Inflation Accounting

Stable measuring unit assumption

Inflation accounting is "an accounting system that adjusts values for changes in purchasing power" of money. Inflation has two components: monetary inflation called cash inflation and non-monetary inflation called historical cost accounting inflation. Cash or monetary inflation destroys the real value or purchasing power of money and other monetary items.

Unit of account

"One of the basic principles in accounting is “The Measuring Unit principle: The unit of measure in accounting shall be the base money unit of the most relevant currency." The accounting monetary unit of account is the only international standard unit of account that is not a stable unit of measure. All other units of measure, for example the inch, centimeter, millimeter, kilometer, mile, pound, gram, etc are, in fact, stable units of measure.

Accountants use a pyrrhic solution which created money illusion along the ages. They simply assume that all the many different monetary units in all the many different economies in the world created and managed by whichever central bank or government are all "stable" units of account in low inflation economies.

Price stability

This money illusion is aided and abetted even today by statements by the European Central Bank that "Price stability is defined as a year-on-year increase in the Harmonised Index of Consumer Prices (HICP) for the euro area of below 2%. The Governing Council has also clarified that, in the pursuit of price stability, it aims to maintain inflation rates below, but close to, 2% over the medium term."

This is stated despite the fact that continuous 2% annual inflation will destroy 51% of the real value of all monetary items as well as 51% of the real value of all retained earnings of all companies registered in the European Monetary Union over 35 years - all else except inflation being equal.

A high degree of price stability is a year-on-year increase in the Consumer Price Index of below 2%.

Price stability is a year-on-year increase in the Consumer Price Index of 0%.

Historical cost accounting model

The historical cost accounting model is the global basic accounting model.
“In most countries, primary financial statements are prepared on the historical cost basis of accounting without regard either to changes in the general level of prices or to increases in specific prices of assets held, except to the extent that property, plant and equipment and investments may be revalued.”

Stable measuring unit assumption

The stable measuring unit assumption is one of the basic principles of the historical cost model. The very basis of the historical cost model is not a fact but an assumption.

"One of the basic principles in accounting is “The Measuring Unit principle: The unit of measure in accounting shall be the base money unit of the most relevant currency. This principle also assumes the unit of measure is stable; that is, changes in its general purchasing power are not considered sufficiently important to require adjustments to the basic financial statements.”

Today the stable measuring unit assumption is implemented as part of the historical cost model only for the purpose of valuing constant real value non-monetary items in low inflationary economies. The accounting profession has realized over the years that the stable measuring unit assumption cannot be applied to variable real value non-monetary items. Variable real value non-monetary items are valued today, for example, at fair value, market value, present value, net realizable value or recoverable value in terms of IASB International Accounting and Financial Reporting Standards and US GAAPs as issued by the FASB.

Examples of variable real value non-monetary items are land, buildings, property, plant, equipment, vehicles, stock, raw materials, finished goods, marketable securities, foreign exchange, etc.

Foreign currency is not the functional currency in an economy where it is not the unit of account; that is, where companies do not officially do their books only in a foreign currency. Foreign currency is only the functional currency in countries that have dollarized their economies, for exmple, Panama, Ecuador and El Salvador.

Stable money: Normal or historic cost accounting assumes that transactions occurring over a period of time can be measured in terms of a single, stable measuring unit eg Pounds, Dollars ... This means that, in the UK, all accounts are drawn up in Pounds; and this year's balance sheet can be compared with last year's balance sheet. Consequently, if fixed assets brought down from last year were £1,000 and a further £500 of fixed assets were bought during this year, we would say fixed assets carried down from this year were worth £1,000 + 500 = £1,500. All of this gives rise to consistency but there is a problem with reality inflation means that very few currencies are truly stable. Many attempts have been made at solving this problem, incidentally, but, in the UK, for example, all efforts have proven useless. The only really meaningful accounting directive ever enacted on this subject was withdrawn by the accounting bodies in the UK several years ago.


Historical cost accounting inflation

The rapid destruction of the real value of money by Historical Cost Accounting hyperinflation is duplicated in the massive destruction of the real values of all constant real value non-monetary items not fully or never updated by the combination of hyperinflation and the implementation of the stable measuring unit assumption.

Brazil has a history of 30 years of non-monetary anti-inflationary policy measures of indexing non-monetary items from 1964 to 1994 that they called "uma política antiinflacionária não-monetária"

Constant real value non-monetary items are constant real values because of the Luca Pacioli double entry accounting model that we use today. When they were and are not fully or never updated, their real values were and are simply destroyed by the combination of hyperinflation and the implementation of the stable measuring unit assumption.

