The Historical Cost Debate

Missive Nº 289

Hi,

Originally – before there were any GAAPs and IFRSs – all variable items as well as all constant items together with all monetary items (basically all items in financial statements) were valued at Historical Cost since money – the monetary unit of account –was generally assumed to be stable in real value over time: the infamous stable measuring unit assumption. Today, SA accountants maintain this infamous and very destructive and very economically destabilizing assumption only for the valuation of the majority of income statement items (excluding salaries, wages, rents, etc that accountants value in units of constant purchasing power) and all balance sheet constant items during low inflation and deflation.

Values used in relation to variable items include the following:

Market value
Fair value
Net realisable value
Present value
Recoverable value
Current cost
Carrying value

Residual value

“The residual value of an asset is the estimated amount that an entity would currently obtain from disposal of the asset, after deducting the estimated costs of disposal, if the asset were already of the age and in the condition expected at the end of its useful life.”

Value in use
Settlement value
Book value
Replacement cost
Historical cost

The Historical Cost Debate

The Historical Cost Debate is the debate over the last 100 years or so about the exclusive use of Historical Cost for all accounting purposes. The accounting profession has realized for a very long time that financial reports based on Historical Cost for all economic items do not fairly represent a company’s results and operations. As a result of this debate the pure Historical Cost Accounting model has been improved dramatically during this time, so much so, that today we have a huge volume of IFRS where under variable items are not all valued at HC but at the values as indicated above. As a result of the Historical Cost Debate variable items are today valued at, e.g. fair value or the lower of cost and net realizable value or market value or recoverable value or present value. This debate has thus been a very valid and successful debate regarding the valuation of variable real value non-monetary items.

Unfortunately, the stable measuring unit assumption is still an IFRS compliant option that everyone uses for the valuation of most constant items during low inflation and deflation. Fortunately, the option of measuring financial capital maintenance in units of constant purchasing power during low inflation has been approved by the IASB in the Framework, Par. 104 (a) in 1989. Unfortunately, no-one uses it.

SA accountants value variable items in terms of IFRSs or SA GAAP when they implement both the traditional HCA model and whenever they decide to choose to measure financial capital maintenance in units of constant purchasing power. Inflation, per se, has no effect on the real values of variable items. Inflation – per se – can only destroy the real value of money and other monetary items: nothing else.

Kindest regards,

Nicolaas Smith

Variable items exist independently of how SA accountants value them

Missive Nº 298

Hi,

As we know, the economy consists of three basic economic items:

1.Monetary items
2.Variable real value non-monetary items
3.Constant real value non-monetary items

Monetary items are money held and items with an underlying monetary nature. Non-monetary items are all items that are not monetary items. Non-monetary items are further sub-divided into variable and constant items.

Variable items are non-monetary items with variable real values
valued in terms of IFRS or GAAP.

The first economic items were variable items not yet expressed in terms of money since money was not yet invented at that time. Once money was invented all economic items, including variable items, were expressed in monetary terms.

Examples of variable items and how they are valued

Property – at cost or fair value
Freehold Land – at cost or fair value
Buildings – at cost or fair value
Leasehold Improvements – at cost
Plant – at cost
Equipment – at cost
Equipment under Finance Lease – at cost
Investment Property – at fair value
Goodwill – at cost
Other Intangible Assets – at cost
Capitalised Development Items – at cost
Patents – at cost
Trademarks – at cost
Licences – at cost
Investments in Associates – at cost
Joint Ventures – at cost
Other Financial Assets – at fair value
Derivatives designated and effective as hedging instruments – at fair value
Foreign currency forward contracts – at fair value
Interest rate swaps – at fair value
Financial assets carried at fair value through profit or loss
Non-derivative financial assets designated as carried at fair value through profit or loss
Held for trading derivatives that are not designated in hedge accounting relationships – at fair value
Held for trading non-derivative financial assets – at fair value
Available-for-sale investments carried at fair value
Redeemable notes – at fair value
Shares – at fair value
Inventories – at the lower of cost and net realisable value
Raw Materials – at the lower of cost and net realisable value
Work-in-progress – at the lower of cost and net realisable value
Finished Goods – at the lower of cost and net realisable value
Foreign currency – at market value

Variable items in South Africa are valued, for example, at fair value or the lower of cost and net realizable value or recoverable value or market value or present value in terms of IFRS or SA GAAP. “Listed companies use IFRS and the unlisted companies could use either IFRS or Statements of GAAP.” – as per SAICA.

