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Analyzing Financial Statements > Considering Inflation's Distortionary Effects
Considering Inflation's Distortionary Effects
• Impact of Inflation on Financial Statement Analysis
• Disinflation
• Deflation
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Analyzing Financial Statements > Considering Inflation's Distortionary Effects
Impact of Inflation on Financial Statement Analysis
• Many of the historical numbers appearing on financial statements are not
economically relevant because prices have changed since they were incurred.
• Since the numbers on financial statements represent dollars expended at different
points of time and, in turn, embody different amounts of purchasing power, they
are simply not additive.
• Reported profits may exceed the earnings that could be distributed to
shareholders without impairing the company's ongoing operations.
• Future earnings are not easily projected from historical earnings. Future capital
needs are difficult to forecast and may lead to increased leverage, which
Hyperinflation Graph
increases the risk to the business.
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• The asset values for inventory, equipment and plant do not reflect their economic
value to the business.
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Analyzing Financial Statements > Considering Inflation's Distortionary Effects
Disinflation
• Disinflation occurs when the increase in the "consumer price level" slows down
from the previous period when the prices were rising. Disinflation is the reduction
in the general price level in the economy but for a very short period of time.
• The causes of disinflation may be a decrease in the growth rate of the money
supply. If the central bank of a country enacts tighter monetary policy, the supply
of money reduces, and money becomes more upscale and the demand for money
remains constant.
• Disinflation may result from a recession. The central bank adopts contractionary
monetary policy, goods, and services are more expensive. Even though the
demand for commodities fall, the supply still remains unaltered.Thus, the prices
Disinflation
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would fall over a period of time leading to disinflation.
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Analyzing Financial Statements > Considering Inflation's Distortionary Effects
Deflation
• In the IS/LM model (Investment and Saving equilibrium/ Liquidity Preference and
Money Supply equilibrium model), deflation is caused by a shift in the supply-anddemand curve for goods and services, particularly a fall in the aggregate level of
demand.
• In more recent economic thinking, deflation is related to risk: where the riskadjusted return on assets drops to negative, investors and buyers will hoard
currency rather than invest it. This can produce a liquidity trap.
• In monetarist theory, deflation must be associated with either a reduction in the
money supply, a reduction in the velocity of money or an increase in the number
of transactions. But any of these may occur separately without deflation.
US historical inflation rates
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• In mainstream economics, deflation may be caused by a combination of the
supply and demand for goods and the supply and demand for money; specifically
the supply of money going down and the supply of goods going up.
• The effects of deflation are: decreasing nominal prices for goods and services,
increasing buying power of cash money and all assets denominated in cash
terms, possibly decreasing investment and lending if cash holdings are seen as
preferable, and benefiting recipients of fixed incomes.
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Appendix
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Analyzing Financial Statements
Key terms
• business cycle A long-term fluctuation in economic activity between growth and recession.
• deflationary spiral A deflationary spiral is a situation where decreases in price lead to lower production, which in turn leads to
lower wages and demand, which leads to further decreases in price. Since reductions in general price level are called deflation,
a deflationary spiral is when reductions in price lead to a vicious circle, where a problem exacerbates its own cause.
• Financial Accounting Standards Board private, not-for-profit organization whose primary purpose is to develop generally
accepted accounting principles (GAAP) within the United States in the public's interest
• historical cost basis Under this type of accounting, assets and liabilities are recorded at their values when first acquired. They
are not then generally restated for changes in values. Costs recorded in the Income Statement are based on the historical cost
of items sold or used, rather than their replacement costs.
• hyperinflation In economics, this occurs when a country experiences very high, accelerating, and perceptibly "unstoppable"
rates of inflation. In such a condition, the general price level within an economy rapidly increases as the currency quickly loses
real value.
• liquidity trap A liquidity trap is a situation in which injections of cash into the private banking system by a central bank fail to
lower interest rates and hence fail to stimulate economic growth. A liquidity trap is caused when people hoard cash because
they expect an adverse event such as deflation, insufficient aggregate demand, or war.