Constant real value non-monetary items were destroyed by the historical cost model exactly as the historical cost model is today destroying the real values of all constant real value non-monetary items not fully or never updated in all the world's low inflationary economies because of the global implementation of the stable measuring unit assumption.

Examples of constant real value non-monetary items are issued share capital, retained earnings, retained losses, provisions, trade receivables, trade payables, salaries, wages, fees, rent, interest paid and received in the profit and loss account, taxes, VAT, all items in the profit and loss account, eg, costs, expenses, income, revenue; also salaries payable, taxes payable, rent payable, rent receivable, royalties payable, royalties receivable, salaries receivable, other non-monetary receivables, accrued expenses, other non-monetary payables, current income taxes payable and current withholding taxes payable, provisions for warranties or court decisions, liabilities and assets for current tax, deferred tax liabilities and deferred tax assets, capital reserves, prepaid expenses, goodwill, net monetary loss and net monetary gain under Real Value Accounting and IAS 29, etc.

Retained earnings

The best example of historical cost accounting inflation is the current global destruction of the real value of all retained earnings balances in all companies with retained earnings in low inflationary economies by the combination of inflation and the stable measuring unit assumption. It is forbidden to update the real value of retained earnings balances in the world’s low inflation economies in terms of historical cost accounting rules, namely the stable measuring unit assumption. Retained earnings is, in principle, the same as cash on hand in all the world's companies in low inflationary economies. The average annual real value of retained earnings in all companies´ with retained earnings are this very moment being destroyed by the historical cost accounting model at the average annual rate of inflation in low inflationary economies.

Hyperinflation

Only companies operating in an economy with hyperinflation (perhaps only Zimbabwe at the moment with 8 000% inflation) are allowed to update retained earnings real value in terms of International Accounting Standard IAS 29 Financial Reporting in Hyperinflationary Economies.
But, only as long as "the cumulative inflation rate over three years is approaching, or exceeds, 100%" - the cumulative rate required for the implementation of IAS 29.

Once they are not in hyperinflation anymore, for example, 15% annual inflation for an indefinite period of time, they are not allowed to update retained earnings real value any more. Then they are forced by the historical cost model to destroy their retained earnings real value again – at 15% per annum. Or at all the various low levels of inflation in the world economy.
Most accountants are unaware that this is happening and that it is the result of them implementing the historical cost model.

Simply put: The historical cost accounting model destroys real value.

Inflation accounting

Inflation accounting was used to stop this massive destruction in the real values of constant real value non-monetary items in hyperinflationary economies.
Inflation accounting was used in one of two ways:

(1) It revoked the stable measuring unit assumption completely and thus eliminated its massive real value destroying effect in the accounting of constant real value non-monetary items in a hyperinflationary economy entirely; or

(2) It revoked the stable measuring unit assumption almost completely, thus limiting the enormous real value destroying effect in the accounting of constant real value non-monetary items to a low level by comparison.

Unidade Real de Valor

The Brazilian Unidade Real de Valor was an example of the first model.
It was recognized that hyperinflation destroyed the purchasing power of money. A constant purchasing power accounting model was thus developed to maintain the purchasing power of all non-monetary items in a hyperinflationary economy. This was achieved by using a stable non-monetary unit of value as an index unit. The Brazilians developed the Unidade Real de Valor for this purpose. It was a non-monetary reference currency in their unique case. URVs were quoted in Cruzeiros Reais and its intrinsic value was pegged to three price indices and had a fixed parity of 1-to-1 to the U.S. dollar. The exchange rate of URVs to Cruzeiros Reais was recalculated and published daily by the government.

Prices only for non-monetary items were quoted both in URVs and Cruzeiros Reais but payments had to be made exclusively in Cruzeiros Reais.

The fact that the Unidade Real de Valor was based on three Brazilian (not American or other) price indices resulted in the stable measuring unit assumption being revoked 100% in Brazil but only during the time of the Unidade Real de Valor.

Unfortunately the Brazilian Central Bank unwittingly reintroduced the very destructive stable measuring unit assumption into the Brazilian economy when they completed the unique second part of their Unidade Real de Valor and introduced it as their new currency, the Real. With the introduction of the Real they unfortunately adopted the historical cost model again and today the stable measuring unit assumption is destroying the real value of all Brazilian companies´ retained earnings balances at the annual rate of inflation in Brazil.

