Question

Discuss how inflation will influence the evaluation of a company through their financial statements. Propose any adjustments that are necessary to provide a true and fair view of the company performances.

Answer 1

Inflation causes value of balance sheet items to change as rising inflation causes rising values of tangible assets. The debt with fixed charges remain the same while debt with floating charges become expensive. The profit of the company is overstated. Hence the PE ratio drops. The cost of financing increases. The cost of sales increases .The closing inventory is understated since the market rates increases. The expenses stated in the financial statements on historical costs become understated.

To provide true and fair view of the company performances , adjustments should be shown for increase in material costs and the expected increase in sales. The inventory should be valued on LIFO method so that the inventories are recorded at lastest cost.