• recession A period of reduced economic activity.
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Analyzing Financial Statements
Hyperinflation Graph
German Hyperinflation Data
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Wikipedia. "German Hyperinflation." CC BY-SA http://en.wikipedia.org/wiki/File:German_Hyperinflation.jpg View on Boundless.com
Analyzing Financial Statements
Disinflation
Disinflation is a decrease in the rate of inflation as illustrated in the yellow region of this graph.
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Wikipedia. "Disinflation graph." CC BY-SA http://en.wikipedia.org/wiki/File:Disinflation_graph.png View on Boundless.com
Analyzing Financial Statements
US historical inflation rates
Annual inflation (in blue) and deflation (in green) rates in the United States from 1666 to 2004
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Analyzing Financial Statements
Which of the following defines how inflation can distort financial
statements?
A) All of these answers.
B) Assets are not properly valued on balance sheets since each is
recorded at its historical cost.
C) The impact of price changes on monetary assets and liabilities are not
clear.
D) Future capital needs are difficult to forecast and may lead to increased
leverage.
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Analyzing Financial Statements
Which of the following defines how inflation can distort financial
statements?
A) All of these answers.
B) Assets are not properly valued on balance sheets since each is
recorded at its historical cost.
C) The impact of price changes on monetary assets and liabilities are not
clear.
D) Future capital needs are difficult to forecast and may lead to increased
leverage.
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Analyzing Financial Statements
Which of the following is a cause of disinflation?
A) An increase in the growth rate of the money supply.
B) A recession.
C) A business cycle expansion.
D) All of these answers.
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Analyzing Financial Statements
Which of the following is a cause of disinflation?
A) An increase in the growth rate of the money supply.
B) A recession.
C) A business cycle expansion.
D) All of these answers.
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Analyzing Financial Statements
A business is based in a country whose currency is going through
deflation. What does that mean for the business.
A) All of these answers.
B) The price for the goods and services it acquires within the country will
decrease.
C) The business may need to decrease the price of its products and
services.
D) Fewer investors may purchase the company's stock or buy its
corporate bonds.
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Analyzing Financial Statements
A business is based in a country whose currency is going through
deflation. What does that mean for the business.
A) All of these answers.
B) The price for the goods and services it acquires within the country will
decrease.
C) The business may need to decrease the price of its products and
services.
D) Fewer investors may purchase the company's stock or buy its
corporate bonds.
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Analyzing Financial Statements
Attribution
• Wikipedia. "Inflation accounting." CC BY-SA 3.0
http://en.wikipedia.org/wiki/Inflation_accounting#Historical_cost_basis_in_financial_statements
• Wikipedia. "Financial Accounting Standards Board." CC BY-SA 3.0
http://en.wikipedia.org/wiki/Financial_Accounting_Standards_Board
• Wikipedia. "hyperinflation." CC BY-SA 3.0 http://en.wikipedia.org/wiki/hyperinflation
• Wikipedia. "historical cost basis." CC BY-SA 3.0 http://en.wikipedia.org/wiki/historical%20cost%20basis
• Wikipedia. "Inflation accounting." CC BY-SA 3.0 http://en.wikipedia.org/wiki/Inflation_accounting
• Wikipedia. "Deflation." CC BY-SA 3.0 http://en.wikipedia.org/wiki/Deflation
• Wikipedia. "liquidity trap." CC BY-SA 3.0 http://en.wikipedia.org/wiki/liquidity%20trap
• Wikipedia. "deflationary spiral." CC BY-SA 3.0 http://en.wikipedia.org/wiki/deflationary%20spiral
• Wikipedia. "Disinflation." CC BY-SA 3.0 http://en.wikipedia.org/wiki/Disinflation
• Wiktionary. "business cycle." CC BY-SA 3.0 http://en.wiktionary.org/wiki/business+cycle
• Wiktionary. "recession." CC BY-SA 3.0 http://en.wiktionary.org/wiki/recession
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