The predominance of the historical cost model in the accounting profession and accounting education results in the stable measuring unit being very well hidden away and hardly ever mentioned in accounting literature. The leading expert in inflation accounting, Geoffrey Whittington, did not mention the stable measuring unit assumption even once in his benchmark work "Inflation Accounting" which was a comprehensive study of the state of inflation accounting in 1983.

Country dollarization

The second example of the constant purchasing power inflation accounting model where the stable measuring unit assumption was almost completely revoked was the dollarization of countries ´ economies for example Yugoslavia, Panama and Ecuador. The fact that they introduced a relatively stable currency in their previously hyperinflationary economies as the only legal tender, reduced inflation in their countries to the inflation level of the hard currency introduced. In the case of Yugoslavia it was the German Mark (the Euro today) and the US Dollar in the other two countries.

They reduced the destruction of real value by the stable measuring unit assumption dramatically - by making the relatively stable hard currency the only legal tender in their countries - but, not completely. Since they all continue to implement the historical cost model, the combination of low inflation in their adopted hard currency, the US Dollar and the Euro, and the stable measuring unit assumption is continuing to permanently destroy the real values of all their constant real value non-monetary items not fully or never updated - the same as in the rest of the low inflation world economy. This destruction of real value now continues at a very much lower rate than the economy destroying rates during hyperinflation.

The total real value permanently destroyed world wide each and every year just in the real value of retained earnings is estimated in the hundreds of billions of US Dollars. Revoking the stable measuring unit assumption completely like in the case of the Brazilian Unidade Real de Valor by updating all non-monetary items monthly with reference to the respective country Consumer Price Index figures in the world's low inflationary economies would stop this destruction permanently. Countries with very low inflation rates would most probably only update all constant real value non-monetary items annually. That would permanently maintain hudreds of billions of US Dollars of Retained earnings real value in the world economy for an unlimited period of time in stead of destroying it permanently year in year out. That may lead to a paradigm shift away from Historical cost to a real value paradigm.

Company dollarization

An individual company can unilaterally apply inflation accounting to safeguard the company's constant real value non-monetary items from being destroyed by historical cost accounting inflation, namely, the combination of hyperinflation and the stable measuring unit assumption.
Dollarization of a company's daily business and accounting practices is a very effective company inflation accounting model. It is one of the simplest, the cheapest and easiest to understand and implement by the owners, management and workers of a company. It reduces historical cost accounting inflation to the level of the hard currency used.

The critical requirement is that the company must be able to continually update all its selling prices at the daily parallel rate. When a company can do that, it can dollarize the rest of its business. It will have no fear of hyperinflation. The rate would be immaterial to it.
It has an extremely low implementation cost.

The stable measuring unit assumption and the historical cost model are 98% revoked under this inflation accounting practice.

Any relatively stable currency can be used. It is best to use the hard currency that the company does most of its business in.

The lack of understanding of the principles of inflation accounting by company accountants, namely, the effects of the stable measuring unit assumption as well as the workings of a non-monetary index plus misguided very short term self-interest by the company owners normally stop company owners from unilaterally dollarizing their company accounts on an economy wide basis.

The total destruction of the Zimbabwean economy by the combination of hyperinflation and the stable measuring unit assumption as implemented as part of the historical cost accounting model would have been impossible if all companies in Zimbabwe had dollarized their accounts during the last seventeen years that Zimbabwe had been in hyperinflation.

International Accounting Standard IAS29 Financial Reporting in Hyperinflationary Economies.

The International Accounting Standards Board defines hyperinflation in IAS 29 as :
"the cumulative inflation rate over three years is approaching, or exceeds, 100%."


This is the same as 26% annual inflation for three years in a row.

Companies are required to restate their Historical cost financial reports in terms of the period end hyperinflation rate in order to make these financial reports more meaningful.

IAS 29 restated items are only valid new real values when the tax authorities of a hyperinflationary country pass the necessary legislation to accept the restated values as such.

IAS 29 is not very well accepted in hyperinflationary economies as a result of the many judgemental issues in the standard. Some companies refuse to apply it.

Despite the undeniable fact that the IASB revokes the stable measuring unit assumption only for the purpose of restatement in IAS 29, it is also very clear that the restatement of historical cost financial statements in terms of IAS 29 does not signify the abolishment of the historical cost model. This is confirmed by PricewaterhouseCoopers:
"Inflation-adjusted financial statements are an extension to, not a departure from, historical cost accounting."