SA financial reports fairly represent the fundamental real values of variable items in terms of IFRS or SA GAAP only at the balance sheet date – excluding those valued at original nominal Historical Cost when that original date is not the balance sheet date on a primary valuation basis. The fundamental real values of variable items exist independently of being valued at their original nominal HC after the original date they came about or were acquired by the firm. Valuing a variable item at its original nominal HC during its lifetime does not destroy its real value because it will be valued at its current market value whenever it is finally exchanged or sold or disposed of in the future.

Kindest regards,

Nicolaas Smith

SAICA put your money where your mouth is

Missive Nº 297

Hi,

The South African Institute of Chartered Accountants states:

"We do not concur with the suggestion that the standards should reject the stable unit measuring assumption."

and

"Inflation-adjusted accounts in a low inflation environment insult the user."

SAICA should put its money where its mouth is and state at the entrance to their offices at Bruma Lake and on their website that salaries at SAICA are frozen and that they will never inflation-adjust their salaries in the future.

SAICA is a very credible institute. SAICA has a very high level of credibility.

Yours sincerely,

Nicolaas Smith

Measurement of the Elements of Financial Statements

Missive Nº 296

Hi,

Here is a verbatim copy of some paragraphs of the International Accounting Standard Board´s

Framework for the Preparation and Presentation of Financial Statements



Measurement of the Elements of Financial Statements

Par. 99. Measurement is the process of determining the monetary amounts at which the elements of the financial statements are to be recognised and carried in the balance sheet and income statement. This involves the selection of the particular basis of measurement.

Par. 100. A number of different measurement bases are employed to different degrees and in varying combinations in financial statements. They include the following:

(a) Historical cost. Assets are recorded at the amount of cash or cash equivalents paid or the fair value of the consideration given to acquire them at the time of their acquisition. Liabilities are recorded at the amount of proceeds received in exchange for the obligation, or in some circumstances (for example, income taxes), at the amounts of cash or cash equivalents expected to be paid to satisfy the liability in the normal course of business.

(b) Current cost. Assets are carried at the amount of cash or cash equivalents that would have to be paid if the same or an equivalent asset was acquired currently. Liabilities are carried at the undiscounted amount of cash or cash equivalents that would be required to settle the obligation currently.

(c) Realisable (settlement) value. Assets are carried at the amount of cash or cash equivalents that could currently be obtained by selling the asset in an orderly disposal. Liabilities are carried at their settlement values; that is, the undiscounted amounts of cash or cash equivalents expected to be paid to satisfy the liabilities in the normal course of business.

(d) Present value. Assets are carried at the present discounted value of the future net cash inflows that the item is expected to generate in the normal course of business. Liabilities are carried at the present discounted value of the future net cash outflows that are expected to be required to settle the liabilities in the normal course of business.

Par. 101. The measurement basis most commonly adopted by entities in preparing their financial statements is historical cost. This is usually combined with other measurement bases. For example, inventories are usually carried at the lower of cost and net realisable value, marketable securities may be carried at market value and pension liabilities are carried at their present value. Furthermore, some entities use the current cost basis as a response to the inability of the historical cost accounting model to deal with the effects of changing prices of non-monetary assets.



The above sections of the Framework do not include measurement in units of constant purchasing power. This comes next in the concept of capital and the concept of capital maintenance in the Framework. It is an actual measurement basis. It is the measurement basis currently used by all accountants world wide - including SA accountants - to value salaries, wages, rentals, regulated prices, etc in units of constant purchasing power during low inflation. It is thus universally used for the valuation of only some income statement constant real value non-monetary items during low inflation.

It is required to be used for all non-monetary items - variable and constant real value non-monetary items - during hyperinflation. This is a requirement of IAS 29 Financial Reporting in Hyperinflationary Economies.

It is also required by the IASB to be used for the valuation of all income statement and balance sheet constant items during low inflation when accountants choose financial capital maintenance in units of constant purchasing power in terms of the Framework, Par. 104 (a) during low inflation.

Measurement in units of constant purchasing power is thus completely generally accepted as a distinct and well understood and universally used measurement basis during low inflation. It is a generall accepted accounting principle (GAAP) during low and hyperinflation.

