Lellith Garcia in Economists and Finance, Financial Analyst Jan 20, 2021 · 1 min read · +700

3 Ways the Inflation Rate Can Distort the Balance Sheet

The inflation rate is the increase in the prices of goods and services and consequently decreases the buying power of money. Then how does the inflation rate affect the financial modeling result? The financial statement is using the actual costs to record transactions, and these values are seldom equal to the market value. Also, it doesn't consider the unrealized gains and losses; that's why accounting income differs from economic income.

3 Ways the Inflation Rate Can Distort the Balance Sheet

1. Value of Assets. The balance sheet recorded asset value based on the acquisition cost. It does not consider the market value of the assets. It makes the assets and the expenses understated as the depreciation deducted is not the current value, which results in overstated income. Overstated income means higher taxes paid than usual and will lead to higher dividends paid to the investors.

2. Inventory Cost Valuation. The kind of inventory management used has a different impact when the inflation rate is considered. We will discuss below how the last-in, first-out (LIFO), and first-in, first-out (FIFO) valuations effect if there is inflation in prices.

     a. Last in, first-out (LIFO). LIFO uses the cost of the latest inventory, which increases the costs of goods sold and decreases income. Low income means low tax. However, its ending inventory is understated since valued at its purchase cost. This method would be impractical for businesses that sell perishable goods since they won't dispose of the latest stocks and let the old inventory left into decay. Companies must use this approach with consideration for more accurate accounting of costs.

     b. First in, first-out (FIFO). This valuation uses the oldest (first) inventory in its operation, which means lower costs of goods sold, resulting in higher reported income. High income means high taxes for the company. On the other side, the latest inventory reported for the ending stock captures the increase of prices and the more accurate value of the asset.

3. Reported Interest Expense. Due to inflation, the value of the debt decreases, resulting in overstated interest expense as computed using the book value. The outcome is an understated income and a lower tax rate.

By knowing the effects of the inflation rate on the financial modeling result, you can select a better method that suits bests for your business. Business accountants must suggest a way that can best shows business condition and profitability. To help with the financial modeling and easy to use model templates for your three financial statements, you can access eFinancialModels.com.