Financial statements provided by a company are nothing more than historical documents that indicate the financial position of the company at some time in the past. Fast-changing market conditions, investor opinions, and the value of currency all alter the financial position of a corporation. Inflation is but one influence on the discrepancy between the book and market values of assets that are listed on a firm’s financial records.
According to Dictionary.com, inflation is defined as:
a persistent, substantial rise in the general level of prices related to an increase in the volume of money and resulting in the loss of value of currency
Essentially, as more money enters an economic system, prices will rise to compensate for the increase in the amount of money circulating in the system. Because of inflation, it takes more money to buy something today than it did yesterday and it will cost even more tomorrow. From the twenty years from about 1988 to 2008, inflation increased prices by a factor of about 1.65x. In other words, something that cost $1.00 in 1988 cost about $1.65 in 2008, a 65% increase due to inflation.
Figuring inflation is nothing more than a simple time value of money calculation. For example suppose that 2% annual inflation is expected over the next five years. How much will something that costs $1.00 today cost in five years? The future value formula is given as:
FV = PV * (1 + r)n
where FV is the Future Value, PV is the Present Value, r is the inflation rate, and n is the number of years. So, the inflation rate of 2% in five years is:
FV = 1.00 * (1 + 0.02)5
It is also possible to figure out the price of something in the past by using the Present Value formula:
PV = FV / (1 + r)n
To find out the price of something five years assuming 2% inflation per year at a cost of $1.00 today, use the Present Value formula as:
PV = 1.00 / (1 + 0.02)5