Inflation accounting

Inflation accounting addresses a fundamental problem in economic measurement: when the price level changes, comparing nominal figures across time becomes misleading. A company reporting £1 billion in revenue in 2026 vs £800 million in 2021 appears to have grown 25% — but if CPI rose 20% over the same period, real revenue growth was only about 4%. Without inflation adjustment, nominal growth overstates real performance.

The problem applies to GDP (hence the distinction between nominal and real GDP), wages (nominal vs real wages), interest rates (nominal vs real interest rates), corporate profits, asset values, and tax liabilities. In all these cases, inflation accounting applies a deflator — typically a price index — to convert nominal figures to a consistent real-terms basis.

Standard financial accounting (historical cost accounting) records assets and inventories at their original purchase price. During inflation, this creates two distortions:

Inventory profit illusion: Companies using FIFO (first in, first out) inventory accounting sell goods at current prices but record cost of goods sold at the (lower) historical purchase price. The resulting "profit" is partly real and partly an inflationary holding gain. During 2021–23, many US retailers reported strong nominal profit growth that was partly inventory illusion — driven by rising prices, not genuine operating efficiency. The LIFO (last in, first out) method partially corrects for this.

Understated depreciation: Depreciation is calculated on the historical cost of assets. During inflation, replacing an asset costs more than its depreciated book value — so reported depreciation understates the true economic cost of asset usage. Capital-intensive industries (utilities, manufacturing) are most affected. The IFRS IAS 29 standard requires full inflation adjustment in hyperinflationary economies (defined as cumulative 3-year inflation above 100%).

The choice of deflator matters. For GDP, national statisticians use the GDP deflator — a broad price index covering all domestically produced goods and services. For consumer purchasing power, CPI or PCE is used. For specific industries, sector-specific producer price indices (PPI) are more appropriate.

An important subtlety: CPI measures what consumers pay, not what producers receive. If import prices are rising while domestic production costs are stable, CPI rises but the GDP deflator may not rise as much. A multinational comparing revenues across countries should use market-specific deflators, not a single global CPI. For cross-country economic comparisons, Purchasing Power Parity (PPP) adjustments — as published by the World Bank — are used to account for both price-level differences and over time changes.