Lecture 7: The Impact of Inflation on the Balance Sheet

Sometimes people view inflation as an evil process that depletes the value of
hard-earned savings. This is not always the case. Inflation is, quite simply, the
decline in the purchasing power of the U.S. dollar (or whatever currency is
utilized by the business). The type of assets held by an individual or business, as
well as the corresponding leverage employed, will determine how favorable or
unfavorable the impact of inflation will be (Makoujy, 2010; Rao and Thukaram,
2007).

Certain assets lose value as domestic inflation rises. Examples are cash (in U.S.
dollars) and accounts receivable. If a business holds U.S. dollars and the dollar
weakens, more of the cash will need to be utilized to purchase the same amount
of goods. Accounts receivable, similarly, lose value as the cash to which they
convert has reduced purchasing power upon receipt (Makoujy, 2010; Tracy,
2016).

Other assets may increase in value with inflation. A company may own real
estate or foreign currency, both of which would likely grow in value
denominated in U.S. dollars. To exaggerate the point, imagine that an owned
building is worth $1 million. Now let’s drop the value of the U.S. dollar by 50
percent. Now it takes twice as many dollars to buy the building, which is
currently worth $2 million. In short, hard assets offer greater protection from a
falling local currency (Makoujy, 2010). Of course, the impact of inflation must
also be considered on the income statement. To the extent that inflation hurts
business profits, the balance sheet will suffer as well over time due to lower
retained earnings. The main determinant of the positive or adverse effect that
inflation has on the income statement is whether the price received for goods or
services sold rises faster or slower than a company’s expenses. For example, if a
restaurant is unable to raise prices in a competitive environment (like my
favorite bastion of capitalism, the mall food court) and its costs for food
inventory go up, its gross margins will be squeezed and its profitability will
decline (Makoujy, 2010).

References
Makoujy, R. (2010). How to Read a Balance Sheet: The Bottom Line on What You Need to
Know about Cash Flow, Assets, Debt, Equity, Profit... and How It all Comes Together.
McGraw Hill Professional.
Rao, M. T., and Thukaram, R. M. (2007). Accounting and financial management for BCA &
MCA. New Age International.
Tracy, J. A. (2016). Accounting for dummies. John Wiley & Sons.

Exercise:
Determine whether the statements given below are true of false.
- Inflation can cause the book value of property, in particular, to differ greatly
from its current (replacement) value.
- Most financial statements are prepared on a historical cost basis and do not
account for the changes in the value of money due to inflation. This can distort
the true value of assets and liabilities, especially in high-inflation environments.