Kindest regards,

Nicolaas Smith

The net monetary gain or loss conundrum

Missive Nº 295

Hi,

SA accountants have to calculate the net monetary loss or gain from holding monetary items when they choose the Constant ITEM Purchasing Power Accounting model in terms of the International Accounting Standards Board´s Framework, Par. 104 (a) and measure financial capital maintenance in units of constant purchasing power in the same way as the IASB currently in terms of IAS 29 requires its calculation and accounting during hyperinflation.

There are net monetary losses and net monetary gains during low inflation too, but they are not required to be calculated when accountants choose the traditional Historical Cost Accounting model.

It is an inexplicable contradiction that net monetary gains and losses are required by the IASB to be calculated and accounted during hyperinflation but not during non-hyperinflationary periods, especially when the IASB approved alternative to HCA, namely CIPPA does require their calculation and accounting during low inflation.

Kindest regards,

Nicolaas Smith

Ultimately, inflation-adjusting accounts in a low inflation environment is a blessing to users.

Missive Nº 294

Hi,

The statement "Financial capital maintenance can be measured in either nominal monetary units or units of constant purchasing power," in the IASB´s Framework, Paragraph 104 (a), means that Constant ITEM Purchasing Power Accounting has been authorized by the IASB since 1989 as an alternative to the traditional HCA model, including during periods of low inflation.

This means that the international accounting profession has been in agreement regarding the use of CIPPA for financial capital maintenance in units of CPP during low inflation since 1989. It also means that CIPPA and the inflation-adjustment of constant items to maintain their real values in a low inflationary environment are authorized by IFRS since the Framework is applicable in the absence of specific IFRS.

Income statement constant items like salaries, wages, rents, pensions, utilities, transport fees, etc are normally valued by accountants in units of CPP during low inflation in most economies. Payments in money for these items are normally inflation-adjusted by means of the CPI to compensate for the destruction of the real value of money (the monetary medium of exchange) by inflation.

Inflation is always and everywhere a monetary phenomenon and can only destroy the real value of money (the functional currency inside an economy) and other monetary items. Inflation can not and does not destroy the real value of non-monetary items. Constant items´ real values can be maintained by accountants choosing the CIPPA model as per the Framework during low inflation as authorized by the IASB since 1989 instead of currently being destroyed by the implementation by accountants of the traditional HC model when they apply the stable measuring unit assumption.

It is thus accountants´ choice of the HCA model and not inflation that destroys the real value of constant items never maintained at a rate equal to the inflation rate when HC accountants choose to implement the stable measuring unit assumption for an indefinite period of time during continuous inflation.

Implementing the CIPPA model means accountants choose to reject the stable measuring unit assumption which they implement when they choose to measure financial capital maintenance in nominal monetary units. Accountants world wide currently choose the traditional HCA model except during hyperinflation when they are required by the IASB to implement IAS 29 which is based on the CPPA inflation accounting model.

Kindest regards,

Nicolaas Smith

Hyperinflation in South Africa

Missive Nº 293

IFRS compliant financial capital maintenance in units of constant purchasing power would always be a better accounting model than HCA during inflation.

SA accountants unknowingly destroy the real value of reported Retained Earnings at the rate of inflation under HCA implementing the stable measuring unit assumption in the SA real economy.

Rejecting the stable measuring unit assumption by measuring financial capital maintenance in units of constant purchasing power as authorized by the IASB in the Framework, Par. 104 (a) in 1989 would stop this destruction of real value in Retained Earnings.

It would remove distortions in the real economy, improve economic stability and guarantee that no wipe-out of internal demand would be possible in the SA economy like what happened in the recent past in the Zimbabwean economy under very high rates of inflation.

Hyperinflation is still possible in SA in the Rand, but, with no stable measuring unit assumption and all constant items (including salaries, wages, rentals, shareholders´ equity, trade debtors, trade creditors, taxes payable, taxes receivable, etc) being automatically updated in units of constant purchasing power, economic stability in the real economy would be guaranteed as it was in Brazil during 30 years of hyperinflation of up to 2000% per annum.

Brazil used indexation to maintain the real values of non-monetary items during the 30 years of hyperinflation in their internal currencies during that period.

Financial capital maintenance in units of constant purchasing power in terms of the Framework, Par. 104 (a), is the same as indexation, but, only in constant items - not in variable real value non-monetary items. The latter are valued in terms of IFRS or SA GAAP.

Retained Earnings can be updated under IFRS but not under HCA.

Kindest regards,

Nicolaas Smith