The application of IAS 29 succeeds in maintaining the real values of constant real value non-monetary items such as shareholders equity items with six-monthly and annual balance sheet restatement as well as income statement items with monthly restatement. Since it lacks the essential daily update requirement, it fails as an effective inflation accounting model.

IAS 29 is not very well accepted, is fundamentally flawed which leads to many errors, maintains the stable measuring unit assumption and the historical cost model and lacks the essential daily update component.

PricewaterhouseCoopers

IAS 29 defines monetary items as :"Money held and items to be received or paid in money." The incorrect second half of the definition is followed by all accounting and auditing firms as evidenced by the PricewaterhouseCoopers ebook - bottom of Page 7 - that lists trade debtors and trade creditors as monetary items.

It is very unfortunate that PricewaterhouseCoopers give credibility to the incorrect second half of the definition. Not all items to be received or paid in money are monetary items. Money is simply used as a generally accepted monetary medium of exchange to affect the transfer of the real values of non-monetary items between economic entities. The real values of all non-monetary items are generally expressed in monetary values. That does not make them monetary items. Trade debtors and trade creditors are expressed in monetary values but are not monetary items when the underlying basis of the commercial transaction is non-monetary.
During the period of the Unidade Real de Valor, the proven and very successful Brazilian real value index unit, all trade debtors and trade creditors were updated in terms of the Unidade Real de Valor as non-monetary items. A trade debtor and the corresponding trade creditor are non-monetary items when the underlying basis of the commercial transaction is a non-monetary item.

PricewaterhouseCoopers confirm this principle when they state: :
"All balance sheet items must be segregated into monetary and non-monetary items. Most balance sheet items are obviously monetary or non-monetary. In less straightforward cases, the determination as to whether a component is monetary depends on its underlying characteristics. For example, the provision for doubtful receivables is considered monetary because receivables are monetary. The provision for inventory obsolescence is non-monetary because inventory is non-monetary."


Despite the above correct statement that the underlying basis of a transaction determines whether items are monetary or non-monetary, they still incorrectly and inexplicably list trade receivables, other receivables, trade payables, accrued expenses, other eayables, current income taxes and withholding taxes payable as monetary items.

Despite stating otherwise their analysis seems to be based on whether the deferred leg of a transaction or accounting entry involves payment of money or not and not the underlying monetary or non-monetary basis. In both cases the underlying basis is non-monetary but that seems to be ignored and overridden by the fact that there will be payment by means of money or not. When the deferred leg does not lead to payment of money, then the deferred leg is a non-monetary item (provision for inventory obsolescense). Where payment of money is involved the deferred leg item is considered a monetary item despite the fact that the underlying basis of the deferred leg is a non-monetary item. That analysis is obviously wrong. It is the underlying basis of the transaction or entry that counts not the choice of the future medium of exchange. The transacting parties can agree to use strawberries as the future medium of exchange to settle the trade debtor of current tax payable. That does not make the trade debtor or current tax payable equal to strawberries. They are still and will always be non-monetary items. The future medium of exchange will be strawberries. That has nothing to do with the current trade debtor or tax payable.

The Angolan tax authorities applied a non-monetary index to update taxes payable at a rate very similar to the parallel rate towards the end of the hyperinflatinary period in that country.

The International Accounting Standards Board

The accounting profession's failure after more than a 100 years of inflation accounting research and as well as many years of actual inflation accounting practice to produce - under the auspices of the International Accounting Standards Board - an effective inflation accounting model is reflected in the total destruction of the Zimbabwean economy by the combination of hyperinflation and the stable measuring unit assumption as part of the historical cost accounting model.

The lack of an effective international inflation accounting standard is due to the following:

(1) The very substantial problem of a lack of a single daily rate for the local currency in a fully fledged hyperinflationary economy and how to overcome that in an accounting standard.

(2) The fact that IAS 29 does not require - like the Unidade Real de Valor did - that all non-monetary items have to be updated at a daily non-monetary index rate. This eliminates any possibility of revoking the stable measuring unit assumption on a daily basis without which no inflation accounting model can be effective in a hyperinflationary economy.

(3) The fact that IAS 29 is fundamentally flawed in the way it defines monetary items which leads to many errors in application. See PricewaterhouseCoopers above.

(4) The novelty of the current real value principle whereby all non-monetary items are always updated to today's real value (the only real value we understand today) - in business and accounting practices as well as in financial reporting.

(5) The fact that IAS 29 requires updates to be done in terms of the Consumer Price Index in stead of the exchange rate between the local currency and the US Dollar.

See also

· Real versus nominal value