. Do you really think that (on average) the consumer goods you purchased in 2011 were 10% or more greater than 2010?
That would be a complete game changer for understanding how much we’re earning on our investments, or how much salary increase we need each year just to keep up with inflation.
Now this is a topic I could see spending some time on if I was an accounting researcher…
Off to read Statement #33 now…
I realize that the main point of your post concerns the issue of whether financial reporting rules should consider inflation.
But I just cannot get past the blatant sloppiness in your definitions of what passes for inflation.
“According to my naked eye, the U.S. is afflicted with significant inflation…Everything is up, except my mortgage payments.”
Such ‘naked eye’ commentary is fine for water cooler discussions. But it is horribly imprecise for legitimate treatment of the issue. And regardless of all the costs that “are up”, housing-related payments (which are NOT up) represent anywhere from 30%-60% of most households’ monthly income. If you take an honest look at the composition of the cost of living for the average household, it becomes obvious that the U.S. is not “afflicted with significant inflation”.
I do not trust the BLS CPI or the Shadowstats figures; for both come from gov’t numbers subject to rampant adjustments and assumptions.
Inflation is always and everywhere a monetary phenomenon. It is the increase/decrease in broad credit outstanding, marked-to-market. Just because there may not be a convenient data point reporting this exact reading on a monthly basis, that is no excuse to use sloppy, imprecise, and misleading assumptions as a